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The Project Gutenberg eBook of Accounting theory and
practice, Volume 2 (of 3)
This eBook is for the use of anyone anywhere in the United States and most
other parts of the world at no cost and with almost no restrictions
whatsoever. You may copy it, give it away or re-use it under the terms of
the Project Gutenberg License included with this eBook or online at
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this eBook.
Title: Accounting theory and practice, Volume 2 (of 3)
a textbook for colleges and schools of business administration
Author: Roy B. Kester
Release date: April 15, 2023 [eBook #70556]
Language: English
Original publication: United States: Ronald Press, 1922
Other information and formats: www.gutenberg.org/ebooks/70556
Credits: Richard Tonsing and the Online Distributed Proofreading Team at
https://www.pgdp.net (This file was produced from images
generously made available by The Internet Archive)
*** START OF THE PROJECT GUTENBERG EBOOK ACCOUNTING
THEORY AND PRACTICE, VOLUME 2 (OF 3) ***
practice, Volume 2 (of 3)
This eBook is for the use of anyone anywhere in the United States and most
other parts of the world at no cost and with almost no restrictions
whatsoever. You may copy it, give it away or re-use it under the terms of
the Project Gutenberg License included with this eBook or online at
www.gutenberg.org. If you are not located in the United States, you will
have to check the laws of the country where you are located before using
this eBook.
Title: Accounting theory and practice, Volume 2 (of 3)
a textbook for colleges and schools of business administration
Author: Roy B. Kester
Release date: April 15, 2023 [eBook #70556]
Language: English
Original publication: United States: Ronald Press, 1922
Other information and formats: www.gutenberg.org/ebooks/70556
Credits: Richard Tonsing and the Online Distributed Proofreading Team at
https://www.pgdp.net (This file was produced from images
generously made available by The Internet Archive)
*** START OF THE PROJECT GUTENBERG EBOOK ACCOUNTING
THEORY AND PRACTICE, VOLUME 2 (OF 3) ***
Page 4
ACCOUNTING
THEORY AND PRACTICE
A TEXT-BOOK FOR COLLEGES AND
SCHOOLS OF BUSINESS ADMINISTRATION
BY
ROY B. KESTER, Ph.D., C. P. A.
PROFESSOR OF ACCOUNTING, SCHOOL OF BUSINESS,
COLUMBIA UNIVERSITY
VOLUME II
(SECOND YEAR)
Twelfth Printing
NEW YORK
THE RONALD PRESS COMPANY
1922
THEORY AND PRACTICE
A TEXT-BOOK FOR COLLEGES AND
SCHOOLS OF BUSINESS ADMINISTRATION
BY
ROY B. KESTER, Ph.D., C. P. A.
PROFESSOR OF ACCOUNTING, SCHOOL OF BUSINESS,
COLUMBIA UNIVERSITY
VOLUME II
(SECOND YEAR)
Twelfth Printing
NEW YORK
THE RONALD PRESS COMPANY
1922
Page 5
Copyright, 1918, by
The Ronald Press Company
To Nancy
As a Tribute of Love and Tender
Memory to Her Mother
The Ronald Press Company
To Nancy
As a Tribute of Love and Tender
Memory to Her Mother
Page 6
PREFACE
A knowledge of the subject matter of Volume I is a prerequisite to the
profitable study of the present work. Therefore, it may be well to review
briefly the contents of the latter as an introduction to this book. In Volume I
the attempt was made to formulate and illustrate the basic principles upon
which the practice of accounting is founded. The principles of debit and
credit were developed and their application explained—as related
ultimately to the balance sheet and statement of profit and loss. The chief
books of original entry (the voucher register excepted) and the various
ledgers were described and illustrated. Columnar books, controlling
accounts, methods and devices for preventing and detecting errors, methods
for the proper handling of purchases, sales, cash, and trade discounts, and
some phases of proportion and interest were discussed in detail.
Some special applications of accounting principles, as viewed in
relation to the accounting problems involved therein, were also explained
and illustrated under such heads as: notes receivable discounted and
dishonored; consignments and approval sales; single and joint venture
accounts; accounts current, their reconciliation and adjustment; instalment
sales; sales for future delivery; single entry, its methods and the results
attainable under it; etc.
From the standpoint of business organization, the accounting problems
peculiar to the single proprietorship and the partnership were given full
treatment. The advantages and disadvantages of the various types of
organization, the rights and duties of owners among themselves and to
outsiders, the accounting procedure necessary under different conditions for
changing from one form of organization to another, and other like items
were set forth. Underlying the entire treatment of the subject was the
guiding principle that accounting is never an end in itself, that its right to
existence depends solely on the service it can render from the standpoint of
administrative and financial management.
In content, the present volume is primarily a study of the corporation, its
accounting and financial problems, although most of the material, in so far
A knowledge of the subject matter of Volume I is a prerequisite to the
profitable study of the present work. Therefore, it may be well to review
briefly the contents of the latter as an introduction to this book. In Volume I
the attempt was made to formulate and illustrate the basic principles upon
which the practice of accounting is founded. The principles of debit and
credit were developed and their application explained—as related
ultimately to the balance sheet and statement of profit and loss. The chief
books of original entry (the voucher register excepted) and the various
ledgers were described and illustrated. Columnar books, controlling
accounts, methods and devices for preventing and detecting errors, methods
for the proper handling of purchases, sales, cash, and trade discounts, and
some phases of proportion and interest were discussed in detail.
Some special applications of accounting principles, as viewed in
relation to the accounting problems involved therein, were also explained
and illustrated under such heads as: notes receivable discounted and
dishonored; consignments and approval sales; single and joint venture
accounts; accounts current, their reconciliation and adjustment; instalment
sales; sales for future delivery; single entry, its methods and the results
attainable under it; etc.
From the standpoint of business organization, the accounting problems
peculiar to the single proprietorship and the partnership were given full
treatment. The advantages and disadvantages of the various types of
organization, the rights and duties of owners among themselves and to
outsiders, the accounting procedure necessary under different conditions for
changing from one form of organization to another, and other like items
were set forth. Underlying the entire treatment of the subject was the
guiding principle that accounting is never an end in itself, that its right to
existence depends solely on the service it can render from the standpoint of
administrative and financial management.
In content, the present volume is primarily a study of the corporation, its
accounting and financial problems, although most of the material, in so far
Page 7
as it consists of a statement of general principles, is equally applicable to
other types of organization. The emphasis of the volume is laid upon the
problem of valuation as met in the commercial balance sheet. Chapters IV
to XXVII inclusive comprise this portion of the subject matter. The other
chapters treat miscellaneous matters, a knowledge of which is essential to
the student of accounting. These latter form parts of the work of the second
year as mapped out in the author’s scheme of instruction, whereby the
whole field of accounting is covered by a well-graded three-year course of
study. In this scheme cost accounting should be studied concurrently and as
a parallel course with the work of this second volume. Only a bare outline
of some of the problems and methods of cost accounting is presented in this
volume.
As to the division of the text and its use in the general scheme, it is
suggested that the first twenty-seven chapters should comprise the text
material for the first semester, leaving the remainder for the second
semester in which the chief emphasis should be placed on the solution of
problems rather than on the formal classroom lecture. Hence the text
material is lessened for this semester’s work, and the student’s main effort
is directed towards the application to the problems of business of the
principles already established.
Instead of following the plan of the first volume in placing the practice
work for the student at the end of each chapter of text, this material is
presented separately in three appendices. It is believed that this will be
found a more convenient arrangement.
The author desires to emphasize the need of ample practice work and at
the same time to take a stand against the method of teaching accounting
exclusively by the so-called laboratory or case method. A happy
combination of text containing a statement of principles and showing
methods of application, together with practice material intelligently made
up so as to require a knowledge of principles before solution, is the
desideratum in any course of instruction. Principles, theory, without
application are barren and soon slip away, even if seemingly understood at
the time. Practice without a thorough grounding in fundamental theory can
never be sure of itself. An equitable division of the student’s time between
theory and practice portions should be aimed at. In the present volume,
while the time required for the practice assignments may at times seem
other types of organization. The emphasis of the volume is laid upon the
problem of valuation as met in the commercial balance sheet. Chapters IV
to XXVII inclusive comprise this portion of the subject matter. The other
chapters treat miscellaneous matters, a knowledge of which is essential to
the student of accounting. These latter form parts of the work of the second
year as mapped out in the author’s scheme of instruction, whereby the
whole field of accounting is covered by a well-graded three-year course of
study. In this scheme cost accounting should be studied concurrently and as
a parallel course with the work of this second volume. Only a bare outline
of some of the problems and methods of cost accounting is presented in this
volume.
As to the division of the text and its use in the general scheme, it is
suggested that the first twenty-seven chapters should comprise the text
material for the first semester, leaving the remainder for the second
semester in which the chief emphasis should be placed on the solution of
problems rather than on the formal classroom lecture. Hence the text
material is lessened for this semester’s work, and the student’s main effort
is directed towards the application to the problems of business of the
principles already established.
Instead of following the plan of the first volume in placing the practice
work for the student at the end of each chapter of text, this material is
presented separately in three appendices. It is believed that this will be
found a more convenient arrangement.
The author desires to emphasize the need of ample practice work and at
the same time to take a stand against the method of teaching accounting
exclusively by the so-called laboratory or case method. A happy
combination of text containing a statement of principles and showing
methods of application, together with practice material intelligently made
up so as to require a knowledge of principles before solution, is the
desideratum in any course of instruction. Principles, theory, without
application are barren and soon slip away, even if seemingly understood at
the time. Practice without a thorough grounding in fundamental theory can
never be sure of itself. An equitable division of the student’s time between
theory and practice portions should be aimed at. In the present volume,
while the time required for the practice assignments may at times seem
Page 8
heavy, an attempt has been made to keep it to the minimum deemed
essential for adequate training either for general or professional use. It
cannot be too emphatically stated that accounting as a profession ranks as to
subject matter and the need for its services with the other professions. If it is
to enjoy equal honor, dignity, and professional standing, teachers and
practitioners must condemn without qualification the idea prevalent among
many that a few months’ training suffices to turn out a finished product. Too
often has such a course given point to the witticism that an accountant is a
bookkeeper without a job. As stated in the preface of Volume I, a course of
at least three years’ professional study is now quite generally recognized as
essential. Accounting is so broad in its many ramifications that less than
that gives inadequate training.
The reception accorded the first volume and the report of results
achieved in the classroom, through its use leads the author to hope that this
second volume may have a courteous hearing and trial. Criticisms and
suggestions will be much appreciated. The author hopes to be able to offer
in the not too remote future the third and concluding volume in this series
on general accounting.
The author is indebted for much assistance and counsel.
Acknowledgment is due Miss Nina Miller of the Columbia staff and Eric
Bodine for help in gathering and preparing much of the material for
Chapters XXVIII to XXXIII; to H. A. Inghram of the University of
Georgia, for preparation of a large part of Appendix D; to Leo Greendlinger
and David E. Boyce for the use of problems prepared by them; and to his
good friend, Joseph Gill, for help in reading the proof. To S. B. Koopman
and James F. Hughes of the Columbia staff in second year accounting, the
author is under special obligation for many suggestions. Mr. Koopman has
furnished most of the problems for Appendix B, and has collected those for
Appendix C.
As with Volume I, so in shaping the content of the present volume the
author has had the good counsel and ever ready help of his chief, Robert H.
Montgomery, and desires again to offer goodly acknowledgment, for his
debt is large.
R. B. Kester.
essential for adequate training either for general or professional use. It
cannot be too emphatically stated that accounting as a profession ranks as to
subject matter and the need for its services with the other professions. If it is
to enjoy equal honor, dignity, and professional standing, teachers and
practitioners must condemn without qualification the idea prevalent among
many that a few months’ training suffices to turn out a finished product. Too
often has such a course given point to the witticism that an accountant is a
bookkeeper without a job. As stated in the preface of Volume I, a course of
at least three years’ professional study is now quite generally recognized as
essential. Accounting is so broad in its many ramifications that less than
that gives inadequate training.
The reception accorded the first volume and the report of results
achieved in the classroom, through its use leads the author to hope that this
second volume may have a courteous hearing and trial. Criticisms and
suggestions will be much appreciated. The author hopes to be able to offer
in the not too remote future the third and concluding volume in this series
on general accounting.
The author is indebted for much assistance and counsel.
Acknowledgment is due Miss Nina Miller of the Columbia staff and Eric
Bodine for help in gathering and preparing much of the material for
Chapters XXVIII to XXXIII; to H. A. Inghram of the University of
Georgia, for preparation of a large part of Appendix D; to Leo Greendlinger
and David E. Boyce for the use of problems prepared by them; and to his
good friend, Joseph Gill, for help in reading the proof. To S. B. Koopman
and James F. Hughes of the Columbia staff in second year accounting, the
author is under special obligation for many suggestions. Mr. Koopman has
furnished most of the problems for Appendix B, and has collected those for
Appendix C.
As with Volume I, so in shaping the content of the present volume the
author has had the good counsel and ever ready help of his chief, Robert H.
Montgomery, and desires again to offer goodly acknowledgment, for his
debt is large.
R. B. Kester.
Page 9
Columbia University,
New York City, August 5, 1918.
New York City, August 5, 1918.
Page 10
CONTENTS
CHAPTER PAGE
I The Corporation 1
The Corporation
Classification and Definitions
Method of Ownership
Working Organization
Different Classes of Stock
Common Stock
Preferred Stock
Guaranteed Stock
Founders’ Stock
Debenture Stock
Stock of No Par Value
Watered Stock
Treasury Stock
Forfeited Stock
Bonus Stocks or Bonds
Accounting for Stocks
Discount on Stock
Premium on Stock
Property Exchanged for Stock
Treasury Stock Donated
Bonus Stock
Treasury Stock Purchased
Redemption of Preferred Stock
Forfeited Stock
Stock of No Par Value
Distinctive Records
Stock Ledger
Minute Book
Conclusion
CHAPTER PAGE
I The Corporation 1
The Corporation
Classification and Definitions
Method of Ownership
Working Organization
Different Classes of Stock
Common Stock
Preferred Stock
Guaranteed Stock
Founders’ Stock
Debenture Stock
Stock of No Par Value
Watered Stock
Treasury Stock
Forfeited Stock
Bonus Stocks or Bonds
Accounting for Stocks
Discount on Stock
Premium on Stock
Property Exchanged for Stock
Treasury Stock Donated
Bonus Stock
Treasury Stock Purchased
Redemption of Preferred Stock
Forfeited Stock
Stock of No Par Value
Distinctive Records
Stock Ledger
Minute Book
Conclusion
Page 11
II The Voucher System 26
Purchasing for the Manufacturing Business
Expansion of the Purchase Journal
Development of Voucher System
Definition and Description of Voucher
Operation of Voucher System
Voucher Check
Form of Voucher Register
Distribution of Vouchers
Posting of Summary Totals
Effect on Cash Book and Bank Account
Payment of Vouchers
Voucher Index of Creditors
Control of Vouchers Payable
Introduction of System
Purchase Returns and Allowances
Partial Payments
Handling of Notes Payable
Cash Discount on Purchases
Modifications of System
Summary of Operation and Advantages
III Factory Costs 49
Difference Between Factory and Financial Accounting
Definitions of Terms
Special Purposes of Cost Records
Nature of Raw Materials and Supplies
Accounting for Material Cost
Direct and Indirect Labor
Time-Keeping Records
Pay-Roll
Safeguarding the Pay-Roll
Distribution of Labor Charges
Expense
Purchasing for the Manufacturing Business
Expansion of the Purchase Journal
Development of Voucher System
Definition and Description of Voucher
Operation of Voucher System
Voucher Check
Form of Voucher Register
Distribution of Vouchers
Posting of Summary Totals
Effect on Cash Book and Bank Account
Payment of Vouchers
Voucher Index of Creditors
Control of Vouchers Payable
Introduction of System
Purchase Returns and Allowances
Partial Payments
Handling of Notes Payable
Cash Discount on Purchases
Modifications of System
Summary of Operation and Advantages
III Factory Costs 49
Difference Between Factory and Financial Accounting
Definitions of Terms
Special Purposes of Cost Records
Nature of Raw Materials and Supplies
Accounting for Material Cost
Direct and Indirect Labor
Time-Keeping Records
Pay-Roll
Safeguarding the Pay-Roll
Distribution of Labor Charges
Expense
Page 12
Summary of Manufacturing Cost
IV The Balance Sheet 60
Business Methods under the Microscope
The Reading of the Balance Sheet
Definition
Relation Between Balance Sheet and Trial Balance
Form of Balance Sheet
Purpose and Uses
Types of Balance Sheet
Origin of English Form of Balance Sheet
Variation of English Form
Balance Sheet Titles
Grouping and Classification
Arrangement of Groups
Report and Account Forms
Valuation Accounts
Statutory Requirements as to Frequency of
Balance Sheets
Condensation of Information in the Balance Sheet
Use of Supporting Schedules
V General Principles of Valuation 81
Content of the Balance Sheet
Valuations for Rate Regulation
Valuation for Sale and Purchase
Other Kinds of Valuations
Going Concern Valuation
Kinds of Value
Source of Data as to Values
Cost Value the Usual Basis
Definition of Capital and Revenue Expenditures
Organization Expenses
Definition of Replacements, Renewals, Maintenance, etc.
Treatment of Renewal of Parts
IV The Balance Sheet 60
Business Methods under the Microscope
The Reading of the Balance Sheet
Definition
Relation Between Balance Sheet and Trial Balance
Form of Balance Sheet
Purpose and Uses
Types of Balance Sheet
Origin of English Form of Balance Sheet
Variation of English Form
Balance Sheet Titles
Grouping and Classification
Arrangement of Groups
Report and Account Forms
Valuation Accounts
Statutory Requirements as to Frequency of
Balance Sheets
Condensation of Information in the Balance Sheet
Use of Supporting Schedules
V General Principles of Valuation 81
Content of the Balance Sheet
Valuations for Rate Regulation
Valuation for Sale and Purchase
Other Kinds of Valuations
Going Concern Valuation
Kinds of Value
Source of Data as to Values
Cost Value the Usual Basis
Definition of Capital and Revenue Expenditures
Organization Expenses
Definition of Replacements, Renewals, Maintenance, etc.
Treatment of Renewal of Parts
Page 13
Treatment of Cost-Cutting Changes
Asset Subject to Depreciation a Deferred Charge to Operations
Authorization of Booking Capital Expenditures
Repairs on Second-Hand Plant
Construction Costs
Distinction Between Capital and Revenue Expenditures
Often Based on Opinion
Main Groups of Asset Items
Valuation of Liability Items
Over- and Under-Valuation
The Balance Sheet an Expression of Opinion
VI Depreciation—Aspects and Definitions of Terms 99
Aspects of Depreciation
Definitions
Authoritative Opinions
Why the Depreciation Factor Arises
Actual or Absolute Depreciation
Theoretical Depreciation
Comparison of Actual and Theoretical Depreciation
“Accounting” and “Fair” Depreciation
Complete and Incomplete Depreciation
Individual and Composite Depreciation
Physical and Functional Depreciation
Deferred Maintenance and Accrued Depreciation
Attitude of the Law
Decision of Supreme Court
Recognition of the Depreciation Factor
Distinction Between Repairs and Renewals
Depreciation and Plant Efficiency
Unit Efficiency
Depreciation and Fluctuations in Market Value
Distinction Between Depreciation and Depletion
Effect on Different Kinds of Business
Asset Subject to Depreciation a Deferred Charge to Operations
Authorization of Booking Capital Expenditures
Repairs on Second-Hand Plant
Construction Costs
Distinction Between Capital and Revenue Expenditures
Often Based on Opinion
Main Groups of Asset Items
Valuation of Liability Items
Over- and Under-Valuation
The Balance Sheet an Expression of Opinion
VI Depreciation—Aspects and Definitions of Terms 99
Aspects of Depreciation
Definitions
Authoritative Opinions
Why the Depreciation Factor Arises
Actual or Absolute Depreciation
Theoretical Depreciation
Comparison of Actual and Theoretical Depreciation
“Accounting” and “Fair” Depreciation
Complete and Incomplete Depreciation
Individual and Composite Depreciation
Physical and Functional Depreciation
Deferred Maintenance and Accrued Depreciation
Attitude of the Law
Decision of Supreme Court
Recognition of the Depreciation Factor
Distinction Between Repairs and Renewals
Depreciation and Plant Efficiency
Unit Efficiency
Depreciation and Fluctuations in Market Value
Distinction Between Depreciation and Depletion
Effect on Different Kinds of Business
Page 14
VII Depreciation—Its Causes 120
Analysis of Causes
Age as a Cause of Depreciation
Wear and Tear of Use
Functional Depreciation
Inadequacy as a Factor
Inadequacy Through Change of Policy
Inadequacy Through Motives of Economy
Inadequacy Due to Unforeseen Development
Inadequacy Imposed from Without
Obsolescence as a Cause
Treatment of Obsolescence
Contingent Depreciation
Terminable Rights
Effective Depreciation
VIII Depreciation—Factors of Rate Determination 136
Fundamental Purpose of Depreciation
Depreciation a Cost of Operation
Complication of Short Fiscal Periods
The Factor of Idle Time
Depreciation a Means of Financing
Danger of the Financing Viewpoint
The Standardization of Depreciation Rates
Effect of Local Conditions
Factors in Determining Depreciation Rate
Bases of Normal Rate
Policies as to Repairs
Depreciation Rate an Engineering Problem
Attitude of Regulatory Bodies
Methods of Handling Repairs
IX Depreciation—Methods of Calculating 150
Methods of Calculation
Factors of Calculation
Analysis of Causes
Age as a Cause of Depreciation
Wear and Tear of Use
Functional Depreciation
Inadequacy as a Factor
Inadequacy Through Change of Policy
Inadequacy Through Motives of Economy
Inadequacy Due to Unforeseen Development
Inadequacy Imposed from Without
Obsolescence as a Cause
Treatment of Obsolescence
Contingent Depreciation
Terminable Rights
Effective Depreciation
VIII Depreciation—Factors of Rate Determination 136
Fundamental Purpose of Depreciation
Depreciation a Cost of Operation
Complication of Short Fiscal Periods
The Factor of Idle Time
Depreciation a Means of Financing
Danger of the Financing Viewpoint
The Standardization of Depreciation Rates
Effect of Local Conditions
Factors in Determining Depreciation Rate
Bases of Normal Rate
Policies as to Repairs
Depreciation Rate an Engineering Problem
Attitude of Regulatory Bodies
Methods of Handling Repairs
IX Depreciation—Methods of Calculating 150
Methods of Calculation
Factors of Calculation
Page 15
Symbols to be Used
1. Proportional Methods
(a) Straight Line Method
(b) Working Hours Method
(c) Composite Life Method
(d) Service Output Method
2. Variable Percentage Methods
(a) Fixed Percentage of Diminishing Value Method
(b) Changing Percentage of Cost Less Scrap Method
(c, d) Arbitrary Methods
3. Compound Interest Methods
(a) Sinking Fund Method
(b) Annuity Method
(c) Unit Cost Method
4. Miscellaneous Methods
(a) Maintenance Method
(b) Replacement Method
(c) The Fifty Per Cent Method
(d) Appraisal Method
(e) Insurance Method
(f) Gross Earnings Method
Condition Per Cent
X Depreciation—Appraisement of the various Methods 173
General Considerations
Ideal Basis for Distribution of Depreciation Charge
1. Proportional Methods
(a) Straight Line Method
(b) Working Hours Method
(c) Composite Life Method
(d) Service Output Method
2. Variable Percentage Methods
(a) Fixed Per Cent of Diminishing Value Method
(b) Sum of Expected Life-Periods Method
(c, d) Arbitrary Methods
1. Proportional Methods
(a) Straight Line Method
(b) Working Hours Method
(c) Composite Life Method
(d) Service Output Method
2. Variable Percentage Methods
(a) Fixed Percentage of Diminishing Value Method
(b) Changing Percentage of Cost Less Scrap Method
(c, d) Arbitrary Methods
3. Compound Interest Methods
(a) Sinking Fund Method
(b) Annuity Method
(c) Unit Cost Method
4. Miscellaneous Methods
(a) Maintenance Method
(b) Replacement Method
(c) The Fifty Per Cent Method
(d) Appraisal Method
(e) Insurance Method
(f) Gross Earnings Method
Condition Per Cent
X Depreciation—Appraisement of the various Methods 173
General Considerations
Ideal Basis for Distribution of Depreciation Charge
1. Proportional Methods
(a) Straight Line Method
(b) Working Hours Method
(c) Composite Life Method
(d) Service Output Method
2. Variable Percentage Methods
(a) Fixed Per Cent of Diminishing Value Method
(b) Sum of Expected Life-Periods Method
(c, d) Arbitrary Methods
Page 16
3. Compound Interest Methods
General Considerations
(a) Sinking Fund Method
(b) Annuity Method
(c) Unit Cost Method
4. Miscellaneous Methods
(a) Maintenance Method
(b) Replacement Method
(c) Fifty Per Cent Method
(d) Appraisal Method
(e) Insurance Method
(f) Percentage of Gross Earnings Method
Effect on Return on Investment
XI Recording Depreciation on the Books 187
Methods Commonly Employed
Renewals and Replacements
Subsidiary Records
Grouping and Classification of Plant Assets
Form of Plant Ledger
Asset Record
Periodic Revision of Rates
Frequency of Revision of Rates
Test of Condition Per Cent
Composite and Group Rates
The Reserve as an Index of Financial Condition
The Reserve in Relation to Expanding Plant
Reserve as Related to Efficiency
Reserve Not Based on Cost of Replacement
The Financing of Replacements
Secret Reserve
Insufficient Charge
Appreciation as an Offset to Depreciation
Appreciation Due to Physical Changes
Appreciation Due to Adaptation to Use
General Considerations
(a) Sinking Fund Method
(b) Annuity Method
(c) Unit Cost Method
4. Miscellaneous Methods
(a) Maintenance Method
(b) Replacement Method
(c) Fifty Per Cent Method
(d) Appraisal Method
(e) Insurance Method
(f) Percentage of Gross Earnings Method
Effect on Return on Investment
XI Recording Depreciation on the Books 187
Methods Commonly Employed
Renewals and Replacements
Subsidiary Records
Grouping and Classification of Plant Assets
Form of Plant Ledger
Asset Record
Periodic Revision of Rates
Frequency of Revision of Rates
Test of Condition Per Cent
Composite and Group Rates
The Reserve as an Index of Financial Condition
The Reserve in Relation to Expanding Plant
Reserve as Related to Efficiency
Reserve Not Based on Cost of Replacement
The Financing of Replacements
Secret Reserve
Insufficient Charge
Appreciation as an Offset to Depreciation
Appreciation Due to Physical Changes
Appreciation Due to Adaptation to Use
Page 17
Unearned Increment
Depreciation Policy and Stockholders
XII Cash and Mercantile Credits 210
Introduction
What Cash Includes
Stamps Remitted as Cash
Temporary Cash Disbursements
Disposition of Cash Funds
Cash Held Abroad
Accounts and Notes Receivable
Objection to the Title, Accounts Receivable
Risk for Credit Losses
Risk and Length of Credit Period
Analysis of Customers’ Accounts as the Basis
for Estimate of Bad Debts
Basis of Estimate of Bad Debts
Discounts and Collection Costs
Valuation of Other Receivable Items on Open Account
Loss on Notes Receivable
Interest on Notes Receivable
Balance Sheet Titles for Notes Receivable
XIII Merchandise Stock-in-Trade 225
Definition and Scope of Term
Valuation at Market or Cost Price
Objections to Valuation at Less than Cost
Anticipation of Profits or Losses Undesirable
Method of Treatment and Summary
Depreciation of Stock-in-Trade
Full Costs of Stock-in-Trade
The Distribution of Costs Over Stock-in-Trade
The Pricing of the Inventory
Valuation of Manufacturing Inventory
Contracts and Length of Cost Period
Depreciation Policy and Stockholders
XII Cash and Mercantile Credits 210
Introduction
What Cash Includes
Stamps Remitted as Cash
Temporary Cash Disbursements
Disposition of Cash Funds
Cash Held Abroad
Accounts and Notes Receivable
Objection to the Title, Accounts Receivable
Risk for Credit Losses
Risk and Length of Credit Period
Analysis of Customers’ Accounts as the Basis
for Estimate of Bad Debts
Basis of Estimate of Bad Debts
Discounts and Collection Costs
Valuation of Other Receivable Items on Open Account
Loss on Notes Receivable
Interest on Notes Receivable
Balance Sheet Titles for Notes Receivable
XIII Merchandise Stock-in-Trade 225
Definition and Scope of Term
Valuation at Market or Cost Price
Objections to Valuation at Less than Cost
Anticipation of Profits or Losses Undesirable
Method of Treatment and Summary
Depreciation of Stock-in-Trade
Full Costs of Stock-in-Trade
The Distribution of Costs Over Stock-in-Trade
The Pricing of the Inventory
Valuation of Manufacturing Inventory
Contracts and Length of Cost Period
Page 18
Valuation of Scrap
Inventory-Taking
Perpetual Inventory
XIV Temporary Investments; Accrued and Deferred Items 241
Temporary Investments
Nature of Temporary Investments
Valuation of Temporary Investments
Reserve for Investment Fluctuations
“Stock Rights” on Investments
Cost of Investments
Valuation of Bonds
Valuation of Unissued Stock
Valuation of Treasury Stock
Summary of Valuation Formula
Accrued and Deferred Items
Nature of Accrued Income
Inadequacy of Cash Method of Handling Accruals
Correct Method of Handling Accruals
Showing of Accrued Items on Balance Sheet
Valuation of Accrued Items
Accounting for Accrued Income
Illustration of Different Methods of Recording Accrued Items
Prepaid Items—Definitions and Kinds
Valuation of Prepaid Items
Danger of Overvaluation
Accounting for Deferred Debit and Other Items
XV Permanent Investments 258
Nature of Permanent Investments
Permanent Investments as an Aid to Operation
Valuation of Permanent Investments
Holding Company and Subsidiary Enterprises
Controlling Investments
Inventory-Taking
Perpetual Inventory
XIV Temporary Investments; Accrued and Deferred Items 241
Temporary Investments
Nature of Temporary Investments
Valuation of Temporary Investments
Reserve for Investment Fluctuations
“Stock Rights” on Investments
Cost of Investments
Valuation of Bonds
Valuation of Unissued Stock
Valuation of Treasury Stock
Summary of Valuation Formula
Accrued and Deferred Items
Nature of Accrued Income
Inadequacy of Cash Method of Handling Accruals
Correct Method of Handling Accruals
Showing of Accrued Items on Balance Sheet
Valuation of Accrued Items
Accounting for Accrued Income
Illustration of Different Methods of Recording Accrued Items
Prepaid Items—Definitions and Kinds
Valuation of Prepaid Items
Danger of Overvaluation
Accounting for Deferred Debit and Other Items
XV Permanent Investments 258
Nature of Permanent Investments
Permanent Investments as an Aid to Operation
Valuation of Permanent Investments
Holding Company and Subsidiary Enterprises
Controlling Investments
Page 19
Advances to Subsidiary Concerns
Rules for Valuation
Investments in Partial Holdings
Investments Producing No Income
Bond Values and Market Interest Rates
Nature of Bond Discount or Premium
Record of Bond Investments
Amortization of Bond Discount and Premium
Formulas for Compound Interest
Formulas for Annuities
Formulas for Bond Valuation
Valuation of Sinking Funds
Valuation of Investments in Land
XVI Machinery and Tools, Furniture and Fixtures,
and Other Equipment 279
General Considerations
Distinction between Personalty and Real Property
Machinery and Tools
Accounting Records
Operation of Machine Accounts
Valuation of Machinery and Tools
Estimate of Depreciation
History of Machine
Standards of Operation
Abnormal Operation
Map of Machine Location
Methods of Application of Depreciation
Basis of Valuation
Scrap Material
Accounting for Tools
Depreciation on Hand Tools
Valuation of Home-Made Machinery and Tools
Expenditure for Rearrangement of Machinery
Definition of Furniture and Fixtures
Rules for Valuation
Investments in Partial Holdings
Investments Producing No Income
Bond Values and Market Interest Rates
Nature of Bond Discount or Premium
Record of Bond Investments
Amortization of Bond Discount and Premium
Formulas for Compound Interest
Formulas for Annuities
Formulas for Bond Valuation
Valuation of Sinking Funds
Valuation of Investments in Land
XVI Machinery and Tools, Furniture and Fixtures,
and Other Equipment 279
General Considerations
Distinction between Personalty and Real Property
Machinery and Tools
Accounting Records
Operation of Machine Accounts
Valuation of Machinery and Tools
Estimate of Depreciation
History of Machine
Standards of Operation
Abnormal Operation
Map of Machine Location
Methods of Application of Depreciation
Basis of Valuation
Scrap Material
Accounting for Tools
Depreciation on Hand Tools
Valuation of Home-Made Machinery and Tools
Expenditure for Rearrangement of Machinery
Definition of Furniture and Fixtures
Page 20
Valuation of Furniture and Fixtures
Delivery Equipment—Definition and Valuation
Carriers and Containers—Valuation
Patterns, Molds, etc.—Valuation
Disposal of Assets
XVII Buildings, Land, and Wasting Assets 297
Definition of Real Property
Cost of Buildings
Valuation of Buildings
Betterments on Leased Buildings
Application of Depreciation
Accounting for Land
Valuation of Land
Depreciation or Appreciation of Land
Appreciation of Land Values
Depreciation in Land Values
Valuation of Land Investments
Mortgages on Land
Donated Land
Land as Stock-in-Trade
Wasting Assets—Definition and Characteristics
Dividends May Include Return of Capital
Basis of Depletion Charge
Application of Income Tax to Wasting Assets
Depreciation on Buildings and Machinery of a Wasting Asset
Unusual Risks
Water Rights
Leaseholds
XVIII Intangible Assets—Patents, Franchises, Good-Will 316
General Considerations
Patents a Monopoly Grant
Purchase of Patents
Patents Developed Within the Plant
Delivery Equipment—Definition and Valuation
Carriers and Containers—Valuation
Patterns, Molds, etc.—Valuation
Disposal of Assets
XVII Buildings, Land, and Wasting Assets 297
Definition of Real Property
Cost of Buildings
Valuation of Buildings
Betterments on Leased Buildings
Application of Depreciation
Accounting for Land
Valuation of Land
Depreciation or Appreciation of Land
Appreciation of Land Values
Depreciation in Land Values
Valuation of Land Investments
Mortgages on Land
Donated Land
Land as Stock-in-Trade
Wasting Assets—Definition and Characteristics
Dividends May Include Return of Capital
Basis of Depletion Charge
Application of Income Tax to Wasting Assets
Depreciation on Buildings and Machinery of a Wasting Asset
Unusual Risks
Water Rights
Leaseholds
XVIII Intangible Assets—Patents, Franchises, Good-Will 316
General Considerations
Patents a Monopoly Grant
Purchase of Patents
Patents Developed Within the Plant
Page 21
Patents Purchased and Not Used
Elements of Depreciation on Patents
Service Life of Patents
Booking Depreciation on Patents
Accounting Classification of Depreciation on Patents
Royalties
Relation of Depreciation Rate to Cost of Manufacture
Sale Price of Patents
Copyrights
Trade Secrets
Trade-Marks
Franchises—Definition and Kinds
Depreciation on Franchises
Organization Expenses
Good-Will—Definition and Nature
Local and Personal Character of Good-Will
Difficulty of Valuing Good-Will
Creation of Good-Will by Advertising
Valuation of Good-Will Based on Normal Profits
Valuation of Good-Will Based on Excess Profits
Valuation of Good-Will Based on Capitalization of Profits
False Good-Will to Cover Capital Deficiency
Periodic Revaluation of Good-Will
XIX Liabilities on the Balance Sheet; Current and
Contingent Liabilities 339
Form and Valuation
Arrangement on Balance Sheet
Items Within Groups
Cancellation of Liabilities Against Assets
Inventory of Liabilities
Contingent Liabilities
Current Liabilities
Loans from Bank
Elements of Depreciation on Patents
Service Life of Patents
Booking Depreciation on Patents
Accounting Classification of Depreciation on Patents
Royalties
Relation of Depreciation Rate to Cost of Manufacture
Sale Price of Patents
Copyrights
Trade Secrets
Trade-Marks
Franchises—Definition and Kinds
Depreciation on Franchises
Organization Expenses
Good-Will—Definition and Nature
Local and Personal Character of Good-Will
Difficulty of Valuing Good-Will
Creation of Good-Will by Advertising
Valuation of Good-Will Based on Normal Profits
Valuation of Good-Will Based on Excess Profits
Valuation of Good-Will Based on Capitalization of Profits
False Good-Will to Cover Capital Deficiency
Periodic Revaluation of Good-Will
XIX Liabilities on the Balance Sheet; Current and
Contingent Liabilities 339
Form and Valuation
Arrangement on Balance Sheet
Items Within Groups
Cancellation of Liabilities Against Assets
Inventory of Liabilities
Contingent Liabilities
Current Liabilities
Loans from Bank
Page 22
General Classification of Notes
Accounts Payable
Accrued Expenses
Booking of Accrued Expenses
Deferred Credits
Nature of Contingent Liabilities
Statement of Contingent Liabilities
Notes and Drafts Transferred
Guarantees as a Contingent Liability
Long-Term Leases
Purchases for Future Delivery
Pending Lawsuits
Stock Not Fully Paid
Accumulated Dividends on Preferred Stock
Signature to Surety Bond
XX Fixed Liabilities—Bonds and Mortgages 356
Nature of Fixed Liabilities
Purpose of Fixed Liabilities
Corporation Bonds
Nature of Bonds
Difference Between Bond and Real Estate Mortgages
Kinds of Corporation Bonds
Authority for the Issue of Bonds
Financial Considerations Involved in Issue
Bonds versus Stock Issues
Accounting for Bond Issue
Entry of Issue on Books
Entry of Premium or Discount on Books
Entry of Interest Payments on Books
Relation of Bond Interest to Premium or Discount
Example of True Interest Cost
Presentation on Balance Sheet
Other Fixed Liabilities
Accounts Payable
Accrued Expenses
Booking of Accrued Expenses
Deferred Credits
Nature of Contingent Liabilities
Statement of Contingent Liabilities
Notes and Drafts Transferred
Guarantees as a Contingent Liability
Long-Term Leases
Purchases for Future Delivery
Pending Lawsuits
Stock Not Fully Paid
Accumulated Dividends on Preferred Stock
Signature to Surety Bond
XX Fixed Liabilities—Bonds and Mortgages 356
Nature of Fixed Liabilities
Purpose of Fixed Liabilities
Corporation Bonds
Nature of Bonds
Difference Between Bond and Real Estate Mortgages
Kinds of Corporation Bonds
Authority for the Issue of Bonds
Financial Considerations Involved in Issue
Bonds versus Stock Issues
Accounting for Bond Issue
Entry of Issue on Books
Entry of Premium or Discount on Books
Entry of Interest Payments on Books
Relation of Bond Interest to Premium or Discount
Example of True Interest Cost
Presentation on Balance Sheet
Other Fixed Liabilities
Page 23
XXI Capital Stock and its Valuation 372
Problems in Valuation
Kinds of Stock
Par, Real, and Market Values
Value Dependent upon Earning Capacity
Increase of Book Capitalization
Capitalization on Cost
The Law and Stock Issues
Treatment of Discount or Premium
Valuation of Stock Issued for Property
Valuation of Treasury Stock
Redemption and Reduction of Capital Stock
Dividend Stock
Stock Issued as a Bonus
Unissued and Treasury Stock on the Balance Sheet
Preferred Stock Covered by Redemption Contract
XXII Profits 387
Difficulty of Determining Profits
Economic Definition
Legal Definition
Accounting Definition
Methods of Determining Profits
The Problem a Question of Valuation
Effect of Asset Losses on Future Profits
Legal Decisions as to Asset Losses
Loss Charged Against Current Profits
Loss Treated as Deferred Expense Charge
Loss Charged to Capital
Profit on Work in Progress
Goods Made for Stock but Not Sold
Goods Made to Order
Profits on Long-Term Contracts
Profit on Goods Awaiting Delivery
Problems in Valuation
Kinds of Stock
Par, Real, and Market Values
Value Dependent upon Earning Capacity
Increase of Book Capitalization
Capitalization on Cost
The Law and Stock Issues
Treatment of Discount or Premium
Valuation of Stock Issued for Property
Valuation of Treasury Stock
Redemption and Reduction of Capital Stock
Dividend Stock
Stock Issued as a Bonus
Unissued and Treasury Stock on the Balance Sheet
Preferred Stock Covered by Redemption Contract
XXII Profits 387
Difficulty of Determining Profits
Economic Definition
Legal Definition
Accounting Definition
Methods of Determining Profits
The Problem a Question of Valuation
Effect of Asset Losses on Future Profits
Legal Decisions as to Asset Losses
Loss Charged Against Current Profits
Loss Treated as Deferred Expense Charge
Loss Charged to Capital
Profit on Work in Progress
Goods Made for Stock but Not Sold
Goods Made to Order
Profits on Long-Term Contracts
Profit on Goods Awaiting Delivery
Page 24
Interdepartment Profits
Profits Due to Appreciation of Assets
Capital Profits
XXIII Surplus and Reserves 407
Definition
Creation of Margin
Disposition of Profits
Reserves
Different Meanings of Reserves
Reserve for Bad Debts
Under- and Over-Estimate of Reserves
Depletion Reserves
Operating Reserves for Accrued Costs
Collection Costs Not under Contract
Sales Discounts on the Balance Sheet
Distinction Between Reserves and Accrued Items
Contingent Reserves
Deferred Income—Misuse of Term
Proprietorship Reserves
Secret Reserves
Argument for Secret Reserve
Argument Against Secret Reserve
Earmarking of Reserves
Continuity of Reserve Policy
Covered Reserves
Classification of Reserves
Legitimate Use of Surplus Account
Statement of Surplus
XXIV Dividends 428
Introduction
Disposition of Corporation Profits
Shareholders’ Rights as to Profits
Directors’ Control over Profits
Profits Due to Appreciation of Assets
Capital Profits
XXIII Surplus and Reserves 407
Definition
Creation of Margin
Disposition of Profits
Reserves
Different Meanings of Reserves
Reserve for Bad Debts
Under- and Over-Estimate of Reserves
Depletion Reserves
Operating Reserves for Accrued Costs
Collection Costs Not under Contract
Sales Discounts on the Balance Sheet
Distinction Between Reserves and Accrued Items
Contingent Reserves
Deferred Income—Misuse of Term
Proprietorship Reserves
Secret Reserves
Argument for Secret Reserve
Argument Against Secret Reserve
Earmarking of Reserves
Continuity of Reserve Policy
Covered Reserves
Classification of Reserves
Legitimate Use of Surplus Account
Statement of Surplus
XXIV Dividends 428
Introduction
Disposition of Corporation Profits
Shareholders’ Rights as to Profits
Directors’ Control over Profits
Page 25
Provisos as to Declaration of Dividends
Stockholders’ Rights to Dividends
Declaration of Dividends
Liability of Director
Revocation of Dividends
Payment of Dividends
Dividends Paid as Salaries
Methods of Paying Dividends
Borrowing to Pay Dividends
Dividends Paid in Property, or by Borrowing on Property
Bond and Scrip Dividends
Stock Dividends
Dividends Proportional to Holdings
To Whom Payable
Accounting Record
Relation of Capital Losses to Dividends
Liquidating Dividends
XXV The Sinking Fund 447
Origin and Use
Definitions
Mathematical Principles on which Based
Accumulation Based on Agreement
Effect of Settlement of Debt
Relation of Fund to Profits
Accounting for Sinking Fund
The Sinking Fund on the Balance Sheet
Entries to Sinking Fund
Booking the Trustee’s Report
Treatment of Income and Expense
Final Disposition of Fund
Treatment of Sinking Fund Reserve
Relation Between Depreciation and Sinking Fund
XXVI Problems in Connection with the
Stockholders’ Rights to Dividends
Declaration of Dividends
Liability of Director
Revocation of Dividends
Payment of Dividends
Dividends Paid as Salaries
Methods of Paying Dividends
Borrowing to Pay Dividends
Dividends Paid in Property, or by Borrowing on Property
Bond and Scrip Dividends
Stock Dividends
Dividends Proportional to Holdings
To Whom Payable
Accounting Record
Relation of Capital Losses to Dividends
Liquidating Dividends
XXV The Sinking Fund 447
Origin and Use
Definitions
Mathematical Principles on which Based
Accumulation Based on Agreement
Effect of Settlement of Debt
Relation of Fund to Profits
Accounting for Sinking Fund
The Sinking Fund on the Balance Sheet
Entries to Sinking Fund
Booking the Trustee’s Report
Treatment of Income and Expense
Final Disposition of Fund
Treatment of Sinking Fund Reserve
Relation Between Depreciation and Sinking Fund
XXVI Problems in Connection with the
Page 26
Profit and Loss Summary 466
Interrelation of Profit and Loss and Balance Sheet
Periodic Adjustments
Interest as a Cost of Manufacture
Arguments Against the Inclusion of Interest
Problem of Charging Interest on Books
Unrealized Profits
Corporation Dividends
Discount on Bonds
Sinking Funds
Working Capital
The Correction of Closing Errors
XXVII The Profit and Loss Summary—Form and Content 477
Standardization of Form
Synonymous Terms
Cost of Goods Sold—Manufacturing Concern
Cost of Goods Sold—Trading Concern
Further Differentiation of Terms
Desirability of Uniformity in Terms Used
Profit and Method of Showing
Form of Presentation—Account Form
Non-Technical or Report Form
Examples of Forms of Presentation
Form for Manufacturers and Merchants
Content and Manner of Showing
Supporting Schedules
Adjustment of Inventories
Selling Expense and Administrative Schedules
Schedules for Special Needs
XXVIII Liquidation of a Corporation 493
Reasons for Liquidating—Partial and Complete Liquidation
Current Assets Transferred into Fixed Assets
Tying up Cash in Stocks of Material
Interrelation of Profit and Loss and Balance Sheet
Periodic Adjustments
Interest as a Cost of Manufacture
Arguments Against the Inclusion of Interest
Problem of Charging Interest on Books
Unrealized Profits
Corporation Dividends
Discount on Bonds
Sinking Funds
Working Capital
The Correction of Closing Errors
XXVII The Profit and Loss Summary—Form and Content 477
Standardization of Form
Synonymous Terms
Cost of Goods Sold—Manufacturing Concern
Cost of Goods Sold—Trading Concern
Further Differentiation of Terms
Desirability of Uniformity in Terms Used
Profit and Method of Showing
Form of Presentation—Account Form
Non-Technical or Report Form
Examples of Forms of Presentation
Form for Manufacturers and Merchants
Content and Manner of Showing
Supporting Schedules
Adjustment of Inventories
Selling Expense and Administrative Schedules
Schedules for Special Needs
XXVIII Liquidation of a Corporation 493
Reasons for Liquidating—Partial and Complete Liquidation
Current Assets Transferred into Fixed Assets
Tying up Cash in Stocks of Material
Page 27
Unwise Use of Cash for Paying Dividends
Inability to Secure Cash for Refunding Operations
Excessive Borrowing on Short-Term Securities
Losses in Conducting the Business
Loss Through Fraud, Theft, or Unavoidable Causes
Methods of Liquidation
Liquidation under Bankruptcy
Liquidation under Voluntary Dissolution
Liquidation under Receivership
Status of Creditors in Liquidation
Accounting for Liquidation
XXIX Combinations and Consolidations 507
Reason for Combination
Types of Consolidation
Accounting for the Holding Company
Distinction between Consolidation and Merger
Formation of Consolidation and Merger
Principles of Valuation of the Constituent Companies
Fundamental Principle of Equalization of Conditions
Valuation of Partnership
Earning Capacity
Good-Will
Capitalization of a Consolidation or a Merger
Payment of Amalgamated Interests
Closing the Books of the Merged Concerns
Opening the Books of the Merger
XXX Branch House Accounting 521
Advantages of Branch and Agency System
Agency and Branch Differentiated
Degree of Control Desired
Factors of Successful Management
Main Principles of Branch Accounting
Agency Accounts
Inability to Secure Cash for Refunding Operations
Excessive Borrowing on Short-Term Securities
Losses in Conducting the Business
Loss Through Fraud, Theft, or Unavoidable Causes
Methods of Liquidation
Liquidation under Bankruptcy
Liquidation under Voluntary Dissolution
Liquidation under Receivership
Status of Creditors in Liquidation
Accounting for Liquidation
XXIX Combinations and Consolidations 507
Reason for Combination
Types of Consolidation
Accounting for the Holding Company
Distinction between Consolidation and Merger
Formation of Consolidation and Merger
Principles of Valuation of the Constituent Companies
Fundamental Principle of Equalization of Conditions
Valuation of Partnership
Earning Capacity
Good-Will
Capitalization of a Consolidation or a Merger
Payment of Amalgamated Interests
Closing the Books of the Merged Concerns
Opening the Books of the Merger
XXX Branch House Accounting 521
Advantages of Branch and Agency System
Agency and Branch Differentiated
Degree of Control Desired
Factors of Successful Management
Main Principles of Branch Accounting
Agency Accounts
Page 28
Branch Accounting Records
Illustration of Simple Branch Accounts
Illustration of More Complex Branch Accounts
Purchases
Sales
Adjustments on Branch and Head Office Books
Example of Adjusting Entries
Reports from the Branch
Examples of Reports
XXXI Branch House Accounting (Continued) 542
Foreign Exchange
The Accounting Problem of the Foreign Branch
Accounts Opened on Books
Handling Fluctuations in Foreign Exchange
Conversion of Branch Results
Illustrative Bookkeeping Problems
Local Supervision of the Foreign Branch
The Foreign Sales Agency
Method of Conversion of Results
The Foreign Purchasing Agency
XXXII Suspense Accounts; Numbered Accounts;
Adjustment of Fire Losses 556
Suspense Accounts
Definition of Suspense Accounts—General Purpose
Reserve for Doubtful Accounts as a Suspense Account
Use of Suspense Ledger
Accounts Receivable Hypothecated
Accounting for Accounts Receivable Discounted
Numbered Accounts
Allotment of Numbers to Accounts
Adjustment of Fire Losses
Illustration of Simple Branch Accounts
Illustration of More Complex Branch Accounts
Purchases
Sales
Adjustments on Branch and Head Office Books
Example of Adjusting Entries
Reports from the Branch
Examples of Reports
XXXI Branch House Accounting (Continued) 542
Foreign Exchange
The Accounting Problem of the Foreign Branch
Accounts Opened on Books
Handling Fluctuations in Foreign Exchange
Conversion of Branch Results
Illustrative Bookkeeping Problems
Local Supervision of the Foreign Branch
The Foreign Sales Agency
Method of Conversion of Results
The Foreign Purchasing Agency
XXXII Suspense Accounts; Numbered Accounts;
Adjustment of Fire Losses 556
Suspense Accounts
Definition of Suspense Accounts—General Purpose
Reserve for Doubtful Accounts as a Suspense Account
Use of Suspense Ledger
Accounts Receivable Hypothecated
Accounting for Accounts Receivable Discounted
Numbered Accounts
Allotment of Numbers to Accounts
Adjustment of Fire Losses
Page 29
The Insurance Contract
Requirements in Case of Loss
Determination of Value of Loss
Adjustment of Differences
Effect of Coinsurance Clause
Method of Record-Keeping to Facilitate Ready Adjustment
Adjusting Entries for Fire Losses
XXXIII Statistics in Business; Private Books; Journal
Vouchers; Building Expenses and Income 581
Statistics in Business
Value of Business Statistics
Railroad Statistics
Manufacturing Statistics
Mercantile Statistics
Use of Graphs in the Presentation of Statistics
Advantages of the Use of Graphs
Principles of Graph Construction
Private Books
Purpose and Content
Operation of Private Books
Journal Vouchers
Need for the Journal Voucher
Index to Journal Vouchers
Content of Voucher
Other Methods of Authorizing Entries
Building Expenses and Income
Allocation of Building Expense
XXXIV The Consolidated Balance Sheet and
Profit and Loss Summary 600
Purpose and Function
Requirements in Case of Loss
Determination of Value of Loss
Adjustment of Differences
Effect of Coinsurance Clause
Method of Record-Keeping to Facilitate Ready Adjustment
Adjusting Entries for Fire Losses
XXXIII Statistics in Business; Private Books; Journal
Vouchers; Building Expenses and Income 581
Statistics in Business
Value of Business Statistics
Railroad Statistics
Manufacturing Statistics
Mercantile Statistics
Use of Graphs in the Presentation of Statistics
Advantages of the Use of Graphs
Principles of Graph Construction
Private Books
Purpose and Content
Operation of Private Books
Journal Vouchers
Need for the Journal Voucher
Index to Journal Vouchers
Content of Voucher
Other Methods of Authorizing Entries
Building Expenses and Income
Allocation of Building Expense
XXXIV The Consolidated Balance Sheet and
Profit and Loss Summary 600
Purpose and Function
Page 30
Problem of Partial Ownership
Conditions under which Used
The Setting Up of the Consolidated Balance Sheet
Showing of Intercompany Accounts
Showing of Notes Discounted
Reconcilement of Current Accounts
Valuation of Inventory
Reserve for Intercompany Profits
Valuation of Inventory—Minority Interests
Valuation of Liabilities
Showing of Capital Stock
Showing of Surplus
Showing of Deficit
Showing of Profit and Loss Summary
The Consolidated Profit and Loss Summary
Illustration of Consolidated Balance Sheet
XXXV Accounts and Reports of Receivers and Trustees 620
Appointment of Assignee or Receiver
Appointment of Trustee
Accounts and Reports of a Receiver in Equity
Reports to the Court
Accounts and Reports in Bankruptcy Proceedings
Initial Statements Presented to the Court
Reports and Accounts of Receiver or Trustee
Liquidating Dividends
Relative Standing of the Creditors
Statement of Affairs
Basis of Valuations in Statement of Affairs
Deficiency Account
Illustration of Statement of Affairs and Deficiency Account
Realization and Liquidation Account
Evolution of the Realization and Liquidation Account
Supporting Schedules
Conditions under which Used
The Setting Up of the Consolidated Balance Sheet
Showing of Intercompany Accounts
Showing of Notes Discounted
Reconcilement of Current Accounts
Valuation of Inventory
Reserve for Intercompany Profits
Valuation of Inventory—Minority Interests
Valuation of Liabilities
Showing of Capital Stock
Showing of Surplus
Showing of Deficit
Showing of Profit and Loss Summary
The Consolidated Profit and Loss Summary
Illustration of Consolidated Balance Sheet
XXXV Accounts and Reports of Receivers and Trustees 620
Appointment of Assignee or Receiver
Appointment of Trustee
Accounts and Reports of a Receiver in Equity
Reports to the Court
Accounts and Reports in Bankruptcy Proceedings
Initial Statements Presented to the Court
Reports and Accounts of Receiver or Trustee
Liquidating Dividends
Relative Standing of the Creditors
Statement of Affairs
Basis of Valuations in Statement of Affairs
Deficiency Account
Illustration of Statement of Affairs and Deficiency Account
Realization and Liquidation Account
Evolution of the Realization and Liquidation Account
Supporting Schedules
Page 31
The Question of Cash
The Handling of Valuation Reserves
Illustration of Realization and Liquidation Statement
Uses to which Realization and Liquidation Statement May be Put
Liquidation of a Partnership by Instalments
Nature of the Problem
Illustration of Liquidation by Instalments
Appendix A—Practice Work for Student—First Half-Year 655
B—Practice Work for Student—Second Half-Year 694
C—Miscellaneous Problems for Supplementary Work 727
D—Review Questions 755
FORMS AND CHARTS
Page
Stock Book or Stock Ledger 22
Stock Book to be Kept by Brokers
(New York Form Prescribed by Comptroller) 23
Stock Book to be Kept by Corporations and Transfer Agents
(New York Form Prescribed by Comptroller) 23
Voucher 30, 31
Voucher Check—Double 33
Voucher Check—Single 34
Voucher Register 35
Chart Showing Actual and Theoretical Depreciation 105
Chart Showing Progress of Uniform Depreciation
and of Diminishing Efficiency 115
Graphic Chart—Straight Line Method 153
Graphic Chart—Working Hours Method 155
Graphic Chart—Fixed Percentage of Diminishing Value Method 158
Graphic Chart—Sinking Fund Method 162
Graphic Chart—Annuity Method 166
Plant Ledger 193
Branch Report to Head Office 541
The Handling of Valuation Reserves
Illustration of Realization and Liquidation Statement
Uses to which Realization and Liquidation Statement May be Put
Liquidation of a Partnership by Instalments
Nature of the Problem
Illustration of Liquidation by Instalments
Appendix A—Practice Work for Student—First Half-Year 655
B—Practice Work for Student—Second Half-Year 694
C—Miscellaneous Problems for Supplementary Work 727
D—Review Questions 755
FORMS AND CHARTS
Page
Stock Book or Stock Ledger 22
Stock Book to be Kept by Brokers
(New York Form Prescribed by Comptroller) 23
Stock Book to be Kept by Corporations and Transfer Agents
(New York Form Prescribed by Comptroller) 23
Voucher 30, 31
Voucher Check—Double 33
Voucher Check—Single 34
Voucher Register 35
Chart Showing Actual and Theoretical Depreciation 105
Chart Showing Progress of Uniform Depreciation
and of Diminishing Efficiency 115
Graphic Chart—Straight Line Method 153
Graphic Chart—Working Hours Method 155
Graphic Chart—Fixed Percentage of Diminishing Value Method 158
Graphic Chart—Sinking Fund Method 162
Graphic Chart—Annuity Method 166
Plant Ledger 193
Branch Report to Head Office 541
Page 32
Head Office Ledger Account—Summary of Branch Expenses 541
Chart Showing Comparison of Sales with Cost of Advertising 585
Chart Showing Comparison of Sales with Gross Profits 586
Chart Showing Comparison of Sales, Purchases,
and Sales Salaries 587
Chart Showing Comparison of Sales with Cost of Sales 588
Journal Voucher 593
Card Index for Journal Vouchers 594, 595
Chart Showing Comparison of Sales with Cost of Advertising 585
Chart Showing Comparison of Sales with Gross Profits 586
Chart Showing Comparison of Sales, Purchases,
and Sales Salaries 587
Chart Showing Comparison of Sales with Cost of Sales 588
Journal Voucher 593
Card Index for Journal Vouchers 594, 595
Page 33
Accounting—Theory and Practice
Page 34
Page 35
CHAPTER I
THE CORPORATION
The Corporation
In Volume I, Chapters XLVIII and XLIX, the fundamental characteristics of
the corporation were explained and discussed briefly and some of its peculiar
accounting features were set forth. Here these matters will be gone into more
fully and additional aspects of this type of organization will be treated. In
Volume I were explained the advantages and disadvantages of the corporate
form, the procedure incident to the formation of a corporation, its charter,
officers, working organization and management, the records peculiar to a
corporation, the showing of proprietorship, opening the corporation’s books,
booking premium and discount on stock, change from partnership to
corporation, the distribution of profits, dividends, etc. Only so much of the
information already presented will now be repeated as may be necessary to
make the treatment here complete.
Classification and Definitions
As instruments for the transaction of business, corporations may be
classified in a number of ways. First, all corporations are either public or
private. Public corporations are the governmental organizations set up to
transact the collective business of a city, a county, a township, or school district.
Private corporations are divided into two subclasses, stock and non-stock.
Under stock corporations are included all those organized to carry on business
for a profit. Under non-stock corporations are included all those organized to
carry on non-profit-making enterprises, such as libraries, hospitals, religious
organizations, eleemosynary undertakings, etc.
Under the head of stock corporations we may have the following subclasses:
(a) industrial or manufacturing, (b) commercial or trading, (c) public utility or
quasi-public, and (d) financial, i.e., banks, trust companies, insurance
companies, etc.
From the standpoint of the sovereignty to which allegiance is due,
corporations are either domestic or foreign. A corporation is domestic in the
state in which it is organized; foreign in any other state or country. Thus
THE CORPORATION
The Corporation
In Volume I, Chapters XLVIII and XLIX, the fundamental characteristics of
the corporation were explained and discussed briefly and some of its peculiar
accounting features were set forth. Here these matters will be gone into more
fully and additional aspects of this type of organization will be treated. In
Volume I were explained the advantages and disadvantages of the corporate
form, the procedure incident to the formation of a corporation, its charter,
officers, working organization and management, the records peculiar to a
corporation, the showing of proprietorship, opening the corporation’s books,
booking premium and discount on stock, change from partnership to
corporation, the distribution of profits, dividends, etc. Only so much of the
information already presented will now be repeated as may be necessary to
make the treatment here complete.
Classification and Definitions
As instruments for the transaction of business, corporations may be
classified in a number of ways. First, all corporations are either public or
private. Public corporations are the governmental organizations set up to
transact the collective business of a city, a county, a township, or school district.
Private corporations are divided into two subclasses, stock and non-stock.
Under stock corporations are included all those organized to carry on business
for a profit. Under non-stock corporations are included all those organized to
carry on non-profit-making enterprises, such as libraries, hospitals, religious
organizations, eleemosynary undertakings, etc.
Under the head of stock corporations we may have the following subclasses:
(a) industrial or manufacturing, (b) commercial or trading, (c) public utility or
quasi-public, and (d) financial, i.e., banks, trust companies, insurance
companies, etc.
From the standpoint of the sovereignty to which allegiance is due,
corporations are either domestic or foreign. A corporation is domestic in the
state in which it is organized; foreign in any other state or country. Thus
Page 36
corporations chartered in New York are domestic in New York and foreign in
New Jersey and Canada. A foreign corporation may be at a distinct disadvantage
with a domestic corporation. To obviate this, one occasionally sees a separate
incorporation in every state in which a concern intends to do business. Very
infrequently is a domestic corporation subject to more stringent supervision and
regulation than a foreign.
From the standpoint of the fact of incorporation, corporations may be
classed as (1) de jure and (2) de facto, the former comprising those which have
met fully all legal requirements for incorporation, the latter comprising those
which have not met fully all legal requirements but are to all intents and
purposes corporations in fact.
Method of Ownership
Business corporations are sometimes spoken of as “open” or “close.” An
open corporation is one in which ownership of the stock is not held closely but
is being passed about, traded in, or transferred from one owner to a new. A close
corporation is one in which the stock is held very closely in order to retain
control and keep profits and trade secrets within a small compass of ownership.
Thus some corporations are strictly family affairs; others are held by a few
families or a small group.
What is known as a corporation “sole,” while little known now, virtually
exists in some close corporations, as where one man holds all but two shares of
stock. The incorporation of a single individual is not legally possible in this
country.
The corporation, because of its peculiar advantages over other forms of
business organization, has become the accepted form for most large enterprises.
The gathering together of large capital funds, the ease and efficiency of
management and control, continuous life, the facility of transfer of ownership,
and the limited liability of the stockholders, make the corporate form attractive
to the investor and absolutely necessary to the large businesses carried on today.
In some states encouragement is given the small business to incorporate; in the
State of New York, for example, the minimum limit of capitalization is only
$500. In a few other states the old-time fear of the corporate form is still
expressed in their general corporation laws in which the minimum limit for
corporate capitalization is set as high as $10,000.
Working Organization
New Jersey and Canada. A foreign corporation may be at a distinct disadvantage
with a domestic corporation. To obviate this, one occasionally sees a separate
incorporation in every state in which a concern intends to do business. Very
infrequently is a domestic corporation subject to more stringent supervision and
regulation than a foreign.
From the standpoint of the fact of incorporation, corporations may be
classed as (1) de jure and (2) de facto, the former comprising those which have
met fully all legal requirements for incorporation, the latter comprising those
which have not met fully all legal requirements but are to all intents and
purposes corporations in fact.
Method of Ownership
Business corporations are sometimes spoken of as “open” or “close.” An
open corporation is one in which ownership of the stock is not held closely but
is being passed about, traded in, or transferred from one owner to a new. A close
corporation is one in which the stock is held very closely in order to retain
control and keep profits and trade secrets within a small compass of ownership.
Thus some corporations are strictly family affairs; others are held by a few
families or a small group.
What is known as a corporation “sole,” while little known now, virtually
exists in some close corporations, as where one man holds all but two shares of
stock. The incorporation of a single individual is not legally possible in this
country.
The corporation, because of its peculiar advantages over other forms of
business organization, has become the accepted form for most large enterprises.
The gathering together of large capital funds, the ease and efficiency of
management and control, continuous life, the facility of transfer of ownership,
and the limited liability of the stockholders, make the corporate form attractive
to the investor and absolutely necessary to the large businesses carried on today.
In some states encouragement is given the small business to incorporate; in the
State of New York, for example, the minimum limit of capitalization is only
$500. In a few other states the old-time fear of the corporate form is still
expressed in their general corporation laws in which the minimum limit for
corporate capitalization is set as high as $10,000.
Working Organization
Page 37
The peculiar features of the stock corporation are the method of ownership
and working organization. This latter is effected through a board of directors
who are responsible directly to the owners at periodic intervals. Within the
board are its officers and committees to whom duties are assigned by by-laws,
custom, common consent or action of the board. Under these official heads are
the rank and file of the organization—department heads, clerks, employees, etc.
It is not necessary to treat here this phase of the organization further.
Different Classes of Stock
The collective capital of a corporation is divided into shares of equal value.
Ownership of a share or shares in a corporation is evidenced by formal
certificates of stock. Each share carries with it the same privileges, powers, and
duties of ownership as every other share of the same class. It represents a pro
rata share of the total interest of its class. There may be several different kinds
or classes of ownership within the corporation, these classes will have different
privileges, and there may be other points of differentiation. The reason for
setting up these different classes is almost always to secure additional capital
from outside sources by making the investment as attractive as possible. Upon a
reorganization, an adjustment of the various interests concerned may require a
grading of ownership, a differentiation by classes in order equitably to satisfy
the claims of all interested parties. These various classes of stock ownership
will be discussed under the following heads:
1. Common
2. Preferred
3. Guaranteed
4. Founders’
5. Debenture
Common Stock
Common or ordinary stock is that which is evidence of ordinary ownership
in the corporation. The share of ownership of the original organizers of the
corporation is usually in the common stock. The common stockholder is a sort
of remainderman, a residuary legatee. Upon dissolution, after the special claims
and privileges of the other classes of owners have been satisfied, the common
stockholders come in for their share. After the satisfaction of the claims of
preferred owners, the common stockholders have a right to all that is left, their
rights being simply residuary. They are subsequent to those of the other classes
and to that extent inferior to them, though they may be more valuable.
and working organization. This latter is effected through a board of directors
who are responsible directly to the owners at periodic intervals. Within the
board are its officers and committees to whom duties are assigned by by-laws,
custom, common consent or action of the board. Under these official heads are
the rank and file of the organization—department heads, clerks, employees, etc.
It is not necessary to treat here this phase of the organization further.
Different Classes of Stock
The collective capital of a corporation is divided into shares of equal value.
Ownership of a share or shares in a corporation is evidenced by formal
certificates of stock. Each share carries with it the same privileges, powers, and
duties of ownership as every other share of the same class. It represents a pro
rata share of the total interest of its class. There may be several different kinds
or classes of ownership within the corporation, these classes will have different
privileges, and there may be other points of differentiation. The reason for
setting up these different classes is almost always to secure additional capital
from outside sources by making the investment as attractive as possible. Upon a
reorganization, an adjustment of the various interests concerned may require a
grading of ownership, a differentiation by classes in order equitably to satisfy
the claims of all interested parties. These various classes of stock ownership
will be discussed under the following heads:
1. Common
2. Preferred
3. Guaranteed
4. Founders’
5. Debenture
Common Stock
Common or ordinary stock is that which is evidence of ordinary ownership
in the corporation. The share of ownership of the original organizers of the
corporation is usually in the common stock. The common stockholder is a sort
of remainderman, a residuary legatee. Upon dissolution, after the special claims
and privileges of the other classes of owners have been satisfied, the common
stockholders come in for their share. After the satisfaction of the claims of
preferred owners, the common stockholders have a right to all that is left, their
rights being simply residuary. They are subsequent to those of the other classes
and to that extent inferior to them, though they may be more valuable.
Page 38
Preferred Stock
Preferred stock has some kind of preference over the common. Such stocks
differ among themselves, there being no standardized features applicable in
every way to all kinds of preferred stocks. The basic purpose of the various
preferences is to make the stock attractive from an investment standpoint.
Common to all preferred stocks, however, is a preference as to dividends.
Whenever profits have been made and have been set aside for dividend
purposes, the preferred stockholders receive their dividends ahead of the
common stockholders. If only sufficient profits are available to meet the
requirements of the preferred stockholders and are appropriated for that
purpose, the common owners receive nothing. Stock may be preferred as to
assets as well as to profits. By this is meant that in case of dissolution the net
assets remaining after payment of all outside claims are applied first to satisfy
the interests of the owners of preferred stock and any remainder then goes to the
common stockholders.
Cumulative and Non-Cumulative. Preferred stock carries with it a definitely
stated minimum rate of dividend. The preferred claim to the profits may be
cumulative or non-cumulative. In the one case, if profits are insufficient at any
time to meet the preferred dividend requirements or are not appropriated for that
purpose, the claims of the preferred owners accumulate from period to period
until satisfied in full. This satisfaction must take place before the ordinary
owners can have any share in the profits. The rate of accumulation is the
specified minimum and usually interest on unpaid dividends is allowed when
the company finally settles these preferred claims. Of course, since dividends
can be declared only out of profits, no claim for preferred dividends or any
other kind can exist unless sufficient profits have been made. Non-cumulative
stock is stock on which the dividend claim does not, if unsatisfied at any time,
accumulate from period to period. Preferred stock is cumulative unless
otherwise specified.
Dividends on cumulative stock do not have to be paid just because sufficient
profits have been made. Declaration of dividends rests entirely with the board of
directors who may see fit to appropriate profits to other purposes. A holder of
non-cumulative stock may be very unjustly discriminated against in favor of the
common stockholder by the withholding of all profits for a number of periods
until a large amount has been accumulated. This is then disbursed as a dividend
to the common owners after the deduction of as much as may be necessary to
satisfy the preferred owner for the current period. On this account a non-
cumulative stock is not attractive to investors.
Preferred stock has some kind of preference over the common. Such stocks
differ among themselves, there being no standardized features applicable in
every way to all kinds of preferred stocks. The basic purpose of the various
preferences is to make the stock attractive from an investment standpoint.
Common to all preferred stocks, however, is a preference as to dividends.
Whenever profits have been made and have been set aside for dividend
purposes, the preferred stockholders receive their dividends ahead of the
common stockholders. If only sufficient profits are available to meet the
requirements of the preferred stockholders and are appropriated for that
purpose, the common owners receive nothing. Stock may be preferred as to
assets as well as to profits. By this is meant that in case of dissolution the net
assets remaining after payment of all outside claims are applied first to satisfy
the interests of the owners of preferred stock and any remainder then goes to the
common stockholders.
Cumulative and Non-Cumulative. Preferred stock carries with it a definitely
stated minimum rate of dividend. The preferred claim to the profits may be
cumulative or non-cumulative. In the one case, if profits are insufficient at any
time to meet the preferred dividend requirements or are not appropriated for that
purpose, the claims of the preferred owners accumulate from period to period
until satisfied in full. This satisfaction must take place before the ordinary
owners can have any share in the profits. The rate of accumulation is the
specified minimum and usually interest on unpaid dividends is allowed when
the company finally settles these preferred claims. Of course, since dividends
can be declared only out of profits, no claim for preferred dividends or any
other kind can exist unless sufficient profits have been made. Non-cumulative
stock is stock on which the dividend claim does not, if unsatisfied at any time,
accumulate from period to period. Preferred stock is cumulative unless
otherwise specified.
Dividends on cumulative stock do not have to be paid just because sufficient
profits have been made. Declaration of dividends rests entirely with the board of
directors who may see fit to appropriate profits to other purposes. A holder of
non-cumulative stock may be very unjustly discriminated against in favor of the
common stockholder by the withholding of all profits for a number of periods
until a large amount has been accumulated. This is then disbursed as a dividend
to the common owners after the deduction of as much as may be necessary to
satisfy the preferred owner for the current period. On this account a non-
cumulative stock is not attractive to investors.
Page 39
Participating and Non-Participating. Preferred stock may be participating
or non-participating. It is said to be participating when the terms under which it
is issued provide that it shall share in any dividend in excess of its own
specified minimum. Thus, if it is 6% preferred, after the preferred receives its
6% the common stock receives a like dividend, and then the preferred and
common may share alike or in any agreed ratio in any further dividends
declared in that year. Both participating and non-participating stock is either
cumulative or non-cumulative. Preferred stock is non-participating when it is
limited to the rate of dividend specified in the terms of its issue.
Redeemable and Convertible. Other features met in some preferred stocks
are redeemability and convertibility. Preferred stock may be issued under a
contract to redeem it, after a certain length of time, at a named figure—
frequently par plus one year’s dividend. Redemption may be either at the option
of the holder or the company. Redemption may be serial, i.e., a certain amount
called at stated intervals for redemption. Preferred stock is convertible when
under the contract in the terms of its issue it may be converted into some other
form of ownership or obligation. Thus, provision may be made that after a
certain time has elapsed, preferred shares may be converted into common
according to specified rates of conversion; or conversion into bonds of the
company is sometimes provided for. Many nice adjustments may become
necessary from an accounting viewpoint, when redemption or conversion take
place at any ratio other than book values.
Guaranteed Stock
Stock which is issued under a guarantee to pay a specified dividend is said
to be guaranteed stock. Inasmuch as dividends can be declared only out of
profits, a company cannot guarantee its own stock—or rather a guarantee on the
company’s own issue must always be dependent or contingent upon the earning
of profits sufficient for that purpose. Stock issued by one company and
guaranteed by another may with strict propriety be called guaranteed stock.
Thus, a large company may enter into a contract of lease with a smaller concern
whereby the compensation shall be, let us say, an 8% dividend guaranteed to all
holders of the stock of the smaller concern. Such a guarantee is not contingent
but becomes a lien or claim on the guarantor company, regardless of the amount
of its earnings.
Founders’ Stock
or non-participating. It is said to be participating when the terms under which it
is issued provide that it shall share in any dividend in excess of its own
specified minimum. Thus, if it is 6% preferred, after the preferred receives its
6% the common stock receives a like dividend, and then the preferred and
common may share alike or in any agreed ratio in any further dividends
declared in that year. Both participating and non-participating stock is either
cumulative or non-cumulative. Preferred stock is non-participating when it is
limited to the rate of dividend specified in the terms of its issue.
Redeemable and Convertible. Other features met in some preferred stocks
are redeemability and convertibility. Preferred stock may be issued under a
contract to redeem it, after a certain length of time, at a named figure—
frequently par plus one year’s dividend. Redemption may be either at the option
of the holder or the company. Redemption may be serial, i.e., a certain amount
called at stated intervals for redemption. Preferred stock is convertible when
under the contract in the terms of its issue it may be converted into some other
form of ownership or obligation. Thus, provision may be made that after a
certain time has elapsed, preferred shares may be converted into common
according to specified rates of conversion; or conversion into bonds of the
company is sometimes provided for. Many nice adjustments may become
necessary from an accounting viewpoint, when redemption or conversion take
place at any ratio other than book values.
Guaranteed Stock
Stock which is issued under a guarantee to pay a specified dividend is said
to be guaranteed stock. Inasmuch as dividends can be declared only out of
profits, a company cannot guarantee its own stock—or rather a guarantee on the
company’s own issue must always be dependent or contingent upon the earning
of profits sufficient for that purpose. Stock issued by one company and
guaranteed by another may with strict propriety be called guaranteed stock.
Thus, a large company may enter into a contract of lease with a smaller concern
whereby the compensation shall be, let us say, an 8% dividend guaranteed to all
holders of the stock of the smaller concern. Such a guarantee is not contingent
but becomes a lien or claim on the guarantor company, regardless of the amount
of its earnings.
Founders’ Stock
Page 40
In England there is issued what is known as “founders’” stock, a stock
preferred as to its share of dividends. Thus, a comparatively small portion of the
common stock authorized might be set aside as founders’ or promoters’ shares
with the stipulation that these founders’ shares shall receive a dividend out of
proportion to the ratio which they bear to the total common stock. The provision
might be that these shares shall receive one-half or one-third—or any other
specified share—more dividends than shall be given to the common owners.
Instead of being preferred stock with specified dividend rate, it is preferred over
the rest of the shares of the group from which it was originally set aside but its
share of dividends is dependent upon the dividends given the rest of the shares.
The par value of the founders’ shares might represent only one-twentieth of the
value of the rest of the group, while their share of the dividends would be, say,
one-fourth as much as that of the other shares. This preference as to amount of
dividends may give founders’ shares a much higher market value than the other
shares. Provision is sometimes made for their redemption, as usually there is
such a marked difference between their amount ratio and their dividend ratio as
compared with the other shares, that dissatisfaction among the owners results.
Outstanding founders’ shares may then interfere seriously with the marketability
of the other shares.
Debenture Stock
The term debenture stock is applied to a class of liabilities rather than to
proprietorship items. In England debentures of various kinds are frequently
used. A recent book[1] thus describes them: “In Great Britain the term
‘debenture stock’ is used to designate an unsecured loan issued in irregular
amounts. If the amounts were fixed and equal, the issue would be called
‘debenture bonds’ or simply ‘debentures.’ Debenture stock is a debt of the
corporation and does not resemble stock as used in this country.” Debenture
stock has not proven popular in this country, although used to some extent in
Canada. The Public Service Commission of the State of New York defines
debenture stocks as “those issued under contract to pay absolutely thereon at
specified intervals a specified return.” These stocks, while usually of limited life
like bonds, are sometimes “perpetual and give the holders no right to demand
the repayment of their capital, and the company no right to repay it.”[2] When
issued as perpetual, they somewhat resemble capital stock, as the term stock is
used in this country. Because of the fixed and absolute charge for interest—or
dividends as it is sometimes called—which these stocks carry, they are much
more of the nature of bonds than of a stock indicating proprietorship. Debenture
stocks are therefore to be classed as liabilities.
preferred as to its share of dividends. Thus, a comparatively small portion of the
common stock authorized might be set aside as founders’ or promoters’ shares
with the stipulation that these founders’ shares shall receive a dividend out of
proportion to the ratio which they bear to the total common stock. The provision
might be that these shares shall receive one-half or one-third—or any other
specified share—more dividends than shall be given to the common owners.
Instead of being preferred stock with specified dividend rate, it is preferred over
the rest of the shares of the group from which it was originally set aside but its
share of dividends is dependent upon the dividends given the rest of the shares.
The par value of the founders’ shares might represent only one-twentieth of the
value of the rest of the group, while their share of the dividends would be, say,
one-fourth as much as that of the other shares. This preference as to amount of
dividends may give founders’ shares a much higher market value than the other
shares. Provision is sometimes made for their redemption, as usually there is
such a marked difference between their amount ratio and their dividend ratio as
compared with the other shares, that dissatisfaction among the owners results.
Outstanding founders’ shares may then interfere seriously with the marketability
of the other shares.
Debenture Stock
The term debenture stock is applied to a class of liabilities rather than to
proprietorship items. In England debentures of various kinds are frequently
used. A recent book[1] thus describes them: “In Great Britain the term
‘debenture stock’ is used to designate an unsecured loan issued in irregular
amounts. If the amounts were fixed and equal, the issue would be called
‘debenture bonds’ or simply ‘debentures.’ Debenture stock is a debt of the
corporation and does not resemble stock as used in this country.” Debenture
stock has not proven popular in this country, although used to some extent in
Canada. The Public Service Commission of the State of New York defines
debenture stocks as “those issued under contract to pay absolutely thereon at
specified intervals a specified return.” These stocks, while usually of limited life
like bonds, are sometimes “perpetual and give the holders no right to demand
the repayment of their capital, and the company no right to repay it.”[2] When
issued as perpetual, they somewhat resemble capital stock, as the term stock is
used in this country. Because of the fixed and absolute charge for interest—or
dividends as it is sometimes called—which these stocks carry, they are much
more of the nature of bonds than of a stock indicating proprietorship. Debenture
stocks are therefore to be classed as liabilities.
Page 41
Stock of No Par Value
A characteristic of most stock is that it bears a specified par value which
must be uniform for all the shares within a class. The par value of the different
classes may differ, however. In most states no regulation is made of the amount
of par value. A par value of $100 is customary for industrial and commercial
concerns, and of $1 for mining companies. Between those limits, and even
beyond them, one finds stocks of almost any par value.
In the State of New York the issuance of stock of no par value is allowed.
Both preferred and common classes may be issued without par value, but if the
preferred shares have preference as to assets, the certificates for preferred shares
shall state “the amount which the holders of each of such preferred shares shall
be entitled to receive on account of principal from the surplus assets of the
corporation in preference to the holders of other shares.” With this exception,
none of the certificates may express any nominal or par value and this statement
of the amount of preference is regarded as an expression of par value for this
purpose. Each share is equal to every other share within its class.
Every certificate of such stock must bear plainly on its face the number of
shares which it represents and the number of shares the corporation is
authorized to issue. Regardless of the price paid for a share of such stock, all
shares issued by the corporation shall be “deemed fully paid and non-assessable
and the holder of such shares shall not be liable to the corporation or its
creditors in respect thereof.”
To the heedless a named value on a certificate of stock is sometimes
misleading as to the real value of the stock. The no-par-value stock overcomes
this in that a prospective purchaser is at once put on his guard to find out the
worth of the stock. Another advantageous feature is that the questionable
practices sometimes indulged in of booking stocks sold at a discount have no
place here because the stocks, having no par value, cannot be sold at a discount
and the record of their sale will carry therefore the price at which they were
sold. Some points in connection with booking this stock will be discussed later.
Watered Stock
So-called watered stock is stock which has a higher nominal value than the
true value of the properties for which it has been issued. Thus, if $1,000,000
worth—par value—of stock is issued for the purchase of property which has a
marketable value of only $750,000, the stock is said to be watered to the extent
of $250,000. The bookkeeping equation requires that an equality be shown
A characteristic of most stock is that it bears a specified par value which
must be uniform for all the shares within a class. The par value of the different
classes may differ, however. In most states no regulation is made of the amount
of par value. A par value of $100 is customary for industrial and commercial
concerns, and of $1 for mining companies. Between those limits, and even
beyond them, one finds stocks of almost any par value.
In the State of New York the issuance of stock of no par value is allowed.
Both preferred and common classes may be issued without par value, but if the
preferred shares have preference as to assets, the certificates for preferred shares
shall state “the amount which the holders of each of such preferred shares shall
be entitled to receive on account of principal from the surplus assets of the
corporation in preference to the holders of other shares.” With this exception,
none of the certificates may express any nominal or par value and this statement
of the amount of preference is regarded as an expression of par value for this
purpose. Each share is equal to every other share within its class.
Every certificate of such stock must bear plainly on its face the number of
shares which it represents and the number of shares the corporation is
authorized to issue. Regardless of the price paid for a share of such stock, all
shares issued by the corporation shall be “deemed fully paid and non-assessable
and the holder of such shares shall not be liable to the corporation or its
creditors in respect thereof.”
To the heedless a named value on a certificate of stock is sometimes
misleading as to the real value of the stock. The no-par-value stock overcomes
this in that a prospective purchaser is at once put on his guard to find out the
worth of the stock. Another advantageous feature is that the questionable
practices sometimes indulged in of booking stocks sold at a discount have no
place here because the stocks, having no par value, cannot be sold at a discount
and the record of their sale will carry therefore the price at which they were
sold. Some points in connection with booking this stock will be discussed later.
Watered Stock
So-called watered stock is stock which has a higher nominal value than the
true value of the properties for which it has been issued. Thus, if $1,000,000
worth—par value—of stock is issued for the purchase of property which has a
marketable value of only $750,000, the stock is said to be watered to the extent
of $250,000. The bookkeeping equation requires that an equality be shown
Page 42
between the properties purchased and the par value of the stock, and this is
usually done by inflating the value of the properties when they are brought onto
the books.
Treasury Stock
Treasury stock, when the term is used properly, is stock which has been
once issued as fully paid and which through purchase or gift comes back into
possession of the issuing company. Stock which has never been issued should
not be called treasury stock. The distinction between the two lies in the liability
(or freedom from it) to further contribution, in case of need to meet the claims
of creditors, on the part of stockholders who have bought their shares at less
than par value.
In some states the sale of stock at less than par is forbidden. In those states
where the practice is allowed, the purchaser of a previously unissued share at
less than par is liable to the creditors (if the assets are insufficient to satisfy their
claims) for a further contribution equal to the difference between par value and
the price paid for the stock. If, though he pays less than par, the stock is issued
to him by the corporation as fully paid and non-assessable, he is not liable to the
corporation for any further payment to entitle him to all the rights and privileges
of a shareholder; but he may be liable in case of need to outside creditors who
have a right to expect always that assets of equal value to the stock issued
therefor have come into possession of the corporation. As mentioned above, this
trouble is obviated in the case of no-par-value stock. However, after stock has
once been paid for in full, all future purchasers may hold it without liability for
further contribution regardless of the price they pay for it. Because of its
freedom from this liability, treasury stock has a readier marketability than
unissued stock.
In some enterprises, particularly those of a speculative character where it is
extremely difficult if not impossible to place a true valuation on the property to
be used or exploited, the practice is very prevalent of issuing the entire
authorized capital stock in payment for the properties to be acquired. The stock
so issued thus becomes fully paid and its owners liable to no further
contribution. To provide working capital, some portion of the stock is usually
donated to the company for resale. This is sometimes called donated stock and
is, of course, true treasury stock. In states where a corporation is permitted to
buy its own stock, treasury stock may be acquired by purchase. Theoretically,
stock which has been issued under a contract providing for redemption becomes
treasury stock when redeemed and may be reissued until it has been canceled
usually done by inflating the value of the properties when they are brought onto
the books.
Treasury Stock
Treasury stock, when the term is used properly, is stock which has been
once issued as fully paid and which through purchase or gift comes back into
possession of the issuing company. Stock which has never been issued should
not be called treasury stock. The distinction between the two lies in the liability
(or freedom from it) to further contribution, in case of need to meet the claims
of creditors, on the part of stockholders who have bought their shares at less
than par value.
In some states the sale of stock at less than par is forbidden. In those states
where the practice is allowed, the purchaser of a previously unissued share at
less than par is liable to the creditors (if the assets are insufficient to satisfy their
claims) for a further contribution equal to the difference between par value and
the price paid for the stock. If, though he pays less than par, the stock is issued
to him by the corporation as fully paid and non-assessable, he is not liable to the
corporation for any further payment to entitle him to all the rights and privileges
of a shareholder; but he may be liable in case of need to outside creditors who
have a right to expect always that assets of equal value to the stock issued
therefor have come into possession of the corporation. As mentioned above, this
trouble is obviated in the case of no-par-value stock. However, after stock has
once been paid for in full, all future purchasers may hold it without liability for
further contribution regardless of the price they pay for it. Because of its
freedom from this liability, treasury stock has a readier marketability than
unissued stock.
In some enterprises, particularly those of a speculative character where it is
extremely difficult if not impossible to place a true valuation on the property to
be used or exploited, the practice is very prevalent of issuing the entire
authorized capital stock in payment for the properties to be acquired. The stock
so issued thus becomes fully paid and its owners liable to no further
contribution. To provide working capital, some portion of the stock is usually
donated to the company for resale. This is sometimes called donated stock and
is, of course, true treasury stock. In states where a corporation is permitted to
buy its own stock, treasury stock may be acquired by purchase. Theoretically,
stock which has been issued under a contract providing for redemption becomes
treasury stock when redeemed and may be reissued until it has been canceled
Page 43
through charter provision to reduce the capital authorized. (See also pages 15,
16.)
Forfeited Stock
Stock is said to be forfeited through failure to make the agreed purchase
payments on it. The laws of the different states vary with regard to the
conditions under which stock may be declared forfeited. In some states the
instalments paid on the stock—or all but a small amount to cover the cost of
handling the transaction, or a specified portion of the amount paid in—must be
returned to the purchaser. In others, the entire amount paid in may be declared
forfeited. In the State of New York the provision in the law is as follows: “If
default shall be made in the payment of any instalment ... the board may declare
the stock and all previous payments thereon forfeited for the use of the
corporation, after the expiration of sixty days from the service on the defaulting
stockholder, personally or by mail directed to him at his last-known post-office
address, of a written notice requiring him to make payment within sixty days
from the service of the notice at a place specified therein, and stating that, in
case of failure to do so, his stock and all previous payments thereon will be
forfeited for the use of the corporation. Such stock, if forfeited, may be reissued
or subscriptions therefor may be received as in the case of stock not issued or
subscribed for. If not sold for its par value or subscribed for within six months
after such forfeiture, it shall be canceled and deducted from the amount of the
capital stock.” The provisions are very specific and must be carefully followed.
The method of accounting is given on page 19.
Bonus Stocks or Bonds
Bonus stocks or bonds are stocks or bonds given as a bonus upon the
purchase of other stocks or bonds. Thus, upon the purchase of a share of
preferred stock, one share of common may be given as a bonus.
Accounting for Stocks
Accounting for the original issue of stock has been treated in Volume I.
There several different methods of opening the records of the corporation were
given and the manner of treating premiums and discount and instalment
subscriptions was shown. Here some additional problems peculiar to
corporation accounting will be discussed.
Discount on Stock
16.)
Forfeited Stock
Stock is said to be forfeited through failure to make the agreed purchase
payments on it. The laws of the different states vary with regard to the
conditions under which stock may be declared forfeited. In some states the
instalments paid on the stock—or all but a small amount to cover the cost of
handling the transaction, or a specified portion of the amount paid in—must be
returned to the purchaser. In others, the entire amount paid in may be declared
forfeited. In the State of New York the provision in the law is as follows: “If
default shall be made in the payment of any instalment ... the board may declare
the stock and all previous payments thereon forfeited for the use of the
corporation, after the expiration of sixty days from the service on the defaulting
stockholder, personally or by mail directed to him at his last-known post-office
address, of a written notice requiring him to make payment within sixty days
from the service of the notice at a place specified therein, and stating that, in
case of failure to do so, his stock and all previous payments thereon will be
forfeited for the use of the corporation. Such stock, if forfeited, may be reissued
or subscriptions therefor may be received as in the case of stock not issued or
subscribed for. If not sold for its par value or subscribed for within six months
after such forfeiture, it shall be canceled and deducted from the amount of the
capital stock.” The provisions are very specific and must be carefully followed.
The method of accounting is given on page 19.
Bonus Stocks or Bonds
Bonus stocks or bonds are stocks or bonds given as a bonus upon the
purchase of other stocks or bonds. Thus, upon the purchase of a share of
preferred stock, one share of common may be given as a bonus.
Accounting for Stocks
Accounting for the original issue of stock has been treated in Volume I.
There several different methods of opening the records of the corporation were
given and the manner of treating premiums and discount and instalment
subscriptions was shown. Here some additional problems peculiar to
corporation accounting will be discussed.
Discount on Stock
Page 44
In the State of New York the stock of a corporation cannot be sold below
par. Where sale below par is allowed, the proper booking of the discount
requires consideration. The Interstate Commerce Commission requires that
discounts or premiums be shown on the books under those titles, i.e., Discount
on Capital Stock and Premium on Capital Stock. This method is to be
commended as being true to fact and presenting a full and sufficient record of
the facts. In the case of other concerns over whose accounting practices there is
no regulation, that method is honored more in the breach than in the observance.
A prevalent feeling is that the appearance on a balance sheet of such an item as
discount on stock is a serious reflection on the standing of the corporation and is
to be avoided in any way possible. Discount on stock is not an attractive item on
a balance sheet, but there is little justification for such sentiment in those states
where the sale of stock at a discount is a perfectly legitimate transaction. The
balance sheet ought to represent facts as they are until they change; then the
new conditions should be shown. So long as the discount on stock remains a
fact it should be so shown. When the discount has ceased to exist through its
absorption against premium on stock or the general surplus, it should no longer
be reported because it is then a matter of ancient history with which the present
is not concerned.
A favorite method of charging the discount on stock to organization expense
is not approved, not because it is a misnomer, for discount may well be looked
upon as one of the expenses of organization, but because it is an item of
sufficient importance and interest to require separate record. Charging the
discount to some asset account, when payment of stock is made by property
instead of by cash, is to be severely condemned. Inflation of asset values to
cover up such an item cannot be justified.
Premium on Stock
The premium on stock sold above par is best recorded in a premium account
which should remain on the books as a part of the permanent capital and not
therefore be transferred to surplus and returned as a dividend to the shareholder.
It may be legitimately used to cancel any discounts.
In the State of New York a corporation cannot issue its stock “except for
money, labor done, or property actually received for the use and lawful
purposes of such corporation.” A broad interpretation has been given the word
labor so that under the law it may comprise both manual and mental labor and
services of almost any kind legitimately received at the time of organization of
par. Where sale below par is allowed, the proper booking of the discount
requires consideration. The Interstate Commerce Commission requires that
discounts or premiums be shown on the books under those titles, i.e., Discount
on Capital Stock and Premium on Capital Stock. This method is to be
commended as being true to fact and presenting a full and sufficient record of
the facts. In the case of other concerns over whose accounting practices there is
no regulation, that method is honored more in the breach than in the observance.
A prevalent feeling is that the appearance on a balance sheet of such an item as
discount on stock is a serious reflection on the standing of the corporation and is
to be avoided in any way possible. Discount on stock is not an attractive item on
a balance sheet, but there is little justification for such sentiment in those states
where the sale of stock at a discount is a perfectly legitimate transaction. The
balance sheet ought to represent facts as they are until they change; then the
new conditions should be shown. So long as the discount on stock remains a
fact it should be so shown. When the discount has ceased to exist through its
absorption against premium on stock or the general surplus, it should no longer
be reported because it is then a matter of ancient history with which the present
is not concerned.
A favorite method of charging the discount on stock to organization expense
is not approved, not because it is a misnomer, for discount may well be looked
upon as one of the expenses of organization, but because it is an item of
sufficient importance and interest to require separate record. Charging the
discount to some asset account, when payment of stock is made by property
instead of by cash, is to be severely condemned. Inflation of asset values to
cover up such an item cannot be justified.
Premium on Stock
The premium on stock sold above par is best recorded in a premium account
which should remain on the books as a part of the permanent capital and not
therefore be transferred to surplus and returned as a dividend to the shareholder.
It may be legitimately used to cancel any discounts.
In the State of New York a corporation cannot issue its stock “except for
money, labor done, or property actually received for the use and lawful
purposes of such corporation.” A broad interpretation has been given the word
labor so that under the law it may comprise both manual and mental labor and
services of almost any kind legitimately received at the time of organization of
Page 45
the corporation or at any subsequent time. Stock may thus be used to pay for
organization expense, promoters’ fees, etc.
Property Exchanged for Stock
Where stock is issued for property, no more is supposed to be issued than
has a par value equal to a fair market value of the property received therefor. In
valuing the property the judgment of the directors is conclusive, unless fraud
can be shown. Any stock issued for property becomes full-paid and the owner is
neither subject to further call by the corporation nor liable to contribution for
the benefit of creditors. In all statements and reports required by law to be
published, stock issued for property purchased must be so reported.
Treasury Stock Donated
When treasury stock comes into the possession of the company by donation,
the entries needed to show the transactions are somewhat as indicated below,
some variations from the form shown being sometimes met with. Practice varies
as to the value at which treasury stock shall be brought onto the books, some
concerns booking it at an arbitrary value based on an estimate as to what it will
probably bring when sold; others booking it always at par. Practice varies also
as to the manner of showing treasury stock on the balance sheet, some listing it
among the assets at the value at which it was brought on the books; others
treating it as a deduction from authorized capital, a sort of valuation account for
the capital stock. These points are discussed in Chapter XXI and will not be
treated here except to state a conclusion on which the booking of the
transactions depends. Manifestly, if treasury stock is to be treated as a deduction
from capital stock, it will have to be brought onto the books at par. Such
treatment usually results in an inflated showing of the surplus arising from the
donation until that has been adjusted to the values realized from its sale—an
adjustment which cannot be completed with accuracy until all treasury stock has
been disposed of. If treasury stock is to be shown among the assets on the
balance sheet, it is perhaps best booked at an estimated realizable price, a
method which will show the donated surplus also at an estimated realizable
figure. While authorities differ on these points, the weight of opinion seems to
favor booking treasury stock at par and showing it as a valuation account on the
balance sheet.
For the sake of illustration assume that the stockholders donated $100,000
par value of common stock to the corporation and that $50,000 of it is sold at 60
cents on the dollar. The entries to record the transactions would be:
organization expense, promoters’ fees, etc.
Property Exchanged for Stock
Where stock is issued for property, no more is supposed to be issued than
has a par value equal to a fair market value of the property received therefor. In
valuing the property the judgment of the directors is conclusive, unless fraud
can be shown. Any stock issued for property becomes full-paid and the owner is
neither subject to further call by the corporation nor liable to contribution for
the benefit of creditors. In all statements and reports required by law to be
published, stock issued for property purchased must be so reported.
Treasury Stock Donated
When treasury stock comes into the possession of the company by donation,
the entries needed to show the transactions are somewhat as indicated below,
some variations from the form shown being sometimes met with. Practice varies
as to the value at which treasury stock shall be brought onto the books, some
concerns booking it at an arbitrary value based on an estimate as to what it will
probably bring when sold; others booking it always at par. Practice varies also
as to the manner of showing treasury stock on the balance sheet, some listing it
among the assets at the value at which it was brought on the books; others
treating it as a deduction from authorized capital, a sort of valuation account for
the capital stock. These points are discussed in Chapter XXI and will not be
treated here except to state a conclusion on which the booking of the
transactions depends. Manifestly, if treasury stock is to be treated as a deduction
from capital stock, it will have to be brought onto the books at par. Such
treatment usually results in an inflated showing of the surplus arising from the
donation until that has been adjusted to the values realized from its sale—an
adjustment which cannot be completed with accuracy until all treasury stock has
been disposed of. If treasury stock is to be shown among the assets on the
balance sheet, it is perhaps best booked at an estimated realizable price, a
method which will show the donated surplus also at an estimated realizable
figure. While authorities differ on these points, the weight of opinion seems to
favor booking treasury stock at par and showing it as a valuation account on the
balance sheet.
For the sake of illustration assume that the stockholders donated $100,000
par value of common stock to the corporation and that $50,000 of it is sold at 60
cents on the dollar. The entries to record the transactions would be:
Page 46
(1) Treasury Stock, Common $100,000.00
Donated Surplus $100,000.00
(With suitable explanation.)
(2) Cash 30,000.00
Discount on Treasury Stock, Common 20,000.00
Treasury Stock, Common 50,000.00
Other titles for Donated Surplus are “Donated Working Capital,” “Donation
Account,” etc. The account “Discount on Treasury Stock, Common” will
ultimately be closed against Donated Surplus, and there is no objection to
making the charge for discount directly to Donated Surplus instead of as shown
above, although the method shown perhaps makes more easily available the
information as to the discounts allowed on sales of various portions of the
treasury stock. If it is sold at one price, the charge for the discount should be
direct to Donated Surplus. A balance sheet drawn up at an intermediate period,
i.e., before Discount on Treasury Stock is closed, should show Donated Surplus
at its adjusted figure, viz., book value less discount. After all treasury stock has
been sold, the Donated Surplus account, as adjusted, will show the true surplus
arising out of the donation transactions. The proper disposition of this—as to
whether it should be maintained as a permanent increase in capital, be
transferred to general surplus and so be made available for dividends, or be
treated as a deduction from plant values on the theory that they have been
overstated as originally booked—is discussed in detail in Chapter XXI.
Bonus Stock
Bonus stock is usually treasury stock for the very good reason that, if it
carried a liability for contribution in amount up to its par value, recipients of
such stock might not be overly appreciative of the gift. Instead of being an
incentive to purchase the securities which it accompanies as a bonus, it might
act as a deterrent. Bonus stock is a gift on the part of the corporation and is
therefore an expense. While custom favors recording the expense under the title
“Bonus”—or even including it with organization expenses—and treating it as a
deferred expense for a number of periods, a correct analysis of a bonus stock
transaction may dictate other method of record. If the bonus stock is given with
an issue of bonds which could by themselves be disposed of only at a discount,
the difference between the market value of the bonds alone and their par value
should be charged to Bond Discount, and the rest of the loss on the transaction
may be charged either to Bonus account or Discount on Treasury Stock. This
Donated Surplus $100,000.00
(With suitable explanation.)
(2) Cash 30,000.00
Discount on Treasury Stock, Common 20,000.00
Treasury Stock, Common 50,000.00
Other titles for Donated Surplus are “Donated Working Capital,” “Donation
Account,” etc. The account “Discount on Treasury Stock, Common” will
ultimately be closed against Donated Surplus, and there is no objection to
making the charge for discount directly to Donated Surplus instead of as shown
above, although the method shown perhaps makes more easily available the
information as to the discounts allowed on sales of various portions of the
treasury stock. If it is sold at one price, the charge for the discount should be
direct to Donated Surplus. A balance sheet drawn up at an intermediate period,
i.e., before Discount on Treasury Stock is closed, should show Donated Surplus
at its adjusted figure, viz., book value less discount. After all treasury stock has
been sold, the Donated Surplus account, as adjusted, will show the true surplus
arising out of the donation transactions. The proper disposition of this—as to
whether it should be maintained as a permanent increase in capital, be
transferred to general surplus and so be made available for dividends, or be
treated as a deduction from plant values on the theory that they have been
overstated as originally booked—is discussed in detail in Chapter XXI.
Bonus Stock
Bonus stock is usually treasury stock for the very good reason that, if it
carried a liability for contribution in amount up to its par value, recipients of
such stock might not be overly appreciative of the gift. Instead of being an
incentive to purchase the securities which it accompanies as a bonus, it might
act as a deterrent. Bonus stock is a gift on the part of the corporation and is
therefore an expense. While custom favors recording the expense under the title
“Bonus”—or even including it with organization expenses—and treating it as a
deferred expense for a number of periods, a correct analysis of a bonus stock
transaction may dictate other method of record. If the bonus stock is given with
an issue of bonds which could by themselves be disposed of only at a discount,
the difference between the market value of the bonds alone and their par value
should be charged to Bond Discount, and the rest of the loss on the transaction
may be charged either to Bonus account or Discount on Treasury Stock. This
Page 47
distinction is important, as will be seen in Chapter XX where the true nature of
bond discount is discussed. When data are available for making the separation it
should always be done. Thus, if a $1,000 par bond has a market price of $950
but when sold with one share ($100) of treasury stock as a bonus brings $1,000,
the record should be:
(3) Cash $1,000.00
Bond Discount 50.00
Bonus (or Discount on Treasury Stock) 50.00
Bonds Payable $1,000.00
Treasury Stock 100.00
The customary method of showing, as in entry (4) below, is theoretically
incorrect, though it may be necessary to use it when the data needed for the
other entry, i.e., (3) above, are not available.
(4) Cash $1,000.00
Bonus 100.00
Bonds Payable $1,000.00
Treasury Stock 100.00
If a bonus of treasury stock is given with the sale of preferred stock, similar
treatment would make possible a showing of the portion which is really
discount on stock and the portion, if any, which is true bonus. Inasmuch as
discount on stock and bonus are very similar in kind and in manner of treatment
on the books, nothing of real value is perhaps gained in making the separation.
The ultimate disposition of the Bonus account is, as indicated above, to treat it
as a deferred expense, charging it against profits as rapidly as conditions
warrant. It is an undesirable item on the balance sheet or ledger and should be
expunged as soon as possible.
Treasury Stock Purchased
Treasury stock which is created by purchase by the issuing company
requires consideration. If the price paid is less than par, carrying the treasury
stock on the books at par requires an offsetting credit account similar to the
Donated Surplus account used above when the stock is created by donation.
This credit account simply represents a book surplus and should not usually be
made the basis for a dividend. This account may be called “Treasury Stock
Surplus,” “Contingent Profit on Treasury Stock Bought,” or other title
bond discount is discussed. When data are available for making the separation it
should always be done. Thus, if a $1,000 par bond has a market price of $950
but when sold with one share ($100) of treasury stock as a bonus brings $1,000,
the record should be:
(3) Cash $1,000.00
Bond Discount 50.00
Bonus (or Discount on Treasury Stock) 50.00
Bonds Payable $1,000.00
Treasury Stock 100.00
The customary method of showing, as in entry (4) below, is theoretically
incorrect, though it may be necessary to use it when the data needed for the
other entry, i.e., (3) above, are not available.
(4) Cash $1,000.00
Bonus 100.00
Bonds Payable $1,000.00
Treasury Stock 100.00
If a bonus of treasury stock is given with the sale of preferred stock, similar
treatment would make possible a showing of the portion which is really
discount on stock and the portion, if any, which is true bonus. Inasmuch as
discount on stock and bonus are very similar in kind and in manner of treatment
on the books, nothing of real value is perhaps gained in making the separation.
The ultimate disposition of the Bonus account is, as indicated above, to treat it
as a deferred expense, charging it against profits as rapidly as conditions
warrant. It is an undesirable item on the balance sheet or ledger and should be
expunged as soon as possible.
Treasury Stock Purchased
Treasury stock which is created by purchase by the issuing company
requires consideration. If the price paid is less than par, carrying the treasury
stock on the books at par requires an offsetting credit account similar to the
Donated Surplus account used above when the stock is created by donation.
This credit account simply represents a book surplus and should not usually be
made the basis for a dividend. This account may be called “Treasury Stock
Surplus,” “Contingent Profit on Treasury Stock Bought,” or other title
Page 48
indicating the true nature of the item. When the treasury stock is resold and the
discount or premium on it is charged against this surplus or credited to it, as the
case may be, the balance of the Treasury Stock Surplus account will then show
the realized profit or loss on the completed treasury stock transactions and may
be disposed of as indicated above for Donated Surplus.
On the other hand, if the price paid by the company in the purchase of its
own stock is more than par, the premium paid must be charged against general
surplus because there is usually no other place for the charge unless there is still
open on the books a Premium on Stock account arising out of a previous sale of
stock at a premium. Purchase of stock at a premium may represent simply the
payment to the owner of the stock of his share in the general surplus of the
company, in which case the premium paid must be shown as a reduction of that
surplus.
Redemption of Preferred Stock
Handling redemption of a preferred stock issue is exactly the same as
handling treasury stock by purchase. If by contract agreement at the time the
preferred stock was issued it can only be redeemed at a premium, the premium
must be charged, as indicated above, to an open premium account or to general
surplus. The effect is similar to the payment of a special or extra dividend at the
time redemption is made.
Forfeited Stock
Payments made on stock which is declared forfeited constitute an item of
surplus but of a permanent nature, i.e., not a surplus applicable to the
declaration of dividends, though there may be no legal inhibition to that use. If
the stock is resold any discount on the resale is properly charged against the
surplus arising from the forfeiture. By way of illustration, assume that $1,000
worth of stock has been subscribed for and payments amounting to $400 have
been made when the stock is forfeited for failure to pay further instalments. The
stock is offered again for subscription and is sold for $900 and payment has
been received in full. The entries necessary to show the above are:
(5) Subscribers $1,000.00
Capital Stock Subscriptions $1,000.00
(6) Cash 400.00
Subscribers 400.00
(7) Subscribers 400.00
discount or premium on it is charged against this surplus or credited to it, as the
case may be, the balance of the Treasury Stock Surplus account will then show
the realized profit or loss on the completed treasury stock transactions and may
be disposed of as indicated above for Donated Surplus.
On the other hand, if the price paid by the company in the purchase of its
own stock is more than par, the premium paid must be charged against general
surplus because there is usually no other place for the charge unless there is still
open on the books a Premium on Stock account arising out of a previous sale of
stock at a premium. Purchase of stock at a premium may represent simply the
payment to the owner of the stock of his share in the general surplus of the
company, in which case the premium paid must be shown as a reduction of that
surplus.
Redemption of Preferred Stock
Handling redemption of a preferred stock issue is exactly the same as
handling treasury stock by purchase. If by contract agreement at the time the
preferred stock was issued it can only be redeemed at a premium, the premium
must be charged, as indicated above, to an open premium account or to general
surplus. The effect is similar to the payment of a special or extra dividend at the
time redemption is made.
Forfeited Stock
Payments made on stock which is declared forfeited constitute an item of
surplus but of a permanent nature, i.e., not a surplus applicable to the
declaration of dividends, though there may be no legal inhibition to that use. If
the stock is resold any discount on the resale is properly charged against the
surplus arising from the forfeiture. By way of illustration, assume that $1,000
worth of stock has been subscribed for and payments amounting to $400 have
been made when the stock is forfeited for failure to pay further instalments. The
stock is offered again for subscription and is sold for $900 and payment has
been received in full. The entries necessary to show the above are:
(5) Subscribers $1,000.00
Capital Stock Subscriptions $1,000.00
(6) Cash 400.00
Subscribers 400.00
(7) Subscribers 400.00
Page 49
Surplus from Forfeited Stock. 400.00
To transfer the forfeited
payments to Surplus.
(8) Capital Stock Subscriptions $1,000.00
Subscribers $1,000.00
To reverse.
(9) Subscribers 900.00
Surplus from Forfeited Stock 100.00
Capital Stock Subscriptions 1,000.00
(10) Cash 900.00
Subscribers 900.00
(11) Capital Stock Subscriptions 1,000.00
Capital Stock 1,000.00
Stock of No Par Value
Booking capital stock of no par value presents no new principles. Inasmuch
as the stock has no fixed par value, its sale is recorded for what it fetches. There
can be neither discount nor premium. Payment of the subscription may be
made, just as in any other case, by means of cash, property, or services, and the
same care must be exercised in placing proper valuations on the property taken
over. Here there is not the danger of inflating property values to show them
equivalent to the par value of the stock issued therefor. Rather, subscription for
the stock is made at the figure of the fair value of the property to be turned over
in payment of the subscription. In the case of no-par-value stock even greater
care must be exercised to see that the contributed capital shall never be
encroached upon in the declaration of dividends, and careful supervision is
somewhat more difficult because the number of shares issued bears no relation
to the amount of the capital stock.
Distinctive Records
The accounting and other records peculiar to a corporation are explained in
Volume I, Chapter XLVIII. These records are the subscription book and
subscription ledger or instalment book, the stock certificate book and stock
ledger, the stock transfer book, the minute book, sometimes a dividend book, in
large companies a register of transfers (which classifies the information as to
To transfer the forfeited
payments to Surplus.
(8) Capital Stock Subscriptions $1,000.00
Subscribers $1,000.00
To reverse.
(9) Subscribers 900.00
Surplus from Forfeited Stock 100.00
Capital Stock Subscriptions 1,000.00
(10) Cash 900.00
Subscribers 900.00
(11) Capital Stock Subscriptions 1,000.00
Capital Stock 1,000.00
Stock of No Par Value
Booking capital stock of no par value presents no new principles. Inasmuch
as the stock has no fixed par value, its sale is recorded for what it fetches. There
can be neither discount nor premium. Payment of the subscription may be
made, just as in any other case, by means of cash, property, or services, and the
same care must be exercised in placing proper valuations on the property taken
over. Here there is not the danger of inflating property values to show them
equivalent to the par value of the stock issued therefor. Rather, subscription for
the stock is made at the figure of the fair value of the property to be turned over
in payment of the subscription. In the case of no-par-value stock even greater
care must be exercised to see that the contributed capital shall never be
encroached upon in the declaration of dividends, and careful supervision is
somewhat more difficult because the number of shares issued bears no relation
to the amount of the capital stock.
Distinctive Records
The accounting and other records peculiar to a corporation are explained in
Volume I, Chapter XLVIII. These records are the subscription book and
subscription ledger or instalment book, the stock certificate book and stock
ledger, the stock transfer book, the minute book, sometimes a dividend book, in
large companies a register of transfers (which classifies the information as to
Page 50
transfers given in the stock transfer book, and so may serve as a convenient
posting medium for the stock ledger), and a stock register (a record kept by the
officially appointed registrar of the corporation, whose duty it is to see that
there are no irregularities in the issue of stock and that there is no overissue).
The stock register should show the amount of stock authorized and the amount
issued at any given time, the balance being the stock not yet issued. A form for
the stock transfer book and several forms for stock ledgers as prescribed by the
Comptroller of the State of New York are shown below.[3] The two latter forms
of the stock ledger are applicable only to the State of New York.
Ledger Folio 27
Transfer No. 556
Alliance Automobile Company
For value Received, I hereby sell, assign and transfer
unto John H. Lansing, of Newark, New Jersey, Seventy-
six Shares of the Capital Stock of the above-mentioned
Company, now standing in my name on the Company
books and represented by surrendered Certificates Nos.
32, 37, and 44.
Witness my hand and seal this 28th day of
September, 1918.
George B. Goldman [L. S.]
By George Gale, Attorney.
New Certificate No. 224
Issued to John H. Lansing
Ledger Folio 84
Stock Transfer Book
posting medium for the stock ledger), and a stock register (a record kept by the
officially appointed registrar of the corporation, whose duty it is to see that
there are no irregularities in the issue of stock and that there is no overissue).
The stock register should show the amount of stock authorized and the amount
issued at any given time, the balance being the stock not yet issued. A form for
the stock transfer book and several forms for stock ledgers as prescribed by the
Comptroller of the State of New York are shown below.[3] The two latter forms
of the stock ledger are applicable only to the State of New York.
Ledger Folio 27
Transfer No. 556
Alliance Automobile Company
For value Received, I hereby sell, assign and transfer
unto John H. Lansing, of Newark, New Jersey, Seventy-
six Shares of the Capital Stock of the above-mentioned
Company, now standing in my name on the Company
books and represented by surrendered Certificates Nos.
32, 37, and 44.
Witness my hand and seal this 28th day of
September, 1918.
George B. Goldman [L. S.]
By George Gale, Attorney.
New Certificate No. 224
Issued to John H. Lansing
Ledger Folio 84
Stock Transfer Book
Page 51
John H. Kircher, 230 Broadway, New York
To Whom Certificate Number
Date of
Shares are Numbers of
Transfer
Transferred Surrendered Reissued Shares
1917
March 13 W. K. Howard 15 70 10
July 15 Robert Moyer 70 145 40
July 31 Harold McKain 145 40
December 3 James McNeil 85 175 20
December 16 James Archer {175} 231 105
{165}
December 31 Balance 180
395
From Whom Number
Date of Amount Paid Certificate
Shares were of
Transfer on Shares Numbers
Transferred Shares
1917
January 10 Original Issue Full-Paid 15 90
March 25 George Holmes ” 85 75
August 1 Harvey Cornell ” 150 35
August 15 Howard Gaines ” 160 50
”
September 2 John Woodwell ” 165 100
October 5 Henry Simpson ” 42 45
395
1918
January 3 180
To Whom Certificate Number
Date of
Shares are Numbers of
Transfer
Transferred Surrendered Reissued Shares
1917
March 13 W. K. Howard 15 70 10
July 15 Robert Moyer 70 145 40
July 31 Harold McKain 145 40
December 3 James McNeil 85 175 20
December 16 James Archer {175} 231 105
{165}
December 31 Balance 180
395
From Whom Number
Date of Amount Paid Certificate
Shares were of
Transfer on Shares Numbers
Transferred Shares
1917
January 10 Original Issue Full-Paid 15 90
March 25 George Holmes ” 85 75
August 1 Harvey Cornell ” 150 35
August 15 Howard Gaines ” 160 50
”
September 2 John Woodwell ” 165 100
October 5 Henry Simpson ” 42 45
395
1918
January 3 180
Page 52
Stock Book or Stock Ledger
Stock Book to be Kept by Brokers
(New York Form Prescribed by Comptroller)
Stock Book to be Kept by Corporations and Transfer Agents
(New York Form Prescribed by Comptroller)
Stock Ledger
The stock ledger is a subsidiary ledger controlled by the Capital Stock
account or accounts on the general ledger. It may, of course, be made self-
balancing just as any other subsidiary ledger. There has been some controversy
as to whether the stock ledger is normally a credit or a debit balance ledger. In
some concerns the stockholder is debited with the shares owned, and in others
he is credited. Theoretically, in accordance with the principle of all other
controlling accounts, the subsidiary ledger—in this case, the stock ledger—
Stock Book to be Kept by Brokers
(New York Form Prescribed by Comptroller)
Stock Book to be Kept by Corporations and Transfer Agents
(New York Form Prescribed by Comptroller)
Stock Ledger
The stock ledger is a subsidiary ledger controlled by the Capital Stock
account or accounts on the general ledger. It may, of course, be made self-
balancing just as any other subsidiary ledger. There has been some controversy
as to whether the stock ledger is normally a credit or a debit balance ledger. In
some concerns the stockholder is debited with the shares owned, and in others
he is credited. Theoretically, in accordance with the principle of all other
controlling accounts, the subsidiary ledger—in this case, the stock ledger—
Page 53
merely carries the detail of the controlling account. If, then, the controlling
account is a credit balance account, the accounts on the subsidiary ledger must
similarly have credit balances. Accordingly, the stockholder should be credited
with his net holdings. Practically it makes little or no difference because the
subsidiary ledger is no integral part of the debit and credit scheme of the general
ledger. Of course, unless practical difficulties prevent, practice should always
follow the theoretically correct method. No difficulty need be experienced,
however, in accommodating oneself to either method of record on a subsidiary
ledger. In the stock ledger the record of holdings is kept in terms of the number
of shares owned rather than by the par value of the holdings.
Minute Book
Before leaving the subject of the records peculiar to a corporation, it is
desired again to call attention to the keeping of a careful record in the minute
book. This book should contain first a copy or duplicate of the corporation’s
charter. Following this should be the by-laws of the corporation. Sufficient
blank space should be left at the end of each of these documents to make record
of any amendments to charter or by-laws. There should follow a complete
record of the deliberations and authorizations of the board of directors as
affecting the management and control of the corporation’s policy. The minute
book is often the source of authority for many of the most important entries
made on the books of account, and great care must be used to make the record
full, complete, and accurate. Such matters as leases, purchase and sale of
properties, bond issues, dividends, and other similar items should have very
careful record.
Conclusion
Other features of the corporation from the accounting point of view are
treated under their respective heads in later chapters. These include such items
as bond issues, sinking and other funds, reserves and surplus, scrip and stock
dividends and other dividend considerations.
It is proposed in the next two chapters to discuss the corporation from the
manufacturing viewpoint, types of accounting records sometimes used therefor,
and the elements of manufacturing costs. After that the problem of the balance
sheet and the principles of valuation applicable to it will claim attention.
account is a credit balance account, the accounts on the subsidiary ledger must
similarly have credit balances. Accordingly, the stockholder should be credited
with his net holdings. Practically it makes little or no difference because the
subsidiary ledger is no integral part of the debit and credit scheme of the general
ledger. Of course, unless practical difficulties prevent, practice should always
follow the theoretically correct method. No difficulty need be experienced,
however, in accommodating oneself to either method of record on a subsidiary
ledger. In the stock ledger the record of holdings is kept in terms of the number
of shares owned rather than by the par value of the holdings.
Minute Book
Before leaving the subject of the records peculiar to a corporation, it is
desired again to call attention to the keeping of a careful record in the minute
book. This book should contain first a copy or duplicate of the corporation’s
charter. Following this should be the by-laws of the corporation. Sufficient
blank space should be left at the end of each of these documents to make record
of any amendments to charter or by-laws. There should follow a complete
record of the deliberations and authorizations of the board of directors as
affecting the management and control of the corporation’s policy. The minute
book is often the source of authority for many of the most important entries
made on the books of account, and great care must be used to make the record
full, complete, and accurate. Such matters as leases, purchase and sale of
properties, bond issues, dividends, and other similar items should have very
careful record.
Conclusion
Other features of the corporation from the accounting point of view are
treated under their respective heads in later chapters. These include such items
as bond issues, sinking and other funds, reserves and surplus, scrip and stock
dividends and other dividend considerations.
It is proposed in the next two chapters to discuss the corporation from the
manufacturing viewpoint, types of accounting records sometimes used therefor,
and the elements of manufacturing costs. After that the problem of the balance
sheet and the principles of valuation applicable to it will claim attention.
Page 54
CHAPTER II
THE VOUCHER SYSTEM
Purchasing for the Manufacturing Business
Accounting for the business which manufactures its own product is a
much larger problem than that for the concern which limits its activity to
purchase and sale of a stock-in-trade. To the activities of a trading concern
the manufacturing business adds those of the factory. Not only must more
property, and a larger variety, be kept account of and handled so as to get
the most efficient return therefrom, but also in the handling and operation of
this property a somewhat distinct type of expenses is incurred. The
problems of financial and factory management and control are different and
more complicated than those of the trading business. The period between
the expenditure of funds for the purchase of materials and the payment of
expenses and the receipt of money from the sale of the finished product is
much longer. More working capital must therefore be provided and its rate
of turnover is less. A larger element of risk enters in. Raw materials must be
worked and fashioned, machinery must be employed, a different class of
labor must usually be handled, perhaps will have to be trained—these are
problems calling for a special type of management for the manufacturing
end of the business.
The accounting department must be organized to serve these additional
demands and complexities of management and to give the needed
information. The amount and cost of the materials consumed in making the
product, the labor cost expended on it, and the various items of factory
expense incurred, during one period as compared with the same items for
previous periods—all must be kept under constant review if successful
operation is to be secured.
Expansion of the Purchase Journal
To make this information available as soon as the transactions giving
rise to it are entered into, a different method of gathering the information
becomes necessary. Because of the fact that the purchase journal is limited
THE VOUCHER SYSTEM
Purchasing for the Manufacturing Business
Accounting for the business which manufactures its own product is a
much larger problem than that for the concern which limits its activity to
purchase and sale of a stock-in-trade. To the activities of a trading concern
the manufacturing business adds those of the factory. Not only must more
property, and a larger variety, be kept account of and handled so as to get
the most efficient return therefrom, but also in the handling and operation of
this property a somewhat distinct type of expenses is incurred. The
problems of financial and factory management and control are different and
more complicated than those of the trading business. The period between
the expenditure of funds for the purchase of materials and the payment of
expenses and the receipt of money from the sale of the finished product is
much longer. More working capital must therefore be provided and its rate
of turnover is less. A larger element of risk enters in. Raw materials must be
worked and fashioned, machinery must be employed, a different class of
labor must usually be handled, perhaps will have to be trained—these are
problems calling for a special type of management for the manufacturing
end of the business.
The accounting department must be organized to serve these additional
demands and complexities of management and to give the needed
information. The amount and cost of the materials consumed in making the
product, the labor cost expended on it, and the various items of factory
expense incurred, during one period as compared with the same items for
previous periods—all must be kept under constant review if successful
operation is to be secured.
Expansion of the Purchase Journal
To make this information available as soon as the transactions giving
rise to it are entered into, a different method of gathering the information
becomes necessary. Because of the fact that the purchase journal is limited
Page 55
to the record of purchases of stock-in-trade, and that information in regard
to expenses incurred is not usually brought on the books until payment of
them is made, not only do the books fail to give the service which a
management has a right to expect of them but they fail to reflect many
liabilities at the time they are assumed. Thus a new type of record is needed.
This has led to an extension or expansion of the purchase journal. The
way in which this journal can be used so as to analyze purchases of stock-
in-trade on a departmental basis has been explained and illustrated in
Volume I. This new use of the purchase journal is merely an extension of
the principle of analysis there developed. Instead of limiting it to a record of
transactions involving purchases of stock-in-trade, every purchase
transaction, whether of assets, supplies, or of service of any kind, finds this
its place of first record. By introducing sufficient columns, as detailed an
analysis of all the purchasing activities of the business can be secured as
may be desirable. Furthermore, entry here being made at the time of the
purchase rather than at the time of payment for the purchase, the books
make available a mass of valuable data needed for purposes of management
much sooner than it becomes available under the former restricted use of
the purchase journal.
Development of Voucher System
Had the evolution of this record stopped here, the resulting gain would
have been secured at high cost. The entry of all expense purchases in the
purchase journal creates the necessity of opening accounts on the ledger
with numerous creditors for small purchases, as well as the more important
items, both to show the liability incurred and to provide a means of
canceling it when payment is made. In large corporations, where oftentimes
the policy of securing bids on all purchases is followed, resulting in a
constant changing of firms from whom purchases are made and no regularly
established trade with any of them, the burden of handling the creditors
ledger becomes an increasingly heavy one with little or no gain in desirable
information furnished by it. Accordingly, a further development took place
which eliminated the necessity of opening regular accounts with every
creditor, but instead made every transaction, whether one or many were
entered into with the same individual, independent of all others. This makes
possible the showing of the settlement of that transaction in the place where
to expenses incurred is not usually brought on the books until payment of
them is made, not only do the books fail to give the service which a
management has a right to expect of them but they fail to reflect many
liabilities at the time they are assumed. Thus a new type of record is needed.
This has led to an extension or expansion of the purchase journal. The
way in which this journal can be used so as to analyze purchases of stock-
in-trade on a departmental basis has been explained and illustrated in
Volume I. This new use of the purchase journal is merely an extension of
the principle of analysis there developed. Instead of limiting it to a record of
transactions involving purchases of stock-in-trade, every purchase
transaction, whether of assets, supplies, or of service of any kind, finds this
its place of first record. By introducing sufficient columns, as detailed an
analysis of all the purchasing activities of the business can be secured as
may be desirable. Furthermore, entry here being made at the time of the
purchase rather than at the time of payment for the purchase, the books
make available a mass of valuable data needed for purposes of management
much sooner than it becomes available under the former restricted use of
the purchase journal.
Development of Voucher System
Had the evolution of this record stopped here, the resulting gain would
have been secured at high cost. The entry of all expense purchases in the
purchase journal creates the necessity of opening accounts on the ledger
with numerous creditors for small purchases, as well as the more important
items, both to show the liability incurred and to provide a means of
canceling it when payment is made. In large corporations, where oftentimes
the policy of securing bids on all purchases is followed, resulting in a
constant changing of firms from whom purchases are made and no regularly
established trade with any of them, the burden of handling the creditors
ledger becomes an increasingly heavy one with little or no gain in desirable
information furnished by it. Accordingly, a further development took place
which eliminated the necessity of opening regular accounts with every
creditor, but instead made every transaction, whether one or many were
entered into with the same individual, independent of all others. This makes
possible the showing of the settlement of that transaction in the place where
Page 56
its original record was made, without opening up a ledger account for it.
This use of the purchase journal with some slight additions has given rise to
the so-called “voucher system” of handling purchases.
Definition and Description of Voucher
In a broad sense, a voucher is a statement which certifies, i.e., vouches
for, the correctness of a transaction. As used in the restricted sense to which
it is limited under the voucher system, it is a more or less formal document
which shows a receipt for a particular bill of items. As distinguished from a
receipt in general, this latter term is applied to all acknowledgments of
money paid whether or not for a particular bill; whereas the essence of
voucher accounting requires receipts for particular bills. At law a voucher
has no more weight than an ordinary receipt, and a signed receipt is only
prima facie evidence, capable of refutation, though the burden of proof of
non-payment is placed on the complainant.
A formal voucher must therefore provide for a statement of the bill of
which payment is being made and a place for acknowledgment of receipt of
payment by the payee. Usually provision is made also for: (1) certification
of the correctness of the bill by properly authorized house employee and its
approval for payment; and (2) a proper distribution on the accounting
records of the payments authorized, i.e., an official determination of the
debit and credit entries to be made on the books.
A form of voucher is shown on pages 30, 31. On the face of the form
provision is made for (1) detailed statement of bill; (2) house approval of
same; and (3) receipt form to be signed by payee. On the reverse side of the
voucher the distribution of the charges is provided for. This is the
bookkeeper’s authorization for making the indicated entries on his books.
The form is so devised that, when doubled, it is of a convenient size for
filing in a vertical file.
Operation of Voucher System
When the invoice covering any purchase is received, it is held till the
commodities bought arrive. After inspection and acceptance of the goods, a
voucher is made out in duplicate on which is written a copy of the invoice,
with the cash discount, if any, shown deducted. Vouchers are given
consecutive numbering just like checks. If immediate payment is to be
This use of the purchase journal with some slight additions has given rise to
the so-called “voucher system” of handling purchases.
Definition and Description of Voucher
In a broad sense, a voucher is a statement which certifies, i.e., vouches
for, the correctness of a transaction. As used in the restricted sense to which
it is limited under the voucher system, it is a more or less formal document
which shows a receipt for a particular bill of items. As distinguished from a
receipt in general, this latter term is applied to all acknowledgments of
money paid whether or not for a particular bill; whereas the essence of
voucher accounting requires receipts for particular bills. At law a voucher
has no more weight than an ordinary receipt, and a signed receipt is only
prima facie evidence, capable of refutation, though the burden of proof of
non-payment is placed on the complainant.
A formal voucher must therefore provide for a statement of the bill of
which payment is being made and a place for acknowledgment of receipt of
payment by the payee. Usually provision is made also for: (1) certification
of the correctness of the bill by properly authorized house employee and its
approval for payment; and (2) a proper distribution on the accounting
records of the payments authorized, i.e., an official determination of the
debit and credit entries to be made on the books.
A form of voucher is shown on pages 30, 31. On the face of the form
provision is made for (1) detailed statement of bill; (2) house approval of
same; and (3) receipt form to be signed by payee. On the reverse side of the
voucher the distribution of the charges is provided for. This is the
bookkeeper’s authorization for making the indicated entries on his books.
The form is so devised that, when doubled, it is of a convenient size for
filing in a vertical file.
Operation of Voucher System
When the invoice covering any purchase is received, it is held till the
commodities bought arrive. After inspection and acceptance of the goods, a
voucher is made out in duplicate on which is written a copy of the invoice,
with the cash discount, if any, shown deducted. Vouchers are given
consecutive numbering just like checks. If immediate payment is to be
Page 57
made, the voucher will be “approved” and check drawn for the amount. The
voucher with check attached is sent to the creditor with a request that he
receipt the voucher and return it. A creditor is not usually particularly
interested in helping another concern keep its books and the result is that a
large number of vouchers find their way into the creditor’s waste basket. It
is here that the duplicate copy retained in the files serves to keep the file of
vouchers complete, though it does not, of course, constitute a receipt for the
payment.
Sometimes before sending the original voucher, the distribution of the
charges is made on it, and it is used as the basis of the bookkeeper’s entries.
An objection to this method is frequently made that the creditor is thus
given some insight into the business and perhaps a more intimate view of it
than may be desirable. Where such is the case, only the office copy of the
voucher shows the distribution and the book entries are made from it. Both
may be filed together when the original is returned, or the one may be filed
numerically according to voucher numbers, the other alphabetically
according to creditors’ names and so serve as an index to the numerical file.
voucher with check attached is sent to the creditor with a request that he
receipt the voucher and return it. A creditor is not usually particularly
interested in helping another concern keep its books and the result is that a
large number of vouchers find their way into the creditor’s waste basket. It
is here that the duplicate copy retained in the files serves to keep the file of
vouchers complete, though it does not, of course, constitute a receipt for the
payment.
Sometimes before sending the original voucher, the distribution of the
charges is made on it, and it is used as the basis of the bookkeeper’s entries.
An objection to this method is frequently made that the creditor is thus
given some insight into the business and perhaps a more intimate view of it
than may be desirable. Where such is the case, only the office copy of the
voucher shows the distribution and the book entries are made from it. Both
may be filed together when the original is returned, or the one may be filed
numerically according to voucher numbers, the other alphabetically
according to creditors’ names and so serve as an index to the numerical file.
Page 58
Voucher (face)
Page 59
Voucher (reverse)
In some concerns the canceled checks when returned by the bank are
filed with their respective vouchers; in others, they are filed separately in
their own sequence. Inasmuch as each voucher also carries its check
number, cross-reference is easy.
Voucher Check
The difficulty referred to above in securing prompt return of receipted
vouchers has led to the introduction of a combined voucher and check
In some concerns the canceled checks when returned by the bank are
filed with their respective vouchers; in others, they are filed separately in
their own sequence. Inasmuch as each voucher also carries its check
number, cross-reference is easy.
Voucher Check
The difficulty referred to above in securing prompt return of receipted
vouchers has led to the introduction of a combined voucher and check
Page 60
called a “voucher check.” The indorsement on the check, which is
necessary for its collection, serves at the same time as a receipt of the bill.
All vouchers thus ultimately find their way back through the bank. The
legality of the indorsement serving also as an acceptance of the check in
payment of the stated invoice has been thoroughly established, particularly
when on the blank space for indorsement attention is drawn to the fact that
such indorsement will constitute a receipt for the bill; or where the face of
the check states that it is full payment for the invoices covered by it.
Two forms of voucher check are in use, the folded check and the single.
Below are given illustrations of both. If such checks are not unduly large,
banks do not object to handling them.
Because of lack of room on the voucher check, provision is not always
made for showing the distribution of the charges. The single form of check
can be used when a detailed statement of invoices is not desirable or when
invoices carry but few items. Such a voucher check, but differing somewhat
from the one shown, is frequently used for the payment of dividends to
stockholders and does away with the need of a formal receipt or of
signature in the dividend book.
necessary for its collection, serves at the same time as a receipt of the bill.
All vouchers thus ultimately find their way back through the bank. The
legality of the indorsement serving also as an acceptance of the check in
payment of the stated invoice has been thoroughly established, particularly
when on the blank space for indorsement attention is drawn to the fact that
such indorsement will constitute a receipt for the bill; or where the face of
the check states that it is full payment for the invoices covered by it.
Two forms of voucher check are in use, the folded check and the single.
Below are given illustrations of both. If such checks are not unduly large,
banks do not object to handling them.
Because of lack of room on the voucher check, provision is not always
made for showing the distribution of the charges. The single form of check
can be used when a detailed statement of invoices is not desirable or when
invoices carry but few items. Such a voucher check, but differing somewhat
from the one shown, is frequently used for the payment of dividends to
stockholders and does away with the need of a formal receipt or of
signature in the dividend book.
Page 61
Voucher Check—Double (face)
Page 62
Voucher Check—Double (reverse)
Page 63
Voucher Check—Single
Form of Voucher Register
The “Voucher Register,” or the “Accounts Payable Register,” as it is
sometimes called, is the book of original entry in which the voucher and its
distribution are recorded. This register is a journal so far as its scheme of
debit and credit is concerned, but its record is not usually supplemented by
a formal subsidiary ledger—though it may be—posting of it being limited
to the general ledger. The register must provide columns for date, voucher
number, name of creditor, explanation, amount, distribution, and payment.
There are many different forms and rulings, the information desired never
being quite the same in any two businesses, but a typical form of voucher
register is shown on page 35.
Distribution of Vouchers
As soon as a purchase invoice has been approved, a voucher—
sometimes called a voucher jacket where the original invoice itself is
attached to it—is made for it, the distribution of the charges is authorized,
and entry is made in the voucher register. All vouchers are numbered
consecutively and entered in numerical sequence, which is usually also
Form of Voucher Register
The “Voucher Register,” or the “Accounts Payable Register,” as it is
sometimes called, is the book of original entry in which the voucher and its
distribution are recorded. This register is a journal so far as its scheme of
debit and credit is concerned, but its record is not usually supplemented by
a formal subsidiary ledger—though it may be—posting of it being limited
to the general ledger. The register must provide columns for date, voucher
number, name of creditor, explanation, amount, distribution, and payment.
There are many different forms and rulings, the information desired never
being quite the same in any two businesses, but a typical form of voucher
register is shown on page 35.
Distribution of Vouchers
As soon as a purchase invoice has been approved, a voucher—
sometimes called a voucher jacket where the original invoice itself is
attached to it—is made for it, the distribution of the charges is authorized,
and entry is made in the voucher register. All vouchers are numbered
consecutively and entered in numerical sequence, which is usually also
Page 64
chronological sequence. The amount of the voucher is entered in the total
column, Vouchers Payable or Accounts Payable, whatever the account title
is on the general ledger. The next column, Purchase Discount, may or may
not be merely a memorandum column, depending on the use made of it, as
will be explained later.
Voucher Register (left-hand page)
Voucher Register (right-hand page)
From the Vouchers Payable column, distribution on the same line is
made into the columns for the various accounts to be charged. To secure a
complete distribution without waste of space, a Sundry Charges column is
provided for entry in detail of all items of infrequent occurrence, each
account to be charged being named in the explanation space to the right of
this column. Following this comes the record of date and manner of
payment, with a final column in which to extend at the end of the month all
unpaid vouchers and so indicate the detail of the total outstanding liability.
column, Vouchers Payable or Accounts Payable, whatever the account title
is on the general ledger. The next column, Purchase Discount, may or may
not be merely a memorandum column, depending on the use made of it, as
will be explained later.
Voucher Register (left-hand page)
Voucher Register (right-hand page)
From the Vouchers Payable column, distribution on the same line is
made into the columns for the various accounts to be charged. To secure a
complete distribution without waste of space, a Sundry Charges column is
provided for entry in detail of all items of infrequent occurrence, each
account to be charged being named in the explanation space to the right of
this column. Following this comes the record of date and manner of
payment, with a final column in which to extend at the end of the month all
unpaid vouchers and so indicate the detail of the total outstanding liability.
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The voucher record is capable of almost indefinite expansion through the
use of short-margin insert sheets. Provision can in this way be made for a
large number of columns for analysis.
Posting of Summary Totals
At the end of the month, or oftener if desired, the voucher register is
summarized and posted. Inasmuch as usually no subsidiary ledger is kept
when the voucher system is in use, there is no day-to-day record on the
ledger of the purchasing activities of the business. Accordingly, a complete
double entry must be made by way of periodic summary. It was at one time
thought desirable to make this summary entry through the general journal
or, at any rate, by setting up a formal journal entry on the face of the
voucher register. As the degree of analysis increased, the futility of such a
procedure became apparent and now posting to the ledger accounts is made
directly from column totals as shown in the illustration. The Sundry
Charges column is posted in detail to the named accounts as indicated.
Proof of distribution should always be secured by checking the total of the
distributive column totals against the total of the Vouchers Payable column.
In posting, the total of the Voucher Payable column is credited to its
account, while the totals of the distributive columns are debited to their
respective accounts.
Effect on Cash Book and Bank Account
The advantage of this periodic posting of expense column totals as
compared with the detailed posting of such items from the cash book as
required under the old method is apparent. The cash book is in this way
relieved of all need of naming the account to be charged for each detailed
entry, the proper charge having been made from the voucher register. If
every transaction which will ultimately give rise to a disbursement of cash
is vouchered and therefore recorded through the voucher register, there is
really no need of a detailed entry of the checks on the cash book, for only
their total is posted. It is perhaps more usual, however, to enter them in
detail on the cash book. Entry here is, as always, chronologic, by date of
payment.
Sometimes, to facilitate reconciliation with the bank account, the
voucher checks are given a new series of numbers known as treasurer’s
use of short-margin insert sheets. Provision can in this way be made for a
large number of columns for analysis.
Posting of Summary Totals
At the end of the month, or oftener if desired, the voucher register is
summarized and posted. Inasmuch as usually no subsidiary ledger is kept
when the voucher system is in use, there is no day-to-day record on the
ledger of the purchasing activities of the business. Accordingly, a complete
double entry must be made by way of periodic summary. It was at one time
thought desirable to make this summary entry through the general journal
or, at any rate, by setting up a formal journal entry on the face of the
voucher register. As the degree of analysis increased, the futility of such a
procedure became apparent and now posting to the ledger accounts is made
directly from column totals as shown in the illustration. The Sundry
Charges column is posted in detail to the named accounts as indicated.
Proof of distribution should always be secured by checking the total of the
distributive column totals against the total of the Vouchers Payable column.
In posting, the total of the Voucher Payable column is credited to its
account, while the totals of the distributive columns are debited to their
respective accounts.
Effect on Cash Book and Bank Account
The advantage of this periodic posting of expense column totals as
compared with the detailed posting of such items from the cash book as
required under the old method is apparent. The cash book is in this way
relieved of all need of naming the account to be charged for each detailed
entry, the proper charge having been made from the voucher register. If
every transaction which will ultimately give rise to a disbursement of cash
is vouchered and therefore recorded through the voucher register, there is
really no need of a detailed entry of the checks on the cash book, for only
their total is posted. It is perhaps more usual, however, to enter them in
detail on the cash book. Entry here is, as always, chronologic, by date of
payment.
Sometimes, to facilitate reconciliation with the bank account, the
voucher checks are given a new series of numbers known as treasurer’s
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numbers when issued in payment of invoices. Where this is done, the cash
book shows entry of all checks in the numerical sequence of treasurer’s
numbers, just as entry in the voucher record is in the sequence of voucher
numbers. Some checks are held before issue longer than others, due to
different lengths of credit term, etc.; hence the need for this new series of
numbers.
Payment of Vouchers
After a voucher has been made up and entered in the register, if
payment is to be made immediately, it is passed for payment by the
treasurer or other fiscal officer and the check is drawn and issued. Any cash
discount offered is shown deducted on the face of the invoice and the check
carries the net amount. Where payment is not immediate, but observance of
the terms of credit is necessary to secure the discount, the voucher should
be filed away in a tickler file which will automatically bring it up for
attention at the proper time. The original invoice is placed in a temporary
file, arranged alphabetically, until paid, when it may be removed and filed
permanently with the paid voucher. Upon payment of the voucher, the
check is entered among the cash disbursements and a notation is made in
the payment column of the voucher register as to the date and manner of
payment.
Voucher Index of Creditors
It has been stated that one of the essential features of the voucher
system, as it is usually operated, is the dispensing with the formal creditors
ledger. This is accomplished by treating every transaction as an independent
unit, numbering it, and providing a place in the voucher register to indicate
its payment, so that there is no need of a separate ledger to keep track of the
cancellation of the liability. The voucher system fails, however, to give a
record of volume of business done with each creditor. Furthermore, it is
often desirable to make reference to past transactions with creditors. This
would be very difficult without a definite knowledge of the voucher
numbers under which account has been kept of the transactions with a
particular creditor.
Accordingly, for the proper operation of the system an alphabetic index
of creditors must be made up on which should be shown the voucher
book shows entry of all checks in the numerical sequence of treasurer’s
numbers, just as entry in the voucher record is in the sequence of voucher
numbers. Some checks are held before issue longer than others, due to
different lengths of credit term, etc.; hence the need for this new series of
numbers.
Payment of Vouchers
After a voucher has been made up and entered in the register, if
payment is to be made immediately, it is passed for payment by the
treasurer or other fiscal officer and the check is drawn and issued. Any cash
discount offered is shown deducted on the face of the invoice and the check
carries the net amount. Where payment is not immediate, but observance of
the terms of credit is necessary to secure the discount, the voucher should
be filed away in a tickler file which will automatically bring it up for
attention at the proper time. The original invoice is placed in a temporary
file, arranged alphabetically, until paid, when it may be removed and filed
permanently with the paid voucher. Upon payment of the voucher, the
check is entered among the cash disbursements and a notation is made in
the payment column of the voucher register as to the date and manner of
payment.
Voucher Index of Creditors
It has been stated that one of the essential features of the voucher
system, as it is usually operated, is the dispensing with the formal creditors
ledger. This is accomplished by treating every transaction as an independent
unit, numbering it, and providing a place in the voucher register to indicate
its payment, so that there is no need of a separate ledger to keep track of the
cancellation of the liability. The voucher system fails, however, to give a
record of volume of business done with each creditor. Furthermore, it is
often desirable to make reference to past transactions with creditors. This
would be very difficult without a definite knowledge of the voucher
numbers under which account has been kept of the transactions with a
particular creditor.
Accordingly, for the proper operation of the system an alphabetic index
of creditors must be made up on which should be shown the voucher
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numbers relating to transactions with each creditor. This is usually of the
card index type, each creditor being provided with a card on which is noted
a list of the vouchers recording the business done with him. This voucher
index, while not a ledger in the accepted sense, yet when operated in
connection with the Payment column in the voucher register serves all the
essential purposes of a creditors ledger, and the use of the “Unpaid
Vouchers” column, as explained above, secures at the end of the month the
detail of the summary account, Vouchers Payable, carried on the general
ledger.
Control of Vouchers Payable
With the elimination of the detailed ledger record which served as a
check on its controlling account on the general ledger, particular care must
be exercised to see that the control account, Vouchers Payable, reflects the
correct summary of all detailed liabilities. This is readily accomplished
when every item that leads to a disbursement of cash is vouchered. Then the
only postings to “Vouchers Payable” come, for their credits, from the total
of Vouchers Payable column of the voucher register, and for their debits,
from the total of Vouchers Payable column in the cash book.
Introduction of System
Some of the problems encountered in the operation of a voucher system
will now be discussed, the first of which is the introduction of the system in
a business where the old method of handling purchases is in use. The
requirement here is the closing of the open accounts on the purchase ledger
and their transfer to the voucher register. This may be accomplished in two
ways—one of which requires a change in the controlling account, and the
other of which does not. Under the first plan without formality, the accounts
in the purchase ledger are balanced and closed by indicating in their
explanation columns the transfer of the balance to the voucher register. As
these accounts are entered on the voucher register, each of the items
comprising the balance of an account should be given separate vouchers
rather than entered under one voucher for the whole amount. This is
particularly true where the different items are subject to different discount
and credit terms, rendering it undesirable to pay them all at the same time.
After entry on the voucher register, the amounts may be distributed to the
Sundry column and charged to the controlling account, Accounts or
card index type, each creditor being provided with a card on which is noted
a list of the vouchers recording the business done with him. This voucher
index, while not a ledger in the accepted sense, yet when operated in
connection with the Payment column in the voucher register serves all the
essential purposes of a creditors ledger, and the use of the “Unpaid
Vouchers” column, as explained above, secures at the end of the month the
detail of the summary account, Vouchers Payable, carried on the general
ledger.
Control of Vouchers Payable
With the elimination of the detailed ledger record which served as a
check on its controlling account on the general ledger, particular care must
be exercised to see that the control account, Vouchers Payable, reflects the
correct summary of all detailed liabilities. This is readily accomplished
when every item that leads to a disbursement of cash is vouchered. Then the
only postings to “Vouchers Payable” come, for their credits, from the total
of Vouchers Payable column of the voucher register, and for their debits,
from the total of Vouchers Payable column in the cash book.
Introduction of System
Some of the problems encountered in the operation of a voucher system
will now be discussed, the first of which is the introduction of the system in
a business where the old method of handling purchases is in use. The
requirement here is the closing of the open accounts on the purchase ledger
and their transfer to the voucher register. This may be accomplished in two
ways—one of which requires a change in the controlling account, and the
other of which does not. Under the first plan without formality, the accounts
in the purchase ledger are balanced and closed by indicating in their
explanation columns the transfer of the balance to the voucher register. As
these accounts are entered on the voucher register, each of the items
comprising the balance of an account should be given separate vouchers
rather than entered under one voucher for the whole amount. This is
particularly true where the different items are subject to different discount
and credit terms, rendering it undesirable to pay them all at the same time.
After entry on the voucher register, the amounts may be distributed to the
Sundry column and charged to the controlling account, Accounts or
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Vouchers Payable, as the case may be. The register should now be totaled,
i.e., the Vouchers Payable and Sundry columns should be added and the
register ruled off. These totals, being to the credit and debit of the same
account, may or may not be posted, as the balance of the controlling
account is not affected. Under the second plan the register is left open, i.e.,
not totaled. In this way the credit to the Vouchers Payable account is
included with the total to be posted at the end of the current month when the
register is first summarized. This, of course, necessitates posting the
corresponding debit of the amounts distributed to the Sundry column as
explained above.
The new voucher system is now ready for use and current entries will be
made as previously explained.
Purchase Returns and Allowances
The handling of purchase returns and allowances is awkward under the
voucher system. If the goods can be inspected and accepted or adjustment
secured when necessary, before the voucher for the transaction is made up,
then the amount to be paid is always the amount of the voucher and no
change need be made in the amounts entered and distributed on the register.
Where this is done a Purchase Returns and Allowances Account is not
required. This procedure, however, is not always possible, for a first
inspection does not always show the true condition of goods. Adjustment of
the general ledger accounts could be made by entry of the return or
allowance through the general journal. That would not, however, leave any
indication in the voucher register record of the fact that cancellation of the
liability there shown was made by payment of a lesser amount than the one
entered, and it is desirable that these two amounts be the same.
To accomplish this, entry of the allowance should be made, in small red
ink figures on the upper part of the line just below the vouchers affected,
entering in red the voucher number—the same as the voucher to which it
applies—and the amount of the allowance, both in the Vouchers Payable
column and the distributive columns affected by the allowance. These red
ink items are, of course, deductions, the summary amounts of the various
columns being net totals, i.e., the totals of regular items less the red figures;
or two totals may be shown, one above the other, the regular and the red.
Where both black and red totals are shown, both must be posted, the red as
i.e., the Vouchers Payable and Sundry columns should be added and the
register ruled off. These totals, being to the credit and debit of the same
account, may or may not be posted, as the balance of the controlling
account is not affected. Under the second plan the register is left open, i.e.,
not totaled. In this way the credit to the Vouchers Payable account is
included with the total to be posted at the end of the current month when the
register is first summarized. This, of course, necessitates posting the
corresponding debit of the amounts distributed to the Sundry column as
explained above.
The new voucher system is now ready for use and current entries will be
made as previously explained.
Purchase Returns and Allowances
The handling of purchase returns and allowances is awkward under the
voucher system. If the goods can be inspected and accepted or adjustment
secured when necessary, before the voucher for the transaction is made up,
then the amount to be paid is always the amount of the voucher and no
change need be made in the amounts entered and distributed on the register.
Where this is done a Purchase Returns and Allowances Account is not
required. This procedure, however, is not always possible, for a first
inspection does not always show the true condition of goods. Adjustment of
the general ledger accounts could be made by entry of the return or
allowance through the general journal. That would not, however, leave any
indication in the voucher register record of the fact that cancellation of the
liability there shown was made by payment of a lesser amount than the one
entered, and it is desirable that these two amounts be the same.
To accomplish this, entry of the allowance should be made, in small red
ink figures on the upper part of the line just below the vouchers affected,
entering in red the voucher number—the same as the voucher to which it
applies—and the amount of the allowance, both in the Vouchers Payable
column and the distributive columns affected by the allowance. These red
ink items are, of course, deductions, the summary amounts of the various
columns being net totals, i.e., the totals of regular items less the red figures;
or two totals may be shown, one above the other, the regular and the red.
Where both black and red totals are shown, both must be posted, the red as
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contras or offsets to their corresponding black postings. If desired, separate
Purchase Returns and Allowances accounts may be opened.
An alternative method, requiring more work but handling the difficulty
somewhat more neatly, cancels the original voucher by marking it paid and
its check void, and issues in its stead a new one for the correct amount. The
new voucher is handled regularly in the cash book, but in the register
distribution is made to the Sundry column and charged to Vouchers
Payable, as the purchase has already been charged from the original
voucher. This charge to Vouchers Payable cancels the credit from the
journal and allows the liability for the new amount to be shown in the total
of the Vouchers Payable column of the register. The cancellation is best
evidenced by entry in the general journal somewhat as follows:
Vouchers Payable $2,150.40
Vouchers Payable $2,101.59
Purchase Returns and Allowances 48.81
To cancel Vo. #2158 and authorize
its reissue in Vo. #3245, account
of return of defective goods.
Under this method postings to the Vouchers Payable account, instead of
being limited in their origin to voucher register and cash book, will be made
also from the general journal.
Partial Payments
A similarly awkward situation is met when it becomes necessary to
make partial payments on a voucher. The whole system is built on the idea
that each voucher is the unit according to which the record is kept. It,
therefore, presupposes settlement in full of each voucher; otherwise, the
efficient operation of the system is interfered with. Settlement in full is not
always possible, however. Since provision is made in the register for but
one line on which to show payment of the voucher, it is not possible to
indicate partial payments in the allotted space, nor would such practice be
desirable.
Hence, where partial payments are to be made, the original voucher
must be canceled in full and two new vouchers issued in place of it—the
Purchase Returns and Allowances accounts may be opened.
An alternative method, requiring more work but handling the difficulty
somewhat more neatly, cancels the original voucher by marking it paid and
its check void, and issues in its stead a new one for the correct amount. The
new voucher is handled regularly in the cash book, but in the register
distribution is made to the Sundry column and charged to Vouchers
Payable, as the purchase has already been charged from the original
voucher. This charge to Vouchers Payable cancels the credit from the
journal and allows the liability for the new amount to be shown in the total
of the Vouchers Payable column of the register. The cancellation is best
evidenced by entry in the general journal somewhat as follows:
Vouchers Payable $2,150.40
Vouchers Payable $2,101.59
Purchase Returns and Allowances 48.81
To cancel Vo. #2158 and authorize
its reissue in Vo. #3245, account
of return of defective goods.
Under this method postings to the Vouchers Payable account, instead of
being limited in their origin to voucher register and cash book, will be made
also from the general journal.
Partial Payments
A similarly awkward situation is met when it becomes necessary to
make partial payments on a voucher. The whole system is built on the idea
that each voucher is the unit according to which the record is kept. It,
therefore, presupposes settlement in full of each voucher; otherwise, the
efficient operation of the system is interfered with. Settlement in full is not
always possible, however. Since provision is made in the register for but
one line on which to show payment of the voucher, it is not possible to
indicate partial payments in the allotted space, nor would such practice be
desirable.
Hence, where partial payments are to be made, the original voucher
must be canceled in full and two new vouchers issued in place of it—the
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one for the amount of the partial payment, which will thus cancel it, and the
other for the unpaid balance, which will remain open until paid in full or till
other partial payment is made. In the latter case the same procedure of
cancellation and issuance in its stead of two vouchers must be repeated.
This process of cancellation by the reissue of two new vouchers may be
effected directly on the face of the voucher register by a full cross-reference
between the old and the new, usually shown in the Manner of Payment
column; or it may be done by formal entry on the general journal, which
will then constitute the authority for the transaction. At the best, it is an
awkward situation and where financial arrangements cannot be made so as
to make partial payments unnecessary in large measure, the voucher system
itself should be discarded as not adapted to the conditions of the business.
Handling of Notes Payable
Practice differs, under the voucher system, in the handling of notes
payable. If a note is given or a draft accepted upon the purchase of goods,
the liability for it will appear on the books only as a note liability, provided
the purchase is recorded through some other medium than the voucher
register. This medium might be the general journal or the notes payable
journal. If, however, original entry of the purchase is made in the voucher
register, liability for it is thereby created under the account title, Vouchers
Payable. This must be shown canceled by the creation of a note liability in
its place, by entry in general or notes payable journals. If the voucher check
system is used, the check on the original voucher must be canceled by
marking it “Void” or by running it through the bank with the day’s deposits.
In either case for the sake of a complete record of check numbers, it should
be entered among the cash disbursements. From all this it is evident that
less work is entailed and just as complete a record made by entering the
purchase originally in general or notes payable journal as suggested above.
In order to maintain proper control over the cash, when the note
becomes due a check should be drawn for it rather than allow its payment to
rest merely on the bank’s memo of charge against the account, where the
note is made payable at the bank. If a voucher check system is in use,
payment by check results in a momentary transfer of the liability from its
status as a note liability to a vouchers payable—an open account—liability.
Cancellation of the note is made by distribution of the voucher to the
other for the unpaid balance, which will remain open until paid in full or till
other partial payment is made. In the latter case the same procedure of
cancellation and issuance in its stead of two vouchers must be repeated.
This process of cancellation by the reissue of two new vouchers may be
effected directly on the face of the voucher register by a full cross-reference
between the old and the new, usually shown in the Manner of Payment
column; or it may be done by formal entry on the general journal, which
will then constitute the authority for the transaction. At the best, it is an
awkward situation and where financial arrangements cannot be made so as
to make partial payments unnecessary in large measure, the voucher system
itself should be discarded as not adapted to the conditions of the business.
Handling of Notes Payable
Practice differs, under the voucher system, in the handling of notes
payable. If a note is given or a draft accepted upon the purchase of goods,
the liability for it will appear on the books only as a note liability, provided
the purchase is recorded through some other medium than the voucher
register. This medium might be the general journal or the notes payable
journal. If, however, original entry of the purchase is made in the voucher
register, liability for it is thereby created under the account title, Vouchers
Payable. This must be shown canceled by the creation of a note liability in
its place, by entry in general or notes payable journals. If the voucher check
system is used, the check on the original voucher must be canceled by
marking it “Void” or by running it through the bank with the day’s deposits.
In either case for the sake of a complete record of check numbers, it should
be entered among the cash disbursements. From all this it is evident that
less work is entailed and just as complete a record made by entering the
purchase originally in general or notes payable journal as suggested above.
In order to maintain proper control over the cash, when the note
becomes due a check should be drawn for it rather than allow its payment to
rest merely on the bank’s memo of charge against the account, where the
note is made payable at the bank. If a voucher check system is in use,
payment by check results in a momentary transfer of the liability from its
status as a note liability to a vouchers payable—an open account—liability.
Cancellation of the note is made by distribution of the voucher to the
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Sundry column of the register as a charge to Notes Payable; the voucher not
being made or entered until the note falls due. Simultaneous entry of the
check in the cash book cancels the voucher payable liability and completes
the transaction.
If the note is given in cancellation of the open account which had been
set up by previous entry in the voucher register, then the same procedure
must be gone through, as was explained above in connection with the
practice of invariably entering every purchase on the voucher register. If the
note transactions are many, it would prove much less laborious to accept the
bank’s memo of charge as adequate evidence of payment, this memo being
given a treasurer’s number in proper sequence, where treasurer’s numbers
are given to establish order of entry on the cash book. Cancellation of the
notes payable liability is then posted from the cash book entry.
Cash Discount on Purchases
A final problem in connection with the voucher system concerns the
treatment of cash discount on purchases. As discussed in Volume I, Chapter
XXXVI, a cash discount is usually treated as a financial management item,
though it is sometimes looked upon as a purchase department item. The
handling of the voucher register so as to record properly the purchase
discount will depend somewhat upon which theory of cash discount is
adhered to. It is customary to carry a Purchase Discount column in the
voucher register, although this is unnecessary if one is carried in the cash
book. Where both cash book and voucher register are provided with
discount columns, one is usually merely a memorandum carried for the sake
of easy reference.
As regards the amount at which the liability under Vouchers Payable is
carried on the books, we find two methods of making up the voucher and
entering it on the register. This is in turn closely related to the financial
policy as to the taking of discount. If it is an invariable rule of policy
always to maintain a sufficient cash balance to take advantage of all
discount offerings, there is nothing seriously wrong with the practice of
making up the voucher and entering it for the net amount in the Vouchers
Payable column; for if the policy is adhered to, no understatement of
liabilities will result. If the policy is not strictly adhered to, constant
adjustment will be necessary to make the books reflect the true liability.
being made or entered until the note falls due. Simultaneous entry of the
check in the cash book cancels the voucher payable liability and completes
the transaction.
If the note is given in cancellation of the open account which had been
set up by previous entry in the voucher register, then the same procedure
must be gone through, as was explained above in connection with the
practice of invariably entering every purchase on the voucher register. If the
note transactions are many, it would prove much less laborious to accept the
bank’s memo of charge as adequate evidence of payment, this memo being
given a treasurer’s number in proper sequence, where treasurer’s numbers
are given to establish order of entry on the cash book. Cancellation of the
notes payable liability is then posted from the cash book entry.
Cash Discount on Purchases
A final problem in connection with the voucher system concerns the
treatment of cash discount on purchases. As discussed in Volume I, Chapter
XXXVI, a cash discount is usually treated as a financial management item,
though it is sometimes looked upon as a purchase department item. The
handling of the voucher register so as to record properly the purchase
discount will depend somewhat upon which theory of cash discount is
adhered to. It is customary to carry a Purchase Discount column in the
voucher register, although this is unnecessary if one is carried in the cash
book. Where both cash book and voucher register are provided with
discount columns, one is usually merely a memorandum carried for the sake
of easy reference.
As regards the amount at which the liability under Vouchers Payable is
carried on the books, we find two methods of making up the voucher and
entering it on the register. This is in turn closely related to the financial
policy as to the taking of discount. If it is an invariable rule of policy
always to maintain a sufficient cash balance to take advantage of all
discount offerings, there is nothing seriously wrong with the practice of
making up the voucher and entering it for the net amount in the Vouchers
Payable column; for if the policy is adhered to, no understatement of
liabilities will result. If the policy is not strictly adhered to, constant
adjustment will be necessary to make the books reflect the true liability.
Page 72
A voucher entered net should have the discount shown in the Discount
column and the gross amount in the distributive columns. Mathematical
proof of the voucher register is secured by checking the sum of Vouchers
Payable and Discount columns against the sum of the distributive columns.
Here it is best to treat the Purchase Discount column total as an item to be
posted, and the Discount column in the cash book as a memo. As regards
the income from purchase discount, the effect of entering the voucher net is
to bring onto the books the purchase discount income as soon as the
voucher is entered. Purchase discount is not usually looked upon as earned
until payment of the bill is made and thus the right to the discount
established. This method then necessitates at the close of the fiscal period
an adjustment of the difference between the Discount columns in voucher
register and cash book, in order to defer to the next period the discount not
yet earned on all vouchers unpaid at the close of the period. This may be
accomplished by the usual method of deferring income, or by the following
entry, on the theory that it is better for Vouchers Payable to carry the gross
amount of liability, at the end of the period, at all events.
Purchase Discount $........
Vouchers Payable $........
The entry must, of course, be reversed immediately at the opening of the
new period—a procedure which makes this method of adjustment of
doubtful value.
If there is any failure to take the discount, after the voucher has been
entered net, it becomes necessary to make up and enter a supplementary
voucher for the discount, with cross-reference between the original and the
supplementary vouchers. The new voucher must be distributed to Sundry
column as a charge to Purchase Discount. One of the few advantages of this
method is that it makes possible reconciliation with the bank account by
checking the canceled checks against the voucher register, which thus
carries in its Vouchers Payable column the exact amount of the check and
its entries are in the sequence of voucher numbers; whereas on the cash
book voucher number sequence cannot be followed. Accordingly it is
unnecessary to use treasurer’s numbers on the checks in order to secure
sequence of numbers in the cash book.
column and the gross amount in the distributive columns. Mathematical
proof of the voucher register is secured by checking the sum of Vouchers
Payable and Discount columns against the sum of the distributive columns.
Here it is best to treat the Purchase Discount column total as an item to be
posted, and the Discount column in the cash book as a memo. As regards
the income from purchase discount, the effect of entering the voucher net is
to bring onto the books the purchase discount income as soon as the
voucher is entered. Purchase discount is not usually looked upon as earned
until payment of the bill is made and thus the right to the discount
established. This method then necessitates at the close of the fiscal period
an adjustment of the difference between the Discount columns in voucher
register and cash book, in order to defer to the next period the discount not
yet earned on all vouchers unpaid at the close of the period. This may be
accomplished by the usual method of deferring income, or by the following
entry, on the theory that it is better for Vouchers Payable to carry the gross
amount of liability, at the end of the period, at all events.
Purchase Discount $........
Vouchers Payable $........
The entry must, of course, be reversed immediately at the opening of the
new period—a procedure which makes this method of adjustment of
doubtful value.
If there is any failure to take the discount, after the voucher has been
entered net, it becomes necessary to make up and enter a supplementary
voucher for the discount, with cross-reference between the original and the
supplementary vouchers. The new voucher must be distributed to Sundry
column as a charge to Purchase Discount. One of the few advantages of this
method is that it makes possible reconciliation with the bank account by
checking the canceled checks against the voucher register, which thus
carries in its Vouchers Payable column the exact amount of the check and
its entries are in the sequence of voucher numbers; whereas on the cash
book voucher number sequence cannot be followed. Accordingly it is
unnecessary to use treasurer’s numbers on the checks in order to secure
sequence of numbers in the cash book.
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The customary method, and one which usually proves most satisfactory,
is to make up and enter the voucher for the gross amount, using the
Discount column in the voucher register merely as a memo or not at all,
posting the discounts, as earned, from the cash book and using a separate
series of treasurer’s numbers when the checks are entered on the cash book.
Strict adherence to the theory of cash discount as a purchase department
item would require making and entering the voucher net and distributing it
net. The Discount column in the register might well be changed to a
“Neglected Purchase Discounts” column into which would be distributed
the supplementary voucher required when discounts are not taken. Under
this theory, also, the voucher may be made up and entered gross, with the
discount handled as a regular purchase discount item, and the net amount
distributed to the other columns. The student should work out the manner of
handling all the discount contingencies under this method.
Modifications of System
A regular purchase ledger is sometimes used with the voucher system.
In such cases the voucher register becomes merely an analytic purchase
journal and much of the advantage of numbering every transaction is lost.
Accounts may also be set up merely as memos to indicate volume of
business. The voucher index, as explained above, accomplishes this in a
limited way.
A hybrid voucher system is sometimes met, a sort of half-hearted affair,
which gives good results but does away with the essential idea of the
voucher as being a receipted bill. Under it, a house voucher—so called
because it never leaves the house—is made up and used as the basis of
entry. The bill is paid by independent check, which when canceled is filed
with the voucher. In all respects, except that the voucher is not sent with the
check to be receipted, the system is operated as a regular voucher system.
An advantage claimed is that in this way all information as to distribution of
the charge or use of the purchased materials or services is kept strictly
within the business itself. This is done at the sacrifice of securing a
receipted bill.
Summary of Operation and Advantages
is to make up and enter the voucher for the gross amount, using the
Discount column in the voucher register merely as a memo or not at all,
posting the discounts, as earned, from the cash book and using a separate
series of treasurer’s numbers when the checks are entered on the cash book.
Strict adherence to the theory of cash discount as a purchase department
item would require making and entering the voucher net and distributing it
net. The Discount column in the register might well be changed to a
“Neglected Purchase Discounts” column into which would be distributed
the supplementary voucher required when discounts are not taken. Under
this theory, also, the voucher may be made up and entered gross, with the
discount handled as a regular purchase discount item, and the net amount
distributed to the other columns. The student should work out the manner of
handling all the discount contingencies under this method.
Modifications of System
A regular purchase ledger is sometimes used with the voucher system.
In such cases the voucher register becomes merely an analytic purchase
journal and much of the advantage of numbering every transaction is lost.
Accounts may also be set up merely as memos to indicate volume of
business. The voucher index, as explained above, accomplishes this in a
limited way.
A hybrid voucher system is sometimes met, a sort of half-hearted affair,
which gives good results but does away with the essential idea of the
voucher as being a receipted bill. Under it, a house voucher—so called
because it never leaves the house—is made up and used as the basis of
entry. The bill is paid by independent check, which when canceled is filed
with the voucher. In all respects, except that the voucher is not sent with the
check to be receipted, the system is operated as a regular voucher system.
An advantage claimed is that in this way all information as to distribution of
the charge or use of the purchased materials or services is kept strictly
within the business itself. This is done at the sacrifice of securing a
receipted bill.
Summary of Operation and Advantages
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By way of summary, it may be stated that a fully efficient operation of
the voucher system is comprised under the following routine:
1. A verification of invoices.
2. Making up and entering the vouchers.
3. Filing vouchers previous to payment.
4. Paying vouchers.
5. Filing paid vouchers.
6. Indexing vouchers.
Some of the advantages claimed for the voucher system are:
1. It gives a detailed analysis of all purchases.
2. It saves labor by doing away with the purchase
ledger.
3. It secures an up-to-date entry of all liabilities.
4. It localizes responsibility by showing authority for
the auditing, payment, and entry of the items.
5. It secures a receipted bill for all disbursements of
cash.
The chief disadvantages are:
1. Clumsy provision for returns and allowances,
partial payments on bills, and notes payable.
2. Inadequate showing of volume of business with
each creditor.
3. The giving out of information about the business
which should be kept private.
It should always be borne in mind that any satisfactory method of
account-keeping must be adapted to individual conditions. If efficient
results are expected, a business man should beware of ready-to-wear
accounting systems. There are conditions in which the voucher system
gives excellent results. There are also conditions to which it is entirely
unadaptable and inadequate.
the voucher system is comprised under the following routine:
1. A verification of invoices.
2. Making up and entering the vouchers.
3. Filing vouchers previous to payment.
4. Paying vouchers.
5. Filing paid vouchers.
6. Indexing vouchers.
Some of the advantages claimed for the voucher system are:
1. It gives a detailed analysis of all purchases.
2. It saves labor by doing away with the purchase
ledger.
3. It secures an up-to-date entry of all liabilities.
4. It localizes responsibility by showing authority for
the auditing, payment, and entry of the items.
5. It secures a receipted bill for all disbursements of
cash.
The chief disadvantages are:
1. Clumsy provision for returns and allowances,
partial payments on bills, and notes payable.
2. Inadequate showing of volume of business with
each creditor.
3. The giving out of information about the business
which should be kept private.
It should always be borne in mind that any satisfactory method of
account-keeping must be adapted to individual conditions. If efficient
results are expected, a business man should beware of ready-to-wear
accounting systems. There are conditions in which the voucher system
gives excellent results. There are also conditions to which it is entirely
unadaptable and inadequate.
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CHAPTER III
FACTORY COSTS
Difference between Factory and Financial Accounting
As was stated in Chapter II, the accounting records of a concern making
its own product are much more complex than those of a concern which
limits its activities to the buying and selling of stock-in-trade. A much larger
mass of detailed information is needed for the proper conduct of the
business. In this chapter it is purposed to study in a broad way the
fundamental principles involved in factory accounting and to examine some
of its distinctive problems. Factory accounting does not differ in the real
fundamentals of account-keeping from any other kind of accounting. Its
principles of debit and credit are the same; it employs the same or similar
kinds of accounting records; and the same general use is made of the
records, viz., to serve as a guide in the proper management and control of
the business. Its distinctive features are seen in the application of certain
principles to secure special information. To understand the problems
peculiar to factory accounting, it will be necessary to consider the nature of
this information.
Definitions of Terms
Three elements enter into the manufacture of a product. These are
material, labor, and expense. The problems of factory accounting are
therefore those connected with the accounting for the costs of material,
labor, and expense. Some terms used in this connection will need
explanation. A standard terminology for cost-keeping is becoming fairly
well established. Direct and indirect costs, prime cost, factory burden, or
overhead expenses, factory cost, full cost or cost to make and sell—these
are some of the terms needing definition. Direct costs are those which can
be allocated directly to a specific product. They are items which can be
separated from all other cost items and applied solely to a particular
product. Indirect costs are those which are shared in common by the various
products and so must be distributed over them on some equitable basis.
FACTORY COSTS
Difference between Factory and Financial Accounting
As was stated in Chapter II, the accounting records of a concern making
its own product are much more complex than those of a concern which
limits its activities to the buying and selling of stock-in-trade. A much larger
mass of detailed information is needed for the proper conduct of the
business. In this chapter it is purposed to study in a broad way the
fundamental principles involved in factory accounting and to examine some
of its distinctive problems. Factory accounting does not differ in the real
fundamentals of account-keeping from any other kind of accounting. Its
principles of debit and credit are the same; it employs the same or similar
kinds of accounting records; and the same general use is made of the
records, viz., to serve as a guide in the proper management and control of
the business. Its distinctive features are seen in the application of certain
principles to secure special information. To understand the problems
peculiar to factory accounting, it will be necessary to consider the nature of
this information.
Definitions of Terms
Three elements enter into the manufacture of a product. These are
material, labor, and expense. The problems of factory accounting are
therefore those connected with the accounting for the costs of material,
labor, and expense. Some terms used in this connection will need
explanation. A standard terminology for cost-keeping is becoming fairly
well established. Direct and indirect costs, prime cost, factory burden, or
overhead expenses, factory cost, full cost or cost to make and sell—these
are some of the terms needing definition. Direct costs are those which can
be allocated directly to a specific product. They are items which can be
separated from all other cost items and applied solely to a particular
product. Indirect costs are those which are shared in common by the various
products and so must be distributed over them on some equitable basis.
Page 76
Direct costs are sometimes called prime costs. The cost elements which can
almost invariably be applied directly to the product are material and labor.
The sum of these two items constitute, therefore, the prime or first cost of
the product. The other items of cost which are incurred in the factory or
with which the factory is chargeable are variously called factory expense,
overhead, or burden. These indirect costs cannot be charged directly to any
specific product, and so they are shared by the entire factory output.
The sum of prime cost plus factory expense constitutes factory cost, i.e.,
the entire cost of manufacture up to the point at which the product is turned
over to the selling department for sale. This is sometimes called total
manufacturing cost.
Full cost is the price at which the manufactured article can be made and
sold. In other words, to the factory cost of the article must be added its
equitable share of all the other costs of conducting the business and also a
margin of profit in order to arrive at a selling price. These definitions
indicate some of the purposes of cost-keeping. Other purposes are given
below.
Special Purposes of Cost Records
To maintain adequate control over production, careful records as to
consumption of material and labor must be kept, so that the cause of any
marked fluctuations of the costs of the current period from those of former
periods can be investigated. The determination of factory cost makes
possible a comparison of the policy of manufacturing with that of buying
the manufactured article on the open market. This sometimes shows that
manufacture is being carried at a loss. Again, the fixing of a sale price on
the article, which while covering all expenses, shall at the same time leave a
margin of profit, is a prime essential in every business. To be of the greatest
advantage and usefulness, cost records should not only determine factory
cost but they should accumulate the data needed to predetermine the selling
price with accuracy.
Nature of Raw Materials and Supplies
Materials or raw materials constitute the crude commodities or semi-
manufactured articles which are to be worked upon and fashioned into a
new product. It is seldom that any factory takes its material in the raw form
almost invariably be applied directly to the product are material and labor.
The sum of these two items constitute, therefore, the prime or first cost of
the product. The other items of cost which are incurred in the factory or
with which the factory is chargeable are variously called factory expense,
overhead, or burden. These indirect costs cannot be charged directly to any
specific product, and so they are shared by the entire factory output.
The sum of prime cost plus factory expense constitutes factory cost, i.e.,
the entire cost of manufacture up to the point at which the product is turned
over to the selling department for sale. This is sometimes called total
manufacturing cost.
Full cost is the price at which the manufactured article can be made and
sold. In other words, to the factory cost of the article must be added its
equitable share of all the other costs of conducting the business and also a
margin of profit in order to arrive at a selling price. These definitions
indicate some of the purposes of cost-keeping. Other purposes are given
below.
Special Purposes of Cost Records
To maintain adequate control over production, careful records as to
consumption of material and labor must be kept, so that the cause of any
marked fluctuations of the costs of the current period from those of former
periods can be investigated. The determination of factory cost makes
possible a comparison of the policy of manufacturing with that of buying
the manufactured article on the open market. This sometimes shows that
manufacture is being carried at a loss. Again, the fixing of a sale price on
the article, which while covering all expenses, shall at the same time leave a
margin of profit, is a prime essential in every business. To be of the greatest
advantage and usefulness, cost records should not only determine factory
cost but they should accumulate the data needed to predetermine the selling
price with accuracy.
Nature of Raw Materials and Supplies
Materials or raw materials constitute the crude commodities or semi-
manufactured articles which are to be worked upon and fashioned into a
new product. It is seldom that any factory takes its material in the raw form
Page 77
in which it comes from nature. The product of the mines goes through many
degrees and stages of refinement and at each stage of the process some of it
becomes the “raw material” for another class of industry. The term is
therefore relative; that which is the finished output of one factory becomes
the raw material of another factory, to be worked upon and given new
forms.
Auxiliary material and supplies are also made use of. Thus, certain parts
such as screws, bolts, hinges, casters, fastenings, trimmings, and the like,
are incorporated into the finished product without change of form or the
application of any labor thereto. These also constitute a part of the raw
material of the factory, their value as finished product being due to place
utility rather than form utility.
Supplies are to be distinguished from raw materials. This also is a
relative term. In general, material which does not directly form a part of the
finished product is carried under the head of supplies. Materials used in
getting ready or seasoning the raw material, i.e., auxiliary material, such as
paint, putty, etc., the quantity of which used on each piece of product cannot
be measured with exactitude and must therefore be spread over the entire
product—these and similar items constitute manufacturing supplies. They
are usually treated as a part of factory expense rather than as belonging to
prime cost.
There are also factory operating supplies. These comprise the materials
used in the operation of the factory. Repairs material, brooms, oil, waste,
packing, nails, fuel, etc., are examples of this kind of supplies. These, of
course, are classed with factory expense, also.
The raw material which enters into prime cost is thus seen to be only
that which can be charged directly to the particular product. All other
material is overhead or expense.
Accounting for Material Cost
The problem of applying the cost of the material directly to the job is
largely a problem of systematizing which requires the careful oversight and
accounting for all materials bought and used in manufacture. Two general
methods are employed. Under the one, the old method of keeping record of
all purchases and taking the inventory periodically to determine how much
degrees and stages of refinement and at each stage of the process some of it
becomes the “raw material” for another class of industry. The term is
therefore relative; that which is the finished output of one factory becomes
the raw material of another factory, to be worked upon and given new
forms.
Auxiliary material and supplies are also made use of. Thus, certain parts
such as screws, bolts, hinges, casters, fastenings, trimmings, and the like,
are incorporated into the finished product without change of form or the
application of any labor thereto. These also constitute a part of the raw
material of the factory, their value as finished product being due to place
utility rather than form utility.
Supplies are to be distinguished from raw materials. This also is a
relative term. In general, material which does not directly form a part of the
finished product is carried under the head of supplies. Materials used in
getting ready or seasoning the raw material, i.e., auxiliary material, such as
paint, putty, etc., the quantity of which used on each piece of product cannot
be measured with exactitude and must therefore be spread over the entire
product—these and similar items constitute manufacturing supplies. They
are usually treated as a part of factory expense rather than as belonging to
prime cost.
There are also factory operating supplies. These comprise the materials
used in the operation of the factory. Repairs material, brooms, oil, waste,
packing, nails, fuel, etc., are examples of this kind of supplies. These, of
course, are classed with factory expense, also.
The raw material which enters into prime cost is thus seen to be only
that which can be charged directly to the particular product. All other
material is overhead or expense.
Accounting for Material Cost
The problem of applying the cost of the material directly to the job is
largely a problem of systematizing which requires the careful oversight and
accounting for all materials bought and used in manufacture. Two general
methods are employed. Under the one, the old method of keeping record of
all purchases and taking the inventory periodically to determine how much
Page 78
material must have been used in the processes of manufacture, is deemed
sufficient. In a small factory making just one product—or a few simple
products—where the conditions are such that the manager has an intimate
knowledge of all processes and can exercise personal control over them,
fairly satisfactory results may accrue under this method, though the amount
and therefore the cost of the material consumed in the product can never be
known accurately until the inventory has been taken.
The other method requires almost as accurate accounting for material as
for cash. A stores room or department must be established and a stores
ledger installed. As materials are purchased and come into stores, they are
classified in whatever detail is desirable and charged to their respective
class accounts kept in the stores ledger. As material is needed for
manufacture it is drawn by properly authorized order on the stores-keeper.
These orders are called “requisitions” and indicate the material needed and
the job or product to which it is to be charged. The requisitions constitute
the source of the credit entries to the various stores ledger accounts as well
as the charges to the job or product. The balances on the stores ledger
accounts thus show the amount of each class of material which should be on
hand in the stores room.
This method of keeping track of materials is known as the perpetual
inventory system. By its use, it is possible to know without the taking of a
physical inventory how much material is being used in manufacture and the
cost of it. In this way much better control is secured over materials than
under the physical inventory method. In keeping track of material values, of
course, inward freight, cartage, handling and stores room cost must be
loaded onto the invoice cost of the materials to arrive at the full cost at
which they are issued for manufacture.
Direct and Indirect Labor
The second element of prime cost is labor. In factory accounting, labor
is divided into two classes, direct and indirect. These are sometimes called
productive and non-productive, terms doubtless carried over from the old
economics which looked upon some labor as productive and some non-
productive—necessary, it is true, but rather of the nature of a necessary evil.
Direct labor is a direct cost as explained above. That is, it is the labor of the
workmen who apply themselves directly to the manufactured product as
sufficient. In a small factory making just one product—or a few simple
products—where the conditions are such that the manager has an intimate
knowledge of all processes and can exercise personal control over them,
fairly satisfactory results may accrue under this method, though the amount
and therefore the cost of the material consumed in the product can never be
known accurately until the inventory has been taken.
The other method requires almost as accurate accounting for material as
for cash. A stores room or department must be established and a stores
ledger installed. As materials are purchased and come into stores, they are
classified in whatever detail is desirable and charged to their respective
class accounts kept in the stores ledger. As material is needed for
manufacture it is drawn by properly authorized order on the stores-keeper.
These orders are called “requisitions” and indicate the material needed and
the job or product to which it is to be charged. The requisitions constitute
the source of the credit entries to the various stores ledger accounts as well
as the charges to the job or product. The balances on the stores ledger
accounts thus show the amount of each class of material which should be on
hand in the stores room.
This method of keeping track of materials is known as the perpetual
inventory system. By its use, it is possible to know without the taking of a
physical inventory how much material is being used in manufacture and the
cost of it. In this way much better control is secured over materials than
under the physical inventory method. In keeping track of material values, of
course, inward freight, cartage, handling and stores room cost must be
loaded onto the invoice cost of the materials to arrive at the full cost at
which they are issued for manufacture.
Direct and Indirect Labor
The second element of prime cost is labor. In factory accounting, labor
is divided into two classes, direct and indirect. These are sometimes called
productive and non-productive, terms doubtless carried over from the old
economics which looked upon some labor as productive and some non-
productive—necessary, it is true, but rather of the nature of a necessary evil.
Direct labor is a direct cost as explained above. That is, it is the labor of the
workmen who apply themselves directly to the manufactured product as
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distinguished from the labor of those employees who plan, lay out, and
supervise the work of others. Direct labor can be definitely allocated to
specific product or jobs, because it is applied directly to them. Indirect labor
cannot usually be allocated to a definite product because it is applied to all
the product, not being employed long enough or definitely enough on any
specific product to justify keeping track of the time and charging it to
specific product. Direct labor is a prime cost; indirect a factory expense. It
is with direct labor that our present discussion is concerned.
The problem to be solved in accounting for labor is not the
determination of the total cost of labor used, as is part of the problem of
accounting for materials, but the distribution of that cost over the product.
Determination of labor cost, except that accrued at any time, is a
comparatively simple matter because the workmen have to be paid at
regular intervals. Distribution of the labor cost over the product is more
difficult. This necessitates keeping a record of the amount of time spent by
each workman on specific product. In that way the labor costs can be
figured quickly and distributed to the various products worked upon.
Time-Keeping Records
To keep track of the workman’s time spent on each unit of product,
record must be kept by means of time cards, timekeepers, time clocks, or
other similar device which will show the time at which work was
commenced and the time at which it was finished or when the working
force is transferred to other work. The time card is arranged with space for
number or name of the jobs or products worked on and the time spent on
each. Use of the hour or day rate of wages paid the workman gives the labor
charge to each particular product worked upon. This time card, or its
equivalent, may be kept by department foreman, a special timekeeper, or by
the workman himself. At the end of the week or other period, these time
cards are turned into the office and they serve as the basis for making up the
past week’s pay-roll or as a check against the pay-roll where some other
source for the make-up of the pay-roll is used.
Pay-Roll
The pay-roll is merely a list of the names or numbers, or both, of the
workmen, showing the time employed during the past period, and the rate
supervise the work of others. Direct labor can be definitely allocated to
specific product or jobs, because it is applied directly to them. Indirect labor
cannot usually be allocated to a definite product because it is applied to all
the product, not being employed long enough or definitely enough on any
specific product to justify keeping track of the time and charging it to
specific product. Direct labor is a prime cost; indirect a factory expense. It
is with direct labor that our present discussion is concerned.
The problem to be solved in accounting for labor is not the
determination of the total cost of labor used, as is part of the problem of
accounting for materials, but the distribution of that cost over the product.
Determination of labor cost, except that accrued at any time, is a
comparatively simple matter because the workmen have to be paid at
regular intervals. Distribution of the labor cost over the product is more
difficult. This necessitates keeping a record of the amount of time spent by
each workman on specific product. In that way the labor costs can be
figured quickly and distributed to the various products worked upon.
Time-Keeping Records
To keep track of the workman’s time spent on each unit of product,
record must be kept by means of time cards, timekeepers, time clocks, or
other similar device which will show the time at which work was
commenced and the time at which it was finished or when the working
force is transferred to other work. The time card is arranged with space for
number or name of the jobs or products worked on and the time spent on
each. Use of the hour or day rate of wages paid the workman gives the labor
charge to each particular product worked upon. This time card, or its
equivalent, may be kept by department foreman, a special timekeeper, or by
the workman himself. At the end of the week or other period, these time
cards are turned into the office and they serve as the basis for making up the
past week’s pay-roll or as a check against the pay-roll where some other
source for the make-up of the pay-roll is used.
Pay-Roll
The pay-roll is merely a list of the names or numbers, or both, of the
workmen, showing the time employed during the past period, and the rate
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of wages. A column to carry total amount due each workman is provided, as
well as in some cases a place for the signature of the workman’s name to
acknowledge receipt of payment. Provision may be made for other
information, also, such as distribution of the labor cost to the specific
product, but this is not usual. When the time cards of the workmen are
turned in, they are checked against foremen’s reports or sick notices. The
total time spent by each workman multiplied by the rate of wages gives the
amount earned by each man. From this may be deducted any claims, such
as insurance, rent, store charges, hospital and sick benefit, giving the net
amount due the workman.
Safeguarding the Pay-Roll
Since the pay-roll is such a frequent source of error and fraud, all
possible safeguards, chiefly of an internal sort, should be made use of.
Where possible, workmen should be employed through an employment
department to which requests for men needed should be sent. Some form of
card record should be kept for office files of all men taken on—and perhaps
of all men interviewed. Additions of names to the pay-roll should not be
allowed without authorization, and the payment of the men should not be
made by the same clerks who make up the pay-roll. The pay-roll should be
checked as to mathematical correctness and, where possible, as to the
content of the roster, both before and after making payment. Too often has
the total of the pay-roll been changed after its correctness has been proven
but before it has been presented to the treasurer to provide the funds
needed, the thief pocketing the difference between the amount needed for
payment of labor and the raised amount of the pay-roll. Checking before
and after payment will prevent this.
If payment is by check, the total amount of the pay-roll should be
transferred by check to a special bank account on which the individual
checks are drawn. If payment is in currency, this will be secured by check
on the bank and the pay envelopes made up from it. Before drawing the
currency, the individual amounts should be analyzed to determine the
denominations of the coins and currency needed for filling each envelope.
Methods of Pay-Roll Payment. On each pay envelope should be marked
the name and the amount. One pay-roll clerk should count out the amounts,
the other clerk verifying them and filling the envelopes. A very ingenious
well as in some cases a place for the signature of the workman’s name to
acknowledge receipt of payment. Provision may be made for other
information, also, such as distribution of the labor cost to the specific
product, but this is not usual. When the time cards of the workmen are
turned in, they are checked against foremen’s reports or sick notices. The
total time spent by each workman multiplied by the rate of wages gives the
amount earned by each man. From this may be deducted any claims, such
as insurance, rent, store charges, hospital and sick benefit, giving the net
amount due the workman.
Safeguarding the Pay-Roll
Since the pay-roll is such a frequent source of error and fraud, all
possible safeguards, chiefly of an internal sort, should be made use of.
Where possible, workmen should be employed through an employment
department to which requests for men needed should be sent. Some form of
card record should be kept for office files of all men taken on—and perhaps
of all men interviewed. Additions of names to the pay-roll should not be
allowed without authorization, and the payment of the men should not be
made by the same clerks who make up the pay-roll. The pay-roll should be
checked as to mathematical correctness and, where possible, as to the
content of the roster, both before and after making payment. Too often has
the total of the pay-roll been changed after its correctness has been proven
but before it has been presented to the treasurer to provide the funds
needed, the thief pocketing the difference between the amount needed for
payment of labor and the raised amount of the pay-roll. Checking before
and after payment will prevent this.
If payment is by check, the total amount of the pay-roll should be
transferred by check to a special bank account on which the individual
checks are drawn. If payment is in currency, this will be secured by check
on the bank and the pay envelopes made up from it. Before drawing the
currency, the individual amounts should be analyzed to determine the
denominations of the coins and currency needed for filling each envelope.
Methods of Pay-Roll Payment. On each pay envelope should be marked
the name and the amount. One pay-roll clerk should count out the amounts,
the other clerk verifying them and filling the envelopes. A very ingenious
Page 81
pay-roll machine can be used for filling envelopes with the proper amount.
The total amount of the pay-roll is placed in a coin rack operated by a
keyboard. As the amounts of the individual envelopes are set up on the
keyboard, the coin rack delivers the correct amount into a chute which
carries it to the envelope. At the same time the amount delivered is listed,
making it easy, in case of error, to locate the envelope containing the wrong
amount. When the envelopes are delivered to the workmen, each man
should identify himself in the presence of his foreman and give receipt for
his pay. This is usually done by signing the pay-roll. The clerks making
payment and the witnessing foremen should sign the pay-roll. Any
unclaimed envelopes are returned to the treasurer to be held a certain length
of time for claiming, after which time they may be diverted to other uses,
though the liability for them must still be shown.
Distribution of Labor Charges
Distribution of the labor charges may be made in several ways. The
precise method must depend largely on local conditions. In a small factory
making only a few products, or where cost by departments is the
desideratum, the voucher register may be provided with sufficient
distributive columns to meet the requirements. At the time the pay-roll
check is entered, it is distributed according to the labor cost in the various
departments or on the various batches of product. This dispenses with a
general pay-roll or labor account on the ledger. In a larger concern or one in
which a more detailed distribution is desirable in order to secure definite
and accurate costs on a diversified product, distribution on the face of the
voucher register might not be feasible. Here, the pay-roll check will be run
through the register as a charge to pay-roll. When the desired analysis is
made in accordance with workmen’s time cards or other sources of
information, a general or cost journal entry is made, charging the proper
accounts and crediting Pay-Roll. Or, and usually better, a “Pay-Roll
Distribution Book” may be used. This book is a recapitulation of the time
cards distribution sheets. Each time card must be analyzed according to
jobs, product, or departments, and these distributions as summarized should
as a matter of permanent record be entered in a recapitulation book. This,
by being made a posting medium, becomes the pay-roll distribution book.
Charges to the proper accounts are made from this book, offset by a credit
of the total of the book to Pay-Roll account. Sometimes the pay-roll book
The total amount of the pay-roll is placed in a coin rack operated by a
keyboard. As the amounts of the individual envelopes are set up on the
keyboard, the coin rack delivers the correct amount into a chute which
carries it to the envelope. At the same time the amount delivered is listed,
making it easy, in case of error, to locate the envelope containing the wrong
amount. When the envelopes are delivered to the workmen, each man
should identify himself in the presence of his foreman and give receipt for
his pay. This is usually done by signing the pay-roll. The clerks making
payment and the witnessing foremen should sign the pay-roll. Any
unclaimed envelopes are returned to the treasurer to be held a certain length
of time for claiming, after which time they may be diverted to other uses,
though the liability for them must still be shown.
Distribution of Labor Charges
Distribution of the labor charges may be made in several ways. The
precise method must depend largely on local conditions. In a small factory
making only a few products, or where cost by departments is the
desideratum, the voucher register may be provided with sufficient
distributive columns to meet the requirements. At the time the pay-roll
check is entered, it is distributed according to the labor cost in the various
departments or on the various batches of product. This dispenses with a
general pay-roll or labor account on the ledger. In a larger concern or one in
which a more detailed distribution is desirable in order to secure definite
and accurate costs on a diversified product, distribution on the face of the
voucher register might not be feasible. Here, the pay-roll check will be run
through the register as a charge to pay-roll. When the desired analysis is
made in accordance with workmen’s time cards or other sources of
information, a general or cost journal entry is made, charging the proper
accounts and crediting Pay-Roll. Or, and usually better, a “Pay-Roll
Distribution Book” may be used. This book is a recapitulation of the time
cards distribution sheets. Each time card must be analyzed according to
jobs, product, or departments, and these distributions as summarized should
as a matter of permanent record be entered in a recapitulation book. This,
by being made a posting medium, becomes the pay-roll distribution book.
Charges to the proper accounts are made from this book, offset by a credit
of the total of the book to Pay-Roll account. Sometimes the pay-roll book
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itself carries distributive columns and can therefore be made to serve as a
pay-roll distribution record.
Accrued Wages. Distribution of wages accrued at the end of the fiscal
period is perhaps best made through the general journal, although it can
without much difficulty be run through the distribution book by making two
recapitulations of the last week or pay-roll period at the end of the fiscal
period, the portion of the week belonging to the last fiscal period being
summarized separately from the portion belonging to the next period. Both
summaries, however, should be run through on the regular pay-roll voucher
for that week’s wages.
Expense
The third item or element which goes into the cost of manufacture is
factory expense. Under this head are included all the costs of manufacture
excepting the prime cost elements of materials and direct labor. Indirect
labor, factory supplies, light, heat, power, repairs and maintenance to
factory buildings and equipment, depreciation on factory buildings and
equipment, rent, insurance, etc., constitute the main items under this
category. These are the indirect costs of manufacture because, while just as
necessary as the prime cost elements, it is impossible to allocate them
directly to the product. How much of the cost of light, how much of repairs
cost, how much of the cost of factory supplies, etc., shall be charged to each
unit of several different kinds of product constitute a problem on the
solution of which depends the whole structure of accurate costing. Accurate
distribution of materials and labor costs may be complex, but presents no
real difficulties. It requires little more than careful and painstaking work.
On the other hand, to secure an equitable basis for the distribution of
factory expenses, and one which is at the same time a workable basis, is in
some cases well nigh impossible.
One common basis of distribution for all the factory expenses will not
usually give satisfactory results. Each item of overhead must be considered
separately and will often require a distinct basis of distribution. Thus,
indirect labor is sometimes distributed over product on the basis of the cost
of the direct labor item in the product, on the theory that the cost of
supervision is a cost of supervising the direct labor and so closely related
and dependent on that cost. Under some conditions, the number of direct
pay-roll distribution record.
Accrued Wages. Distribution of wages accrued at the end of the fiscal
period is perhaps best made through the general journal, although it can
without much difficulty be run through the distribution book by making two
recapitulations of the last week or pay-roll period at the end of the fiscal
period, the portion of the week belonging to the last fiscal period being
summarized separately from the portion belonging to the next period. Both
summaries, however, should be run through on the regular pay-roll voucher
for that week’s wages.
Expense
The third item or element which goes into the cost of manufacture is
factory expense. Under this head are included all the costs of manufacture
excepting the prime cost elements of materials and direct labor. Indirect
labor, factory supplies, light, heat, power, repairs and maintenance to
factory buildings and equipment, depreciation on factory buildings and
equipment, rent, insurance, etc., constitute the main items under this
category. These are the indirect costs of manufacture because, while just as
necessary as the prime cost elements, it is impossible to allocate them
directly to the product. How much of the cost of light, how much of repairs
cost, how much of the cost of factory supplies, etc., shall be charged to each
unit of several different kinds of product constitute a problem on the
solution of which depends the whole structure of accurate costing. Accurate
distribution of materials and labor costs may be complex, but presents no
real difficulties. It requires little more than careful and painstaking work.
On the other hand, to secure an equitable basis for the distribution of
factory expenses, and one which is at the same time a workable basis, is in
some cases well nigh impossible.
One common basis of distribution for all the factory expenses will not
usually give satisfactory results. Each item of overhead must be considered
separately and will often require a distinct basis of distribution. Thus,
indirect labor is sometimes distributed over product on the basis of the cost
of the direct labor item in the product, on the theory that the cost of
supervision is a cost of supervising the direct labor and so closely related
and dependent on that cost. Under some conditions, the number of direct
Page 83
labor hours is used instead of the cost of direct labor. Again, the time the
product is worked on in a given department is taken as the most equitable
basis for distributing indirect labor costs. Power, where metered to a
machine, may be charged to the product on the meter basis. Where not
metered, it may be charged on the basis of the time the machine is operated.
So, every item of expense must be analyzed and effort made to secure an
equitable basis of distribution.
Summary of Manufacturing Cost
Each unit of product, therefore, as it comes from the factory must carry
its burden of cost composed of materials, labor, and factory expense costs.
The sum total of all of these costs for all products—the entire output of the
factory—will be the record of manufacture on the general books, the
detailed record being carried in subsidiary books. At the close of the fiscal
period when the temporary proprietorship activities of the business must be
summarized, an entirely distinct group or section will be devoted to the
activities of the factory because these costs must be shown separately from
the others. For this purpose, the first section of the profit and loss statement
and account is treated as the “Manufacturing” section, and under it are
summarized in two groups the prime cost elements of materials and direct
labor and the factory expenses. The total of this manufacturing section gives
the cost at which the manufactured product is charged to the sales
department of the business, and there this item takes the place of the cost of
purchases in a business which buys its stock-in-trade. A detailed
explanation of the manufacturing section as a part of the profit and loss
summary is given in Chapter XXVII. The principles of cost accounting
cannot here be developed further than this mere statement of the ends
sought.
product is worked on in a given department is taken as the most equitable
basis for distributing indirect labor costs. Power, where metered to a
machine, may be charged to the product on the meter basis. Where not
metered, it may be charged on the basis of the time the machine is operated.
So, every item of expense must be analyzed and effort made to secure an
equitable basis of distribution.
Summary of Manufacturing Cost
Each unit of product, therefore, as it comes from the factory must carry
its burden of cost composed of materials, labor, and factory expense costs.
The sum total of all of these costs for all products—the entire output of the
factory—will be the record of manufacture on the general books, the
detailed record being carried in subsidiary books. At the close of the fiscal
period when the temporary proprietorship activities of the business must be
summarized, an entirely distinct group or section will be devoted to the
activities of the factory because these costs must be shown separately from
the others. For this purpose, the first section of the profit and loss statement
and account is treated as the “Manufacturing” section, and under it are
summarized in two groups the prime cost elements of materials and direct
labor and the factory expenses. The total of this manufacturing section gives
the cost at which the manufactured product is charged to the sales
department of the business, and there this item takes the place of the cost of
purchases in a business which buys its stock-in-trade. A detailed
explanation of the manufacturing section as a part of the profit and loss
summary is given in Chapter XXVII. The principles of cost accounting
cannot here be developed further than this mere statement of the ends
sought.
Page 84
CHAPTER IV
THE BALANCE SHEET
Business Methods under the Microscope
The balance sheet is occupying an increasingly large place in all affairs of business and even of
state, because the state is taking cognizance of business as never before. All phases of commercial
activity are under the microscope. In these war times the government is tapping every available
source of revenue. Kinds of property, property values, profits, rates of profit on capital invested—
all are under investigation and the publicity resulting therefrom should make for a better conduct of
future business. All this is forcing home to the manufacturer and trader some very obvious but long
disregarded principles of business conduct necessary to secure health and long life. And these
timely lessons will be of even greater use in the struggle for world markets that is imminent. As an
interested party to any condition of business, labor also is claiming the right to be heard. The public
in its direct dependence on certain classes of corporations for many of its necessities and most of its
conveniences is also interested in the proper conduct of those businesses. As a factor in this
increasing interest and scrutiny over business enterprises, exercised both from the inside and from
external sources, banks are exerting a large and beneficent influence. The extension of credit, both
bank and commercial, is no longer done by haphazard rule-of-the-thumb methods as in days gone
by. Every applicant for credit must prove his right to it, must show cause why he deserves it, must
present evidence of financial condition and standing on the basis of which the banker, the money
lender, or the seller will be justified in extending all or some portion of the credit asked.
The Reading of the Balance Sheet
Because, in these and many other ways, the balance sheet offers the readiest means of securing
the necessary information, it becomes an increasingly prominent statement. Before a proper
understanding of the balance sheet can be had, and therefore before it can serve the various
purposes to which it can be adapted, certain principles governing its make-up, both as to form and
content, should be established. A proper reading of the balance sheet cannot be made without a
thorough grasp of these principles.
The knowledge necessary for this is broadly of two kinds, viz.: (1) a knowledge of accounts,
their technique, construction, and meaning; and (2) a knowledge of the principles of valuation as
applied to business enterprises. The latter is not a domain of knowledge pre-empted by the
accountant nor limited exclusively to his use. It touches more or less intimately all related fields of
business endeavor. That is why the modern accountant needs a broad training and something more
than a cursory knowledge of business practices and conditions. He should have a close
acquaintance with the fundamental currents of business life, its organization and finance, and its
basis in law, if he hopes to measure up to present-day requirements.
Thus not only is the accountant interested in the form and content of the balance sheet, but a
proper understanding of it is valuable and increasingly necessary to all business men. In this
chapter and those which follow, it is purposed to study these two problems of form and content,
first establishing the broad basic principles and then showing in detail how these apply to various
conditions and particular data. This chapter will concern itself with the problem of the make-up of
the balance sheet so far as it relates to form.
THE BALANCE SHEET
Business Methods under the Microscope
The balance sheet is occupying an increasingly large place in all affairs of business and even of
state, because the state is taking cognizance of business as never before. All phases of commercial
activity are under the microscope. In these war times the government is tapping every available
source of revenue. Kinds of property, property values, profits, rates of profit on capital invested—
all are under investigation and the publicity resulting therefrom should make for a better conduct of
future business. All this is forcing home to the manufacturer and trader some very obvious but long
disregarded principles of business conduct necessary to secure health and long life. And these
timely lessons will be of even greater use in the struggle for world markets that is imminent. As an
interested party to any condition of business, labor also is claiming the right to be heard. The public
in its direct dependence on certain classes of corporations for many of its necessities and most of its
conveniences is also interested in the proper conduct of those businesses. As a factor in this
increasing interest and scrutiny over business enterprises, exercised both from the inside and from
external sources, banks are exerting a large and beneficent influence. The extension of credit, both
bank and commercial, is no longer done by haphazard rule-of-the-thumb methods as in days gone
by. Every applicant for credit must prove his right to it, must show cause why he deserves it, must
present evidence of financial condition and standing on the basis of which the banker, the money
lender, or the seller will be justified in extending all or some portion of the credit asked.
The Reading of the Balance Sheet
Because, in these and many other ways, the balance sheet offers the readiest means of securing
the necessary information, it becomes an increasingly prominent statement. Before a proper
understanding of the balance sheet can be had, and therefore before it can serve the various
purposes to which it can be adapted, certain principles governing its make-up, both as to form and
content, should be established. A proper reading of the balance sheet cannot be made without a
thorough grasp of these principles.
The knowledge necessary for this is broadly of two kinds, viz.: (1) a knowledge of accounts,
their technique, construction, and meaning; and (2) a knowledge of the principles of valuation as
applied to business enterprises. The latter is not a domain of knowledge pre-empted by the
accountant nor limited exclusively to his use. It touches more or less intimately all related fields of
business endeavor. That is why the modern accountant needs a broad training and something more
than a cursory knowledge of business practices and conditions. He should have a close
acquaintance with the fundamental currents of business life, its organization and finance, and its
basis in law, if he hopes to measure up to present-day requirements.
Thus not only is the accountant interested in the form and content of the balance sheet, but a
proper understanding of it is valuable and increasingly necessary to all business men. In this
chapter and those which follow, it is purposed to study these two problems of form and content,
first establishing the broad basic principles and then showing in detail how these apply to various
conditions and particular data. This chapter will concern itself with the problem of the make-up of
the balance sheet so far as it relates to form.
Page 85
Definition
George Lisle[4] defines a balance sheet as “a concise statement compiled from the books of a
concern which have been kept by double entry, showing on the one side all the liabilities and on the
other side all the assets of the concern at a particular moment of time.” Another writer says, “It is a
cross-section of the business at a given instant”; and another, it is a “screen picture of the financial
position of a going business at a certain moment.” As indicated by the first definition, an attempt is
sometimes made to limit the term balance sheet to a statement made up from a double-entry set of
books. With equal propriety it may be applied to any statement, whether made up from single- or
double-entry books, or from any formal records, or from no records at all, which shows the assets
and liabilities of a concern and the difference between them, i.e., the balance, as the item of net
worth.
To distinguish this latter statement from the balance sheet when used in the restricted sense
above referred to, the title, “statement of assets and liabilities” is sometimes used but there seems
little reason for the distinction. Here the terms will be used as synonyms. The balance sheet then is
a statement of financial condition as distinguished from a statement showing the operations of the
business, and it is true only for a given moment of time. Theoretically the wheels of business are
stopped momentarily, all operations cease, and a summary of the assets and liabilities then existing
with their balance shown as net worth constitutes at that moment the balance sheet—the financial
statement.
Relation between Balance Sheet and Trial Balance
A balance sheet when made up from a double-entry set of books bears a close resemblance to
the trial balance. The trial balance is simply a list of ledger balances. Due to practical
considerations in making the record from day to day, the ledger seldom reflects the true condition
of the business, as there is no distinct separation of assets, liabilities, expenses, and income. Some
accounts take on a mixed character, making necessary the periodic separation of their elements.
This separation is effected by the adjusting entries explained in Volume I. A trial balance of the
ledger after the adjusting entries are made contains the data for both the financial statement and the
operating statement. After the operating data, i.e., the income and expenses, have been summarized
through the Profit and Loss account and its balance has been transferred to some vested
proprietorship account, the records left on the books relate only to assets, liabilities, and vested
proprietorship. A trial balance now taken—a post-closing trial balance—contains only balance
sheet items and to all intents and purposes is a balance sheet. While, as we shall see, the form in
which the data of the balance sheet are presented is a matter of serious importance, any showing of
assets, liabilities, and net worth constitutes a balance sheet.
Form of Balance Sheet
A balance sheet is not an account, nor is it the statement of an account. It is simply a statement
of assets, liabilities, and proprietorship, arranged in whatever form best suits the purpose. Where set
up in parallel columns, it is frequently called the account form; when shown vertically on the page,
assets followed by liabilities and the difference indicated as net worth, it is called the report form. A
balance sheet therefore being only a statement cannot properly be said to have either a debit or a
credit side. It is not a complete system for the record of the transactions of a business set up in debit
and credit form for the sake of proof, although on its statement of fundamental equality may rest
the whole scheme of debit and credit. While usually made up from a system of double-entry books
and so often spoken of as the goal of record-keeping, it may be made up from sources entirely
extraneous to the books.
George Lisle[4] defines a balance sheet as “a concise statement compiled from the books of a
concern which have been kept by double entry, showing on the one side all the liabilities and on the
other side all the assets of the concern at a particular moment of time.” Another writer says, “It is a
cross-section of the business at a given instant”; and another, it is a “screen picture of the financial
position of a going business at a certain moment.” As indicated by the first definition, an attempt is
sometimes made to limit the term balance sheet to a statement made up from a double-entry set of
books. With equal propriety it may be applied to any statement, whether made up from single- or
double-entry books, or from any formal records, or from no records at all, which shows the assets
and liabilities of a concern and the difference between them, i.e., the balance, as the item of net
worth.
To distinguish this latter statement from the balance sheet when used in the restricted sense
above referred to, the title, “statement of assets and liabilities” is sometimes used but there seems
little reason for the distinction. Here the terms will be used as synonyms. The balance sheet then is
a statement of financial condition as distinguished from a statement showing the operations of the
business, and it is true only for a given moment of time. Theoretically the wheels of business are
stopped momentarily, all operations cease, and a summary of the assets and liabilities then existing
with their balance shown as net worth constitutes at that moment the balance sheet—the financial
statement.
Relation between Balance Sheet and Trial Balance
A balance sheet when made up from a double-entry set of books bears a close resemblance to
the trial balance. The trial balance is simply a list of ledger balances. Due to practical
considerations in making the record from day to day, the ledger seldom reflects the true condition
of the business, as there is no distinct separation of assets, liabilities, expenses, and income. Some
accounts take on a mixed character, making necessary the periodic separation of their elements.
This separation is effected by the adjusting entries explained in Volume I. A trial balance of the
ledger after the adjusting entries are made contains the data for both the financial statement and the
operating statement. After the operating data, i.e., the income and expenses, have been summarized
through the Profit and Loss account and its balance has been transferred to some vested
proprietorship account, the records left on the books relate only to assets, liabilities, and vested
proprietorship. A trial balance now taken—a post-closing trial balance—contains only balance
sheet items and to all intents and purposes is a balance sheet. While, as we shall see, the form in
which the data of the balance sheet are presented is a matter of serious importance, any showing of
assets, liabilities, and net worth constitutes a balance sheet.
Form of Balance Sheet
A balance sheet is not an account, nor is it the statement of an account. It is simply a statement
of assets, liabilities, and proprietorship, arranged in whatever form best suits the purpose. Where set
up in parallel columns, it is frequently called the account form; when shown vertically on the page,
assets followed by liabilities and the difference indicated as net worth, it is called the report form. A
balance sheet therefore being only a statement cannot properly be said to have either a debit or a
credit side. It is not a complete system for the record of the transactions of a business set up in debit
and credit form for the sake of proof, although on its statement of fundamental equality may rest
the whole scheme of debit and credit. While usually made up from a system of double-entry books
and so often spoken of as the goal of record-keeping, it may be made up from sources entirely
extraneous to the books.
Page 86
Purpose and Uses
The purpose of the balance sheet is, as indicated, to show financial condition. It may be made
also to show the amount of profit for the period by elaborating the information given in the net
worth section. If there has been during the period neither a withdrawal of any funds nor an
additional investment, a comparison of net worths as at the beginning and at the end of the period
will bring out the increase or decrease in net worth and therefore establish the amount of profit or
loss, though telling little or nothing as to its source. If there has been withdrawal or investment or
both during the period, adjustment must be made on account of these before the amount of profit or
loss for the period can be determined from the balance sheet. The balance sheet may thus be made
to show profit, though that is an incidental rather than an essential purpose of the statement.
As a statement of financial condition the balance sheet should make possible the determination
of several facts. It may be used as the basis for short-time credit. If so, its purpose then is to show
facts as to solvency. It may be used as the basis for floating a bond issue. If so, other groups of data
in addition to the solvency facts must be held under view. It may be used for determining the
advisability of an investment in the business. If so, its data must be examined from still another
angle. In all of these cases the balance sheet must set forth clearly the relationship of the interests of
the various parties in the business. The assets of a corporation are listed usually so as to show the
total properties to which all the parties may look for the satisfaction of their claims. Of the
claimants there are first, then, those whose claims are redeemable within a short time. Failure to
meet these claims may mean insolvency. There are those also whose claims are not necessarily of
immediate urgency, though they may be. Inability to meet these claims may mean bankruptcy and
dissolution. Finally, the owners themselves have a proprietor’s right only to any residue of assets
left after the claims of all outsiders have been satisfied or are capable of being satisfied. Thus the
balance sheet may serve many purposes.
Types of Balance Sheet
As the balance sheet must serve, or can be made to serve, several definite purposes, the best
way to accomplish the end in view must receive careful consideration. It is here that the question of
form enters. The various problems in connection therewith will next be discussed.
As to types of form there are in the main two, the English and the Continental or American,
both of them well standardized, although many variations from the types are found. The chief
difference between the two types lies in the showing of assets on the right side and liabilities and
capital on the left under the English form, and a reversal of the sides under the Continental form. So
much useless controversy has been carried on with such a waste of effort and words over the
relative merits of the two types, that a writer now scarcely dares venture into the subject. As a
matter of historical interest and information to the student, an effort will be made to summarize
briefly the two positions.
Origin of English Form of Balance Sheet
In the development of record-keeping a stage was passed through in which every account on the
ledger was closed. Not only were the temporary proprietorship accounts cleared through the Profit
and Loss account, but all the remaining asset, liability, and vested proprietorship accounts were in
like manner closed into a Balance account opened on the ledger for this purpose. The Balance
account, after transfer of the various accounts into it, became virtually a balance sheet and so was
itself in balance. In this way the whole ledger was closed. The Balance account at this stage, so the
controversialists maintain, represents, and was later adopted as, the Continental form of balance
sheet. The ledger could not, of course, remain closed; it had to be reopened for the record-keeping
The purpose of the balance sheet is, as indicated, to show financial condition. It may be made
also to show the amount of profit for the period by elaborating the information given in the net
worth section. If there has been during the period neither a withdrawal of any funds nor an
additional investment, a comparison of net worths as at the beginning and at the end of the period
will bring out the increase or decrease in net worth and therefore establish the amount of profit or
loss, though telling little or nothing as to its source. If there has been withdrawal or investment or
both during the period, adjustment must be made on account of these before the amount of profit or
loss for the period can be determined from the balance sheet. The balance sheet may thus be made
to show profit, though that is an incidental rather than an essential purpose of the statement.
As a statement of financial condition the balance sheet should make possible the determination
of several facts. It may be used as the basis for short-time credit. If so, its purpose then is to show
facts as to solvency. It may be used as the basis for floating a bond issue. If so, other groups of data
in addition to the solvency facts must be held under view. It may be used for determining the
advisability of an investment in the business. If so, its data must be examined from still another
angle. In all of these cases the balance sheet must set forth clearly the relationship of the interests of
the various parties in the business. The assets of a corporation are listed usually so as to show the
total properties to which all the parties may look for the satisfaction of their claims. Of the
claimants there are first, then, those whose claims are redeemable within a short time. Failure to
meet these claims may mean insolvency. There are those also whose claims are not necessarily of
immediate urgency, though they may be. Inability to meet these claims may mean bankruptcy and
dissolution. Finally, the owners themselves have a proprietor’s right only to any residue of assets
left after the claims of all outsiders have been satisfied or are capable of being satisfied. Thus the
balance sheet may serve many purposes.
Types of Balance Sheet
As the balance sheet must serve, or can be made to serve, several definite purposes, the best
way to accomplish the end in view must receive careful consideration. It is here that the question of
form enters. The various problems in connection therewith will next be discussed.
As to types of form there are in the main two, the English and the Continental or American,
both of them well standardized, although many variations from the types are found. The chief
difference between the two types lies in the showing of assets on the right side and liabilities and
capital on the left under the English form, and a reversal of the sides under the Continental form. So
much useless controversy has been carried on with such a waste of effort and words over the
relative merits of the two types, that a writer now scarcely dares venture into the subject. As a
matter of historical interest and information to the student, an effort will be made to summarize
briefly the two positions.
Origin of English Form of Balance Sheet
In the development of record-keeping a stage was passed through in which every account on the
ledger was closed. Not only were the temporary proprietorship accounts cleared through the Profit
and Loss account, but all the remaining asset, liability, and vested proprietorship accounts were in
like manner closed into a Balance account opened on the ledger for this purpose. The Balance
account, after transfer of the various accounts into it, became virtually a balance sheet and so was
itself in balance. In this way the whole ledger was closed. The Balance account at this stage, so the
controversialists maintain, represents, and was later adopted as, the Continental form of balance
sheet. The ledger could not, of course, remain closed; it had to be reopened for the record-keeping
Page 87
of the next fiscal period. This was accomplished by credit entries to transfer the assets, and by debit
entries to take out the liabilities and vested proprietorship. These reopening entries as appearing in
the Balance account represent the English form of balance sheet.
This explanation of the origin of the two forms is ingenious and even plausible, although not
synchronizing historically with the lapse of use of the Balance account. Others have attempted an
explanation on purely logical grounds. These hold to the theory of the personality of accounts,
which looks upon the business always as an entity distinct from its owners. Here, the English form
of balance sheet is said to be the statement of account rendered by the business to its owners,
whereas the Continental is the account given by the owners to the business. A. Lowes Dickinson,[5]
in discussing the two forms, says: “The balance of argument would seem to favor the latter
(English) on the theory that a balance sheet is intended to set forth the position of the owner of the
property, who should therefore be credited with what he possesses and charged with what he owes.”
Quite opposed to this view is the position taken by an English authority, George Lisle,[6] He
says: “Why ... the assets which are on the debit side (of the ledger)[7] and the liabilities which are
on the credit side, as according to the principles of accounting they ought to be, should change
places (in the balance sheet),[8] it is impossible to justify. The custom seems to have arisen through
the influence of the forms given in Acts of Parliament, chiefly The Companies Act, 1862, which
must have been prepared by those unacquainted with the theory of accounts. The Profit and Loss
account is taken from the ledger, and the sides are not transposed, and there is no logical reason
why the sides in the balance sheet should be reversed.... The form of balance sheet in which the
assets appear upon the left side is both theoretically the correct form and in practice is the most
convenient form to use.... Prior to about the passing of The Companies Act, 1862, it was the form
chiefly adopted in England, but is so no longer.”
R. H. Montgomery[9] proposes a psychological explanation. He says: “The only sound reason
the author can think of for the custom is that a conservative Englishman looks for his liabilities first
and then looks to see if he has enough assets to discharge, them ... that the average American looks
for his assets first and subsequently glances at his liabilities in order to assure himself that his
excess of assets is as much as he believes it to be.” Regardless of the origin of the two types and
their respective merits, a balance sheet is everywhere used to show assets, liabilities, and net worth,
and less and less regard is being paid to debit and credit or left and right sides, technical form
giving place to an elasticity in the method of showing adapted to accomplish definite purposes.
Variation of English Form
A variation of the English form of balance sheet is seen in the make-up of the balance sheet for
British public service companies. These companies are authorized by special act of Parliament to
raise money for designated purposes. The act, therefore, requires as a part of the statement of
financial condition the rendering of an accounting of the receipts from sale of stock and bonds.
Accompanying the financial statement, or rather as a part of it, is the statement, “Receipts and
Expenditures on Capital Account,” comprising the fixed asset and liability sections of the ordinary
balance sheet. Illogical as it may appear in view of the usual English practice, this account is
credited with the capital stock and bonds issued to establish the undertaking, and is debited with the
fixed assets in which the capital funds have been invested, the intent of the law being that the
capital funds raised should be applied to purchase of fixed equipment with which to earn revenue
and that all other expenditures should be made from revenue. If the fixed assets exceed at any time
the fixed liabilities and capital, it means that the excess has been supplied out of revenue. If the
reverse is true, it means that capital receipts are being used as working capital. Any balance is
entries to take out the liabilities and vested proprietorship. These reopening entries as appearing in
the Balance account represent the English form of balance sheet.
This explanation of the origin of the two forms is ingenious and even plausible, although not
synchronizing historically with the lapse of use of the Balance account. Others have attempted an
explanation on purely logical grounds. These hold to the theory of the personality of accounts,
which looks upon the business always as an entity distinct from its owners. Here, the English form
of balance sheet is said to be the statement of account rendered by the business to its owners,
whereas the Continental is the account given by the owners to the business. A. Lowes Dickinson,[5]
in discussing the two forms, says: “The balance of argument would seem to favor the latter
(English) on the theory that a balance sheet is intended to set forth the position of the owner of the
property, who should therefore be credited with what he possesses and charged with what he owes.”
Quite opposed to this view is the position taken by an English authority, George Lisle,[6] He
says: “Why ... the assets which are on the debit side (of the ledger)[7] and the liabilities which are
on the credit side, as according to the principles of accounting they ought to be, should change
places (in the balance sheet),[8] it is impossible to justify. The custom seems to have arisen through
the influence of the forms given in Acts of Parliament, chiefly The Companies Act, 1862, which
must have been prepared by those unacquainted with the theory of accounts. The Profit and Loss
account is taken from the ledger, and the sides are not transposed, and there is no logical reason
why the sides in the balance sheet should be reversed.... The form of balance sheet in which the
assets appear upon the left side is both theoretically the correct form and in practice is the most
convenient form to use.... Prior to about the passing of The Companies Act, 1862, it was the form
chiefly adopted in England, but is so no longer.”
R. H. Montgomery[9] proposes a psychological explanation. He says: “The only sound reason
the author can think of for the custom is that a conservative Englishman looks for his liabilities first
and then looks to see if he has enough assets to discharge, them ... that the average American looks
for his assets first and subsequently glances at his liabilities in order to assure himself that his
excess of assets is as much as he believes it to be.” Regardless of the origin of the two types and
their respective merits, a balance sheet is everywhere used to show assets, liabilities, and net worth,
and less and less regard is being paid to debit and credit or left and right sides, technical form
giving place to an elasticity in the method of showing adapted to accomplish definite purposes.
Variation of English Form
A variation of the English form of balance sheet is seen in the make-up of the balance sheet for
British public service companies. These companies are authorized by special act of Parliament to
raise money for designated purposes. The act, therefore, requires as a part of the statement of
financial condition the rendering of an accounting of the receipts from sale of stock and bonds.
Accompanying the financial statement, or rather as a part of it, is the statement, “Receipts and
Expenditures on Capital Account,” comprising the fixed asset and liability sections of the ordinary
balance sheet. Illogical as it may appear in view of the usual English practice, this account is
credited with the capital stock and bonds issued to establish the undertaking, and is debited with the
fixed assets in which the capital funds have been invested, the intent of the law being that the
capital funds raised should be applied to purchase of fixed equipment with which to earn revenue
and that all other expenditures should be made from revenue. If the fixed assets exceed at any time
the fixed liabilities and capital, it means that the excess has been supplied out of revenue. If the
reverse is true, it means that capital receipts are being used as working capital. Any balance is
Page 88
carried down to the second part of the financial statement known as “General Balance Sheet,” in
which arrangement of the two sides is made according to English custom. The act authorizing this
double-account form of balance sheet allows the valuation of the fixed assets always at cost, on the
theory that their maintenance in a state of constant good repair and efficient working condition
constitutes a charge against revenue and hence that depreciation need not be considered.
It has been suggested that the double-account form of balance sheet, or rather the law on which
it rests, has been responsible for the decisions in the cases of Lee v. Neuchatel Asphalte Co. and
Verner v. The General and Commercial Investment Trust, Ltd., reference to which is made later in
Chapter XXII, “Profits,” and Chapter XXIV, “Dividends.” Here the decisions rested on the
distinction between fixed and circulating assets and declared in favor of the maintenance of the
capital funds invested in circulating assets but not necessarily of those invested in fixed assets. The
following illustrates the double-account form:
The East and West Railway Company
Receipts and Expenditures on Capital Account
Railroads, Franchises and Capital Stock:
Other Properties $410,000.00 Common $200,000.00
Preferred 75,000.00
Current Expenditures for Debenture 50,000.00
Construction and Funded Debt:
Equipment 65,000.00 General Mortgage Bonds 150,000.00
Investments in Other Companies 50,000.00 Equipment Trust Bonds 100,000.00
Securities in Hands of Trustee 15,000.00
Balance carried to
General Balance Sheet 35,000.00
$575,000.00 $575,000.00
General Balance Sheet, December 31, 1918
Capital Account, Securities $50,000.00
credit balance $35,000.00 Prepaid Expenses 750.00
Special Betterment Fund 15,000.00 Accrued Income 1,250.00
Accrued Expenses 1,500.00 Accounts Receivable 25,000.00
Dividends Payable 17,500.00 Materials and Supplies 10,000.00
Accounts Payable 25,000.00 Cash 7,000.00
$94,000.00 $94,000.00
It will be noted that the sides of the capital account follow the debit and credit order of the
ledger, whereas the general balance sheet reverses that order—an inconsistency for which even the
English do not attempt explanation.
Balance Sheet Titles
which arrangement of the two sides is made according to English custom. The act authorizing this
double-account form of balance sheet allows the valuation of the fixed assets always at cost, on the
theory that their maintenance in a state of constant good repair and efficient working condition
constitutes a charge against revenue and hence that depreciation need not be considered.
It has been suggested that the double-account form of balance sheet, or rather the law on which
it rests, has been responsible for the decisions in the cases of Lee v. Neuchatel Asphalte Co. and
Verner v. The General and Commercial Investment Trust, Ltd., reference to which is made later in
Chapter XXII, “Profits,” and Chapter XXIV, “Dividends.” Here the decisions rested on the
distinction between fixed and circulating assets and declared in favor of the maintenance of the
capital funds invested in circulating assets but not necessarily of those invested in fixed assets. The
following illustrates the double-account form:
The East and West Railway Company
Receipts and Expenditures on Capital Account
Railroads, Franchises and Capital Stock:
Other Properties $410,000.00 Common $200,000.00
Preferred 75,000.00
Current Expenditures for Debenture 50,000.00
Construction and Funded Debt:
Equipment 65,000.00 General Mortgage Bonds 150,000.00
Investments in Other Companies 50,000.00 Equipment Trust Bonds 100,000.00
Securities in Hands of Trustee 15,000.00
Balance carried to
General Balance Sheet 35,000.00
$575,000.00 $575,000.00
General Balance Sheet, December 31, 1918
Capital Account, Securities $50,000.00
credit balance $35,000.00 Prepaid Expenses 750.00
Special Betterment Fund 15,000.00 Accrued Income 1,250.00
Accrued Expenses 1,500.00 Accounts Receivable 25,000.00
Dividends Payable 17,500.00 Materials and Supplies 10,000.00
Accounts Payable 25,000.00 Cash 7,000.00
$94,000.00 $94,000.00
It will be noted that the sides of the capital account follow the debit and credit order of the
ledger, whereas the general balance sheet reverses that order—an inconsistency for which even the
English do not attempt explanation.
Balance Sheet Titles
Page 89
The title of the balance sheet is fairly well standardized. Other titles are sometimes met, such as
Financial Statement; Statement of Assets and Liabilities; Statement of Resources and Liabilities;
Statement of Assets, Liabilities, and Capital; Statement of Financial Condition; etc. The title
“Balance Sheet” seems best. Though not so fully descriptive as some of the other titles, it is
generally understood and has not the objection of inadequate descriptiveness and unwieldiness
often raised against the other titles. There is a similar variation in the titles used for the three main
groups of items shown in the balance sheet, viz., assets, liabilities, and net worth. Obviously,
portions of some of the general titles cited apply here with equal appropriateness. In addition, we
find in use or suggested as appropriate, Property and Assets, Active and Passive, Debit and Credit,
Positive and Negative, Proprietorship, Capital and Surplus, Capital, etc. None of these suggested
titles have met with favor in practice, but they have served the worthy purpose, perhaps, of
providing fuel for academic controversy. The titles, Assets or Resources, Liabilities, and Net Worth
or Capital, seem thoroughly established and seem to cover the need.
Grouping and Classification
In the matter of classification and arrangement of the items under these main groups there is
room for greater diversity both in practice and in theory. The need and purpose of classification and
arrangement is obvious. While any statement, list, or schedule which shows assets, liabilities, and
net worth may properly be called a balance sheet, only by a careful grouping and formulation of the
items can their mutual interrelations and proper dependence be shown. Not only does the bringing
of similar items into groups put them in proper perspective, but the arrangement of the groups to
show their relations to one another makes for a more intelligent interpretation of the balance sheet.
The controlling principle underlying classification of the items into groups is, in the main, their
relative degrees of liquidity. Sometimes other factors, such as emphasis, perspicacity, publicity, and
so on, bring about groupings which differ somewhat from those based solely on degree of liquidity.
Thus it may be desirable to call particular attention to, say, the permanent investments of a concern,
to the condition of its sinking and other funds, to the amount of new construction and betterments
for the current period, or to the values tied up in intangible assets. No hard and fast rule can
therefore be followed; elasticity, flexibility to the desired purpose are working rules which must
underlie any scheme of classification.
As to titles for the various groups, one finds many. The current assets are variously styled
Quick, Floating, Liquid, Circulating. As a sub-group under Current or as a separate group we find
Working and Trading assets. Other groups are Fixed or Capital, Investments, Sinking and Reserve
Fund Assets, Deferred Charges to Operation, Deferred Assets, Deferred Debits, Suspense Debits,
with similar titles for corresponding credit items, Contingent Liabilities—in short almost any title
which seems best to fit the needs of the particular case. Some of these may need some explanation.
The distinction between current and working assets is a somewhat fine-drawn one, although
well taken under certain circumstances. Where the two groups are used, current assets include the
cash, receivables, and temporary investments, and the working assets group (or working and
trading assets as it is sometimes captioned) includes the stock-in-trade (finished goods, goods in
process, and raw materials), supplies of all sorts used in preparing the goods for sale or in making
the sale, office supplies, working funds in the hands of branches and agents, and the like. The line
of demarcation between the two groups is not always clearly drawn, some placing the stock-in-
trade among the current assets, others putting finished stocks in the current group and process
materials in the working group. There is apt to be an overlapping also between the working and the
deferred charges groups, supplies of various sorts often being treated as deferred charges to
operation. Capital assets are fixed assets—the plant and those assets in which the capital must first
Financial Statement; Statement of Assets and Liabilities; Statement of Resources and Liabilities;
Statement of Assets, Liabilities, and Capital; Statement of Financial Condition; etc. The title
“Balance Sheet” seems best. Though not so fully descriptive as some of the other titles, it is
generally understood and has not the objection of inadequate descriptiveness and unwieldiness
often raised against the other titles. There is a similar variation in the titles used for the three main
groups of items shown in the balance sheet, viz., assets, liabilities, and net worth. Obviously,
portions of some of the general titles cited apply here with equal appropriateness. In addition, we
find in use or suggested as appropriate, Property and Assets, Active and Passive, Debit and Credit,
Positive and Negative, Proprietorship, Capital and Surplus, Capital, etc. None of these suggested
titles have met with favor in practice, but they have served the worthy purpose, perhaps, of
providing fuel for academic controversy. The titles, Assets or Resources, Liabilities, and Net Worth
or Capital, seem thoroughly established and seem to cover the need.
Grouping and Classification
In the matter of classification and arrangement of the items under these main groups there is
room for greater diversity both in practice and in theory. The need and purpose of classification and
arrangement is obvious. While any statement, list, or schedule which shows assets, liabilities, and
net worth may properly be called a balance sheet, only by a careful grouping and formulation of the
items can their mutual interrelations and proper dependence be shown. Not only does the bringing
of similar items into groups put them in proper perspective, but the arrangement of the groups to
show their relations to one another makes for a more intelligent interpretation of the balance sheet.
The controlling principle underlying classification of the items into groups is, in the main, their
relative degrees of liquidity. Sometimes other factors, such as emphasis, perspicacity, publicity, and
so on, bring about groupings which differ somewhat from those based solely on degree of liquidity.
Thus it may be desirable to call particular attention to, say, the permanent investments of a concern,
to the condition of its sinking and other funds, to the amount of new construction and betterments
for the current period, or to the values tied up in intangible assets. No hard and fast rule can
therefore be followed; elasticity, flexibility to the desired purpose are working rules which must
underlie any scheme of classification.
As to titles for the various groups, one finds many. The current assets are variously styled
Quick, Floating, Liquid, Circulating. As a sub-group under Current or as a separate group we find
Working and Trading assets. Other groups are Fixed or Capital, Investments, Sinking and Reserve
Fund Assets, Deferred Charges to Operation, Deferred Assets, Deferred Debits, Suspense Debits,
with similar titles for corresponding credit items, Contingent Liabilities—in short almost any title
which seems best to fit the needs of the particular case. Some of these may need some explanation.
The distinction between current and working assets is a somewhat fine-drawn one, although
well taken under certain circumstances. Where the two groups are used, current assets include the
cash, receivables, and temporary investments, and the working assets group (or working and
trading assets as it is sometimes captioned) includes the stock-in-trade (finished goods, goods in
process, and raw materials), supplies of all sorts used in preparing the goods for sale or in making
the sale, office supplies, working funds in the hands of branches and agents, and the like. The line
of demarcation between the two groups is not always clearly drawn, some placing the stock-in-
trade among the current assets, others putting finished stocks in the current group and process
materials in the working group. There is apt to be an overlapping also between the working and the
deferred charges groups, supplies of various sorts often being treated as deferred charges to
operation. Capital assets are fixed assets—the plant and those assets in which the capital must first
Page 90
be invested before revenue can accrue. When the group of capital liabilities is shown it usually
includes both the long-term obligations incurred for raising capital as well as the capital stock. This
unfortunately does not recognize a distinct section for the net worth items.
Arrangement of Groups
The arrangement of the groups among themselves, while showing variations, offers few
important matters for consideration. Here, also, the principle of degree of liquidity controls. The
arrangement is sometimes from fixed to liquid but rather more frequently from liquid to fixed. If
the chief interest in the balance sheet is as to the amounts of capital invested in properties and the
growth of such investments, it is claimed that the fixed asset group should be shown first. This
might be the case with railways, steel corporations, and other large concerns wherein the ratio of
the fixed assets to the current is large. In other concerns—and these constitute the larger number—
chief interest centers in the current group. Here, the ability to pay dividends, to extend a sales
market through carrying larger stocks of merchandise, to secure credit, are the items of chief
moment. It is contended that in these cases, the order of the groups should be from current to fixed.
Whatever grouping is made for the assets, a similar arrangement of groups must be insisted
upon for the liabilities; it is the placing in juxtaposition or the same relative positions of similar
groups among the assets and liabilities which makes for an easily intelligent reading of the
statement. After all, the order of the groups, as from fixed to current or vice versa, is of small
importance in comparison with the similar arrangement of both assets and liabilities and with the
surety of the proper content of each group. The thing to be sought is the arrangement which will
facilitate comparison of similar groups. A rather serious objection to the “fixed to current”
arrangement is that it almost invariably necessitates the separation of the net worth elements. Thus,
capital stock and long-term bonds are grouped together at the top for comparison with the fixed
assets; the remainder of the net worth—surplus and reserved profits—must be shown at the end.
The group of all net worth items together compels a general scheme of logical grouping from
current to fixed.
A difference as to order is also found in the placing of deferred charges to operation. Regardless
of the scheme of general grouping, one frequently finds the deferred charges placed as the last
group. This also seems illogical. Only items of prepaid operating expenses should be included in
that group. Such prepayments, while made in the one period, are properly chargeable to the next.
Their effect, therefore, is to bring about a saving of the cash and other current assets for other uses
during the next period. They are thus nearly related to the current group and could without any
serious violation of principle be included thereunder. For the sake of emphasis and a more open
showing, they are best shown in a group by themselves immediately following the current assets.
The intangible assets, good-will, franchises, patents, etc., are usually included among the fixed
assets. Where so shown they should be given unmistakable titles and are best set up at the end of
the group so as not to be covered and lost among the other items. A suggested scheme of grouping
which will make an intelligent showing for most purposes follows:
Assets: Liabilities:
1. Current Assets 1. Current Liabilities
2. Deferred Charges to 2. Deferred Income
Operation 3. Fixed Liabilities
3. Investment of Reserves
4. Permanent Investments Net Worth:
includes both the long-term obligations incurred for raising capital as well as the capital stock. This
unfortunately does not recognize a distinct section for the net worth items.
Arrangement of Groups
The arrangement of the groups among themselves, while showing variations, offers few
important matters for consideration. Here, also, the principle of degree of liquidity controls. The
arrangement is sometimes from fixed to liquid but rather more frequently from liquid to fixed. If
the chief interest in the balance sheet is as to the amounts of capital invested in properties and the
growth of such investments, it is claimed that the fixed asset group should be shown first. This
might be the case with railways, steel corporations, and other large concerns wherein the ratio of
the fixed assets to the current is large. In other concerns—and these constitute the larger number—
chief interest centers in the current group. Here, the ability to pay dividends, to extend a sales
market through carrying larger stocks of merchandise, to secure credit, are the items of chief
moment. It is contended that in these cases, the order of the groups should be from current to fixed.
Whatever grouping is made for the assets, a similar arrangement of groups must be insisted
upon for the liabilities; it is the placing in juxtaposition or the same relative positions of similar
groups among the assets and liabilities which makes for an easily intelligent reading of the
statement. After all, the order of the groups, as from fixed to current or vice versa, is of small
importance in comparison with the similar arrangement of both assets and liabilities and with the
surety of the proper content of each group. The thing to be sought is the arrangement which will
facilitate comparison of similar groups. A rather serious objection to the “fixed to current”
arrangement is that it almost invariably necessitates the separation of the net worth elements. Thus,
capital stock and long-term bonds are grouped together at the top for comparison with the fixed
assets; the remainder of the net worth—surplus and reserved profits—must be shown at the end.
The group of all net worth items together compels a general scheme of logical grouping from
current to fixed.
A difference as to order is also found in the placing of deferred charges to operation. Regardless
of the scheme of general grouping, one frequently finds the deferred charges placed as the last
group. This also seems illogical. Only items of prepaid operating expenses should be included in
that group. Such prepayments, while made in the one period, are properly chargeable to the next.
Their effect, therefore, is to bring about a saving of the cash and other current assets for other uses
during the next period. They are thus nearly related to the current group and could without any
serious violation of principle be included thereunder. For the sake of emphasis and a more open
showing, they are best shown in a group by themselves immediately following the current assets.
The intangible assets, good-will, franchises, patents, etc., are usually included among the fixed
assets. Where so shown they should be given unmistakable titles and are best set up at the end of
the group so as not to be covered and lost among the other items. A suggested scheme of grouping
which will make an intelligent showing for most purposes follows:
Assets: Liabilities:
1. Current Assets 1. Current Liabilities
2. Deferred Charges to 2. Deferred Income
Operation 3. Fixed Liabilities
3. Investment of Reserves
4. Permanent Investments Net Worth:
Page 91
5. Fixed Assets 1. Capital Stock
2. Reserves of Profits
3. Surplus
The content of these groups and any further explanations necessary are treated in the chapters
which follow, where the detailed application of principles is discussed.
As stated above, the important desideratum is a like arrangement of groups to facilitate
comparison and care to secure the proper content of each group. Within the group itself, while the
arrangement of the items is not so important, the principle of degree of liquidity should govern here
too. Whatever the order of general arrangement of the groups, the same order may well be observed
for the items within the group.
Report and Account Forms
Something should be said with regard to the merits of the two methods of arranging the three
main classes of items, i.e., assets, liabilities, and net worth, on the balance sheet. As previously
stated, the method known as the report form makes a vertical showing of the classes, while the
account form shows the items in parallel columns. The one lists the assets and from their total
shows the subtraction of the total liabilities which are in a subjoined list. This difference,
representing net worth, is explained in detail as to the portion represented by capital stock, surplus,
etc. The account form method lists the assets in one column and the liabilities and net worth in a
parallel column, bringing about a balancing of the two columns.
For the report form, it may be said that this method follows the reasoning of the average
business man, particularly the man unacquainted with accounts, who subtracts his liabilities from
his assets to find how much his present net worth is. The account form rests on the fundamental
desire, deep-rooted in the system of double-entry bookkeeping, to show the two sides in balance. It
may be looked upon as the technical form and therefore well adapted for publication purposes. It
secures also a convenient juxtaposition of groups for purposes of comparison. The one may be
regarded as non-technical, easily within the intelligent grasp of the layman; the other as technical
and addressed to those trained to read that form of statement. As previously stated, any method of
showing which fails to list separately the three distinct classes of assets, liabilities, and net worth is
not usually to be justified; a mixture of net worth and liabilities is bad. Omitting detail, the two
following type forms meet the conditions laid down above:
Report Form of Balance Sheet
Assets
Current Assets:
Cash $........
Receivables ........
Stock-in-Trade ........ $........
Deferred Charges to Operation:
(See Schedules) ........
Investment of Reserves:
Sinking and Other Funds
Permanent Investments:
(Held for purposes of control) ........
2. Reserves of Profits
3. Surplus
The content of these groups and any further explanations necessary are treated in the chapters
which follow, where the detailed application of principles is discussed.
As stated above, the important desideratum is a like arrangement of groups to facilitate
comparison and care to secure the proper content of each group. Within the group itself, while the
arrangement of the items is not so important, the principle of degree of liquidity should govern here
too. Whatever the order of general arrangement of the groups, the same order may well be observed
for the items within the group.
Report and Account Forms
Something should be said with regard to the merits of the two methods of arranging the three
main classes of items, i.e., assets, liabilities, and net worth, on the balance sheet. As previously
stated, the method known as the report form makes a vertical showing of the classes, while the
account form shows the items in parallel columns. The one lists the assets and from their total
shows the subtraction of the total liabilities which are in a subjoined list. This difference,
representing net worth, is explained in detail as to the portion represented by capital stock, surplus,
etc. The account form method lists the assets in one column and the liabilities and net worth in a
parallel column, bringing about a balancing of the two columns.
For the report form, it may be said that this method follows the reasoning of the average
business man, particularly the man unacquainted with accounts, who subtracts his liabilities from
his assets to find how much his present net worth is. The account form rests on the fundamental
desire, deep-rooted in the system of double-entry bookkeeping, to show the two sides in balance. It
may be looked upon as the technical form and therefore well adapted for publication purposes. It
secures also a convenient juxtaposition of groups for purposes of comparison. The one may be
regarded as non-technical, easily within the intelligent grasp of the layman; the other as technical
and addressed to those trained to read that form of statement. As previously stated, any method of
showing which fails to list separately the three distinct classes of assets, liabilities, and net worth is
not usually to be justified; a mixture of net worth and liabilities is bad. Omitting detail, the two
following type forms meet the conditions laid down above:
Report Form of Balance Sheet
Assets
Current Assets:
Cash $........
Receivables ........
Stock-in-Trade ........ $........
Deferred Charges to Operation:
(See Schedules) ........
Investment of Reserves:
Sinking and Other Funds
Permanent Investments:
(Held for purposes of control) ........
Page 92
Fixed Assets:
Plant $........
Equipment ........
Good-Will, etc. ........ ........
Total Assets $........
Liabilities
Current Liabilities:
Notes Payable $........
Trade Creditors ........
Accrued Expenses ........ $........
Deferred Income:
(See Schedules) ........
Fixed Liabilities:
Bonds $........
Long-Term Notes ........ ........
Total Liabilities ........
Net Worth $........
Represented by:
Capital Stock $........
Reserves of Profits ........
Surplus ........
Total Net Worth $.......
Account Form of Balance Sheet
Assets Liabilities and Capital
Current Assets: Current Liabilities:
Cash $.... Notes Payable $....
Receivables .... Trade Creditors ....
Stock-in-Trade .... $.... Accrued Expenses .... $....
Deferred Charges to Operation: Deferred Income:
(See Schedules) .... (See Schedules) ....
Investment of Reserves: Fixed Liabilities:
Sinking and Other Funds .... Bonds $....
Long-Term Notes .... ....
Total Liabilities $....
Permanent Investments ....
Fixed Assets:
Plant $........
Equipment ........
Good-Will, etc. ........ ........
Total Assets $........
Liabilities
Current Liabilities:
Notes Payable $........
Trade Creditors ........
Accrued Expenses ........ $........
Deferred Income:
(See Schedules) ........
Fixed Liabilities:
Bonds $........
Long-Term Notes ........ ........
Total Liabilities ........
Net Worth $........
Represented by:
Capital Stock $........
Reserves of Profits ........
Surplus ........
Total Net Worth $.......
Account Form of Balance Sheet
Assets Liabilities and Capital
Current Assets: Current Liabilities:
Cash $.... Notes Payable $....
Receivables .... Trade Creditors ....
Stock-in-Trade .... $.... Accrued Expenses .... $....
Deferred Charges to Operation: Deferred Income:
(See Schedules) .... (See Schedules) ....
Investment of Reserves: Fixed Liabilities:
Sinking and Other Funds .... Bonds $....
Long-Term Notes .... ....
Total Liabilities $....
Permanent Investments ....
Fixed Assets:
Page 93
Plant $.... Net Worth represented by:
Equipment .... Capital Stock $....
Good-Will, etc. .... .... Reserves of Profit ....
Surplus .... ....
Total Assets $.... Total Liabilities and Capital $....
Valuation Accounts
Nothing has been said thus far concerning the showing of valuation accounts on the balance
sheet. Two different practices are met with. Sometimes such accounts are listed with the liabilities,
and there is a sense in which they may be regarded as liabilities. Rather, however, they should be
looked upon as credits to asset accounts, held temporarily in suspense until they can be definitely
allocated to their assets. They are offsets to show the appraised values of the various properties. As
such, therefore, they are best shown as deductions from their corresponding assets with the
appraised value full-extended. This applies to both the debit and the credit valuation accounts. A
full discussion of these and other reserves is given in Chapter XXIII.
Statutory Requirements as to Frequency of Balance Sheets
Excepting in the case of corporations, there are few, if any, compulsory regulations governing
the frequency of balance sheets. Some of our tax laws have brought about an increasing regularity
with regard to the issuance of formal statements, both balance sheet and profit and loss. England,
France, and Germany require a formal statement from corporations once a year. In this country,
most states require some form of statement but oftentimes the requirement is so indefinite or so
inadequately or half-heartedly enforced that the statement submitted is of little value. On the other
hand, some classes of financial and public service corporations are required to present full and
adequate reports periodically, at least once a year. In the case of national banks five reports are
asked for; in the case of savings banks in some states two reports are required.
Condensation of Information in the Balance Sheet
The relation of the formal balance sheet to the post-closing trial balance needs further
consideration. It has been stated that a post-closing trial balance is essentially a balance sheet. As
the purpose of the latter is to present a bird’s-eye view of financial conditions, much of the detailed
information shown in the post-closing trial balance must be condensed and consolidated with
similar items, so that only totals are shown on the balance sheet. Just as the purpose of the ledger is
by a process of analysis to secure detailed information for use in the current control of the business,
so the balance sheet by losing sight of the detail and by setting forth the fundamental currents of
business life and health, provides the data for the larger aspects of control. How far this process of
condensation should be carried depends largely upon the use to which the balance sheet is to be put.
A statement of financial condition to be issued to the public—stockholders and outsiders—can well
omit data which would be required for internal use. Care must always be taken in condensed
statements to avoid consolidation of detail in such a way as to render the statement misleading. The
English Companies Act of 1862 provided that the “auditors’ report should state whether in their
opinion the balance sheet was a ‘full and fair balance sheet’ containing the particulars required by
the company’s Articles and ‘properly drawn up so as to exhibit a true and correct view of the
company’s affairs.’” This represents the proper attitude for every accountant to assume in the
Equipment .... Capital Stock $....
Good-Will, etc. .... .... Reserves of Profit ....
Surplus .... ....
Total Assets $.... Total Liabilities and Capital $....
Valuation Accounts
Nothing has been said thus far concerning the showing of valuation accounts on the balance
sheet. Two different practices are met with. Sometimes such accounts are listed with the liabilities,
and there is a sense in which they may be regarded as liabilities. Rather, however, they should be
looked upon as credits to asset accounts, held temporarily in suspense until they can be definitely
allocated to their assets. They are offsets to show the appraised values of the various properties. As
such, therefore, they are best shown as deductions from their corresponding assets with the
appraised value full-extended. This applies to both the debit and the credit valuation accounts. A
full discussion of these and other reserves is given in Chapter XXIII.
Statutory Requirements as to Frequency of Balance Sheets
Excepting in the case of corporations, there are few, if any, compulsory regulations governing
the frequency of balance sheets. Some of our tax laws have brought about an increasing regularity
with regard to the issuance of formal statements, both balance sheet and profit and loss. England,
France, and Germany require a formal statement from corporations once a year. In this country,
most states require some form of statement but oftentimes the requirement is so indefinite or so
inadequately or half-heartedly enforced that the statement submitted is of little value. On the other
hand, some classes of financial and public service corporations are required to present full and
adequate reports periodically, at least once a year. In the case of national banks five reports are
asked for; in the case of savings banks in some states two reports are required.
Condensation of Information in the Balance Sheet
The relation of the formal balance sheet to the post-closing trial balance needs further
consideration. It has been stated that a post-closing trial balance is essentially a balance sheet. As
the purpose of the latter is to present a bird’s-eye view of financial conditions, much of the detailed
information shown in the post-closing trial balance must be condensed and consolidated with
similar items, so that only totals are shown on the balance sheet. Just as the purpose of the ledger is
by a process of analysis to secure detailed information for use in the current control of the business,
so the balance sheet by losing sight of the detail and by setting forth the fundamental currents of
business life and health, provides the data for the larger aspects of control. How far this process of
condensation should be carried depends largely upon the use to which the balance sheet is to be put.
A statement of financial condition to be issued to the public—stockholders and outsiders—can well
omit data which would be required for internal use. Care must always be taken in condensed
statements to avoid consolidation of detail in such a way as to render the statement misleading. The
English Companies Act of 1862 provided that the “auditors’ report should state whether in their
opinion the balance sheet was a ‘full and fair balance sheet’ containing the particulars required by
the company’s Articles and ‘properly drawn up so as to exhibit a true and correct view of the
company’s affairs.’” This represents the proper attitude for every accountant to assume in the
Page 94
making of statements. This is not meant to require the publication of information which is the
private property of the business. The phrase, “full and fair,” must be interpreted to mean sufficiently
full, and only so much so that it will be fair to both parties. The company is entitled to withhold
legitimate information the publication of which would be detrimental to it, and not to do so would
be unfaithful to the proper guardianship and protection of its interests, and this in turn would bring
about dissatisfaction with the management and oftentimes ill-feeling among the owners.
Use of Supporting Schedules
By means of supporting schedules, as illustrated and discussed briefly on pages 411 and 412 of
Volume I, it is possible to carry condensation to almost any desired degree and still have available
all necessary detail in the accompanying schedules. What items in the balance sheet should be
supported by schedules and what should not, must be determined by the conditions peculiar to each
case. Here again, the determination rests largely upon the use the statement is to serve. The
informational content is therefore largely dependent upon the purpose for which the statement is
drawn.
Balance sheets may serve any one of the following purposes:
1. Internal use by proprietor or manager.
2. Formal report to stockholders.
3. As a basis for application for credit.
4. For publication or report to regulating or supervising commissions.
5. For annual report to the state.
6. For advertising purposes to float new issues of bonds, preferred
stock, etc.
When used for some of these purposes, oftentimes condensation is made a convenient method of
bringing about a misrepresentation of true condition. Of course, no justification can be found for
this.
Emphasis has already been placed on the necessity of choosing titles and captions which shall
indicate clearly the nature and content of the transactions or data recorded thereunder. Statements of
condition which are misleading, whether with intent or by chance, are to be condemned. As H. R.
Hatfield[10] so well summarizes, the lack of clearness and consequent misunderstanding of the
balance sheet are due in the main to three causes: (1) vagueness of terminology; (2) purposeful
misrepresentation; and (3) the very nature of accounting itself which so largely rests on estimates
rather than on facts of definite determination. Some of these troubles have their origin in the form
of the balance sheet, the manner of showing the items; while the others inhere in its content. It is to
a study of the content of the balance sheet from the standpoint of the statement of values, with the
emphasis on quantitative analysis, that we now turn.
private property of the business. The phrase, “full and fair,” must be interpreted to mean sufficiently
full, and only so much so that it will be fair to both parties. The company is entitled to withhold
legitimate information the publication of which would be detrimental to it, and not to do so would
be unfaithful to the proper guardianship and protection of its interests, and this in turn would bring
about dissatisfaction with the management and oftentimes ill-feeling among the owners.
Use of Supporting Schedules
By means of supporting schedules, as illustrated and discussed briefly on pages 411 and 412 of
Volume I, it is possible to carry condensation to almost any desired degree and still have available
all necessary detail in the accompanying schedules. What items in the balance sheet should be
supported by schedules and what should not, must be determined by the conditions peculiar to each
case. Here again, the determination rests largely upon the use the statement is to serve. The
informational content is therefore largely dependent upon the purpose for which the statement is
drawn.
Balance sheets may serve any one of the following purposes:
1. Internal use by proprietor or manager.
2. Formal report to stockholders.
3. As a basis for application for credit.
4. For publication or report to regulating or supervising commissions.
5. For annual report to the state.
6. For advertising purposes to float new issues of bonds, preferred
stock, etc.
When used for some of these purposes, oftentimes condensation is made a convenient method of
bringing about a misrepresentation of true condition. Of course, no justification can be found for
this.
Emphasis has already been placed on the necessity of choosing titles and captions which shall
indicate clearly the nature and content of the transactions or data recorded thereunder. Statements of
condition which are misleading, whether with intent or by chance, are to be condemned. As H. R.
Hatfield[10] so well summarizes, the lack of clearness and consequent misunderstanding of the
balance sheet are due in the main to three causes: (1) vagueness of terminology; (2) purposeful
misrepresentation; and (3) the very nature of accounting itself which so largely rests on estimates
rather than on facts of definite determination. Some of these troubles have their origin in the form
of the balance sheet, the manner of showing the items; while the others inhere in its content. It is to
a study of the content of the balance sheet from the standpoint of the statement of values, with the
emphasis on quantitative analysis, that we now turn.
Page 95
CHAPTER V
GENERAL PRINCIPLES OF VALUATION
Content of the Balance Sheet
The problems of content and valuation strike at the very heart of the
balance sheet. Form, framework, and method of presentation are important
and their usefulness should not be discounted. Particularly is this seen to be
true from the standpoint of availability of the information presented and
facility in its interpretation; but the meat of the balance sheet is its content.
In connection with this, two points demand consideration, viz.: (1) what
items shall be admitted to a place in the balance sheet; and (2) on what basis
shall they be admitted, this latter being the problem of valuation.
The first question can be answered without much trouble. All properties
owned and all liabilities incurred must find a place in the balance sheet. The
properties belonging to a business include both the tangibles and
intangibles, rights and claims. Most of these have cost value, some may
have been gifts. All the assets must, therefore, be listed. Similarly, the
liabilities, all those things which represent debts owed by the business or
established claims against it, must be given place in the balance sheet.
Neither from the assets nor the liabilities must there be allowed omission.
As stated in Chapter IV, as to content, the balance sheet must be “full and
fair.” Some classes of items, known as contingent assets and contingent
liabilities, will be discussed and their place determined as they are met. The
net worth items, in whatever detail desirable, must also be included.
Valuations for Rate Regulation
The second problem as to the basis on which items shall be valued for
the balance sheet is our chief problem. The general question of valuation
may be viewed from so many points that definition of its meaning here is
necessary. Principles that are applicable to valuations for one purpose
frequently cannot be made to serve another purpose. Because of the
agitation in recent years relative thereto, when the problem of valuation is
mentioned it is associated almost invariably with public service
GENERAL PRINCIPLES OF VALUATION
Content of the Balance Sheet
The problems of content and valuation strike at the very heart of the
balance sheet. Form, framework, and method of presentation are important
and their usefulness should not be discounted. Particularly is this seen to be
true from the standpoint of availability of the information presented and
facility in its interpretation; but the meat of the balance sheet is its content.
In connection with this, two points demand consideration, viz.: (1) what
items shall be admitted to a place in the balance sheet; and (2) on what basis
shall they be admitted, this latter being the problem of valuation.
The first question can be answered without much trouble. All properties
owned and all liabilities incurred must find a place in the balance sheet. The
properties belonging to a business include both the tangibles and
intangibles, rights and claims. Most of these have cost value, some may
have been gifts. All the assets must, therefore, be listed. Similarly, the
liabilities, all those things which represent debts owed by the business or
established claims against it, must be given place in the balance sheet.
Neither from the assets nor the liabilities must there be allowed omission.
As stated in Chapter IV, as to content, the balance sheet must be “full and
fair.” Some classes of items, known as contingent assets and contingent
liabilities, will be discussed and their place determined as they are met. The
net worth items, in whatever detail desirable, must also be included.
Valuations for Rate Regulation
The second problem as to the basis on which items shall be valued for
the balance sheet is our chief problem. The general question of valuation
may be viewed from so many points that definition of its meaning here is
necessary. Principles that are applicable to valuations for one purpose
frequently cannot be made to serve another purpose. Because of the
agitation in recent years relative thereto, when the problem of valuation is
mentioned it is associated almost invariably with public service
Page 96
corporations. Most of the so-called valuation work has been done in
connection with railroads, water companies, gas and light companies, etc.
Here the issue of regulation is involved. Regulation of rates is price
regulation and therefore regulation of profits. The purpose of valuation in
connection with public utilities is the determination of the amount of
investment on which rates must be so regulated as to secure a return based
on fairness and equity to all parties.
Where such valuations have been made they have not proven entirely
satisfactory and it is placing too great faith in human kind to expect the
satisfaction of all parties with the results of any valuation. Where the
properties involved have not been exceedingly complex and have been
fairly well localized, results have seemed to justify the effort; but in the case
of a large and complex plant covering widely separated areas and serving
many and different communities, as is the situation with railroads, in the
minds of many the results obtained in such instances are of doubtful value
when compared with the effort and cost expended. Though much can be
learned from such valuations, the principles underlying them differ at many
points from those which must control in valuations as applied to
commercial balance sheets. It is in connection with public service
valuations that very valuable studies of the depreciation problem have been
made.
Valuation for Sale and Purchase
Again, valuations and appraisals are often made in cases of prospective
sale and purchase negotiations. While most of the determining principles
are the same, not all apply to our problem of going concern valuation. Thus,
the plant to be purchased may not be continued in its present use but must
be adapted to other uses. Results secured towards controlling the market by
means of this purchase may make the plant much more valuable than its
physical worth. Elements of “going concern” and good-will call for
valuation in the case of a purchase and sale transaction and are frequently
not present in commercial balance sheet valuations. These last questions
touch closely our problem and will receive careful consideration in their
proper places.
Other Kinds of Valuations
connection with railroads, water companies, gas and light companies, etc.
Here the issue of regulation is involved. Regulation of rates is price
regulation and therefore regulation of profits. The purpose of valuation in
connection with public utilities is the determination of the amount of
investment on which rates must be so regulated as to secure a return based
on fairness and equity to all parties.
Where such valuations have been made they have not proven entirely
satisfactory and it is placing too great faith in human kind to expect the
satisfaction of all parties with the results of any valuation. Where the
properties involved have not been exceedingly complex and have been
fairly well localized, results have seemed to justify the effort; but in the case
of a large and complex plant covering widely separated areas and serving
many and different communities, as is the situation with railroads, in the
minds of many the results obtained in such instances are of doubtful value
when compared with the effort and cost expended. Though much can be
learned from such valuations, the principles underlying them differ at many
points from those which must control in valuations as applied to
commercial balance sheets. It is in connection with public service
valuations that very valuable studies of the depreciation problem have been
made.
Valuation for Sale and Purchase
Again, valuations and appraisals are often made in cases of prospective
sale and purchase negotiations. While most of the determining principles
are the same, not all apply to our problem of going concern valuation. Thus,
the plant to be purchased may not be continued in its present use but must
be adapted to other uses. Results secured towards controlling the market by
means of this purchase may make the plant much more valuable than its
physical worth. Elements of “going concern” and good-will call for
valuation in the case of a purchase and sale transaction and are frequently
not present in commercial balance sheet valuations. These last questions
touch closely our problem and will receive careful consideration in their
proper places.
Other Kinds of Valuations
Page 97
There are several other kinds of valuations, all more or less closely
related to commercial balance sheet valuations but differing from them in
some respects because of their differing purposes and ends sought. The
chief of these are: (1) valuations for purposes of fire loss adjustments; (2)
valuations for purposes of liquidation to satisfy creditors and determine the
owners’ equities, as in bankruptcy and voluntary dissolutions; and (3)
valuations for purposes of taxation. In all of these cases, many points of
similarity to, and of some differences from, our present problem are found.
In the first and third kinds enumerated, there is marked similarity, but the
problem in the case of the income tax is not so broad. In the second kind,
the problem is entirely different, as values have to be determined on the
basis of forced sale.
Going Concern Valuation
The kind of valuation to be treated here may be called “going concern”
valuation. By that will be meant the values at which the various items shall
appear in the balance sheet when viewed from the standpoint of a concern
which expects to continue operations—a going concern as contrasted with
one which is facing dissolution, reorganization, sale, or other eventuality.
As stated above, the principles of going concern valuation are not distinct
and separate, except in a few instances, from those governing the other
types of valuation referred to. Oftentimes they are the same principles
applied in the same way because the purpose is practically the same; again
they are the same principles but applied differently in order to serve
different purposes; and finally they are sometimes entirely distinct
principles because the purpose to be served is entirely different.
It is not purposed in this treatment of valuation to set forth the points of
variance and sameness with the other types; that is beyond the scope of the
present volume. Endeavor will be made to set forth clearly underlying
principles and their detailed application to the chief items met in the
average balance sheet as viewed from the standpoint of a going concern.
Elsewhere, notably in Chapter XXXV, some principles of another type of
valuation will be discussed.
In any consideration of valuation, it is necessary to seek out the sources
and kinds of value to determine in the one case its basis, and in the other to
establish the type of value applicable to the given conditions. Value is not of
related to commercial balance sheet valuations but differing from them in
some respects because of their differing purposes and ends sought. The
chief of these are: (1) valuations for purposes of fire loss adjustments; (2)
valuations for purposes of liquidation to satisfy creditors and determine the
owners’ equities, as in bankruptcy and voluntary dissolutions; and (3)
valuations for purposes of taxation. In all of these cases, many points of
similarity to, and of some differences from, our present problem are found.
In the first and third kinds enumerated, there is marked similarity, but the
problem in the case of the income tax is not so broad. In the second kind,
the problem is entirely different, as values have to be determined on the
basis of forced sale.
Going Concern Valuation
The kind of valuation to be treated here may be called “going concern”
valuation. By that will be meant the values at which the various items shall
appear in the balance sheet when viewed from the standpoint of a concern
which expects to continue operations—a going concern as contrasted with
one which is facing dissolution, reorganization, sale, or other eventuality.
As stated above, the principles of going concern valuation are not distinct
and separate, except in a few instances, from those governing the other
types of valuation referred to. Oftentimes they are the same principles
applied in the same way because the purpose is practically the same; again
they are the same principles but applied differently in order to serve
different purposes; and finally they are sometimes entirely distinct
principles because the purpose to be served is entirely different.
It is not purposed in this treatment of valuation to set forth the points of
variance and sameness with the other types; that is beyond the scope of the
present volume. Endeavor will be made to set forth clearly underlying
principles and their detailed application to the chief items met in the
average balance sheet as viewed from the standpoint of a going concern.
Elsewhere, notably in Chapter XXXV, some principles of another type of
valuation will be discussed.
In any consideration of valuation, it is necessary to seek out the sources
and kinds of value to determine in the one case its basis, and in the other to
establish the type of value applicable to the given conditions. Value is not of
Page 98
spontaneous origin; it cannot be created out of nothing. Here it is not
intended to search for causes of value or to inquire into the forces back of
them. The author is content to leave that to the economist.
Kinds of Value
Various kinds of value are established facts of the world of business and
by their sources, as the term is used here, is meant the information which
vouches for or establishes the fact of value, rather than a search for the
cause of it. Thus we find, among others, the following kinds of value:
1. Cost value
2. Market value
3. Sales price value
4. Reproduction cost value
5. Scrap, salvage, junk, or break-up value
6. Service value
7. Present or depreciated value
8. Tangible or physical value
9. Intangible value
10. Taxable value
11. Earning value or earnings-capitalized value
12. Liquidation or forced-sale value, etc.
It is to be understood that these various kinds are in no sense mutually
exclusive and separate; they are met in the common vocabulary of men of
affairs, are construed loosely in most cases, but have quite technical
connotations in some places. Any of the terms employed here will,
whenever necessary, be defined. Thus, in accounting, by cost value is
usually meant full cost of a product or other asset in position ready for its
intended use.
Source of Data as to Values
The sources of data as to values are several. Where double-entry books
are kept, the original cost of the various assets can usually be secured from
the books of account, barring errors of principle and omission in making the
intended to search for causes of value or to inquire into the forces back of
them. The author is content to leave that to the economist.
Kinds of Value
Various kinds of value are established facts of the world of business and
by their sources, as the term is used here, is meant the information which
vouches for or establishes the fact of value, rather than a search for the
cause of it. Thus we find, among others, the following kinds of value:
1. Cost value
2. Market value
3. Sales price value
4. Reproduction cost value
5. Scrap, salvage, junk, or break-up value
6. Service value
7. Present or depreciated value
8. Tangible or physical value
9. Intangible value
10. Taxable value
11. Earning value or earnings-capitalized value
12. Liquidation or forced-sale value, etc.
It is to be understood that these various kinds are in no sense mutually
exclusive and separate; they are met in the common vocabulary of men of
affairs, are construed loosely in most cases, but have quite technical
connotations in some places. Any of the terms employed here will,
whenever necessary, be defined. Thus, in accounting, by cost value is
usually meant full cost of a product or other asset in position ready for its
intended use.
Source of Data as to Values
The sources of data as to values are several. Where double-entry books
are kept, the original cost of the various assets can usually be secured from
the books of account, barring errors of principle and omission in making the
Page 99
record. If not found there (as is often the case where single-entry books are
kept), the original purchase invoice gives the chief item of cost, but does
not usually show any inward-carrying or placement costs. Where there is a
formally established market, this may give the information as to value when
no book entries are available. Quoted prices in trade catalogues or lists as of
the date of purchase, offer another means of procuring the information.
Sometimes, even the memory must be relied upon.
Present values of properties purchased formerly may be determined on
the basis of original cost adjusted to take cognizance of depreciation and,
sometimes, of appreciation. This adjustment is made in the light of the best
available experience. The amount of the adjustment is sometimes called an
“experience figure.” Stated otherwise it is an estimate made on the basis of
past experience with some regard to future contingencies. This estimate
may be made by some one within the organization—manager, owner, etc.—
or by regular appraisal companies who specialize on this kind of work.
Usually, however, the appraisal company bases its value on present cost less
depreciation—a reproduction cost value.
Again, for some purposes the statement of earnings as giving the
amount to be capitalized becomes the source of values. As has been seen,
however, earnings themselves contain many elements which rest on
estimated values. In almost all instances there is an element of speculation
—an estimate—in the determination of values.
Cost Value the Usual Basis
The values which are, for the most part, shown in the commercial
balance sheet are cost value or adjusted cost value. Occasionally, values
which bear only an indirect relation to cost must be taken into account. The
determination of cost value is sometimes a comparatively simple matter, as
where the source is a purchase invoice, but more often it involves numerous
other costs in addition to those shown by the purchase invoice, both definite
and indefinite, i.e., estimates. It is in connection with the determination of
cost that the proper segregation of the so-called capital and revenue charges
is of vital importance. An effort will be made to formulate the distinction
between them so as to give a working rule for their determination under
most circumstances.
kept), the original purchase invoice gives the chief item of cost, but does
not usually show any inward-carrying or placement costs. Where there is a
formally established market, this may give the information as to value when
no book entries are available. Quoted prices in trade catalogues or lists as of
the date of purchase, offer another means of procuring the information.
Sometimes, even the memory must be relied upon.
Present values of properties purchased formerly may be determined on
the basis of original cost adjusted to take cognizance of depreciation and,
sometimes, of appreciation. This adjustment is made in the light of the best
available experience. The amount of the adjustment is sometimes called an
“experience figure.” Stated otherwise it is an estimate made on the basis of
past experience with some regard to future contingencies. This estimate
may be made by some one within the organization—manager, owner, etc.—
or by regular appraisal companies who specialize on this kind of work.
Usually, however, the appraisal company bases its value on present cost less
depreciation—a reproduction cost value.
Again, for some purposes the statement of earnings as giving the
amount to be capitalized becomes the source of values. As has been seen,
however, earnings themselves contain many elements which rest on
estimated values. In almost all instances there is an element of speculation
—an estimate—in the determination of values.
Cost Value the Usual Basis
The values which are, for the most part, shown in the commercial
balance sheet are cost value or adjusted cost value. Occasionally, values
which bear only an indirect relation to cost must be taken into account. The
determination of cost value is sometimes a comparatively simple matter, as
where the source is a purchase invoice, but more often it involves numerous
other costs in addition to those shown by the purchase invoice, both definite
and indefinite, i.e., estimates. It is in connection with the determination of
cost that the proper segregation of the so-called capital and revenue charges
is of vital importance. An effort will be made to formulate the distinction
between them so as to give a working rule for their determination under
most circumstances.
Page 100
Definition of Capital and Revenue Expenditures
Capital expenditures may be defined as expenditures of funds or other
assets on capital account. In accounting language, they may be said to be
those expenditures which result in charges to some asset account. They may
sometimes ultimately result in a charge to a liability account by the
conversion of the asset to the decrease of the liability. Expenditures of
capital may be made on account of expenses. This can occur only when
revenues are insufficient to meet all expenses. Such expenditures of capital
bring about an impairment of capital. As the term is generally used,
however, capital expenditures have the meaning first given.
Revenue expenditures may be defined similarly as expenditures of
funds or other assets on revenue account. That is, such expenditures must be
booked as charges to expense accounts. They represent the expenses
incurred in the earning of the revenue, and measure its cost. Just as the
original capital fund, through its expenditure, must provide the plant and
equipment with which to work, so the other expenditures necessary to
prepare and market the product must provide the revenue out of which to
meet these expenditures and secure a margin of profit; else there is
encroachment upon the original capital funds.
A few other terms need definition by way of differentiation from these.
The term “capital receipts” is used to differentiate receipts of funds from the
sale of capital stock or the sale of capital or fixed assets, from funds or
other assets received from revenue or profits sources. Thus, upon the sale of
any asset which was originally purchased out of capital, the receipts
therefor must first be applied to take the place of the capital expended for
the asset, and any balance not used for the first purpose is then a receipt of
revenue.
The term “capital expense” is sometimes used to indicate the group of
expenses incurred in providing the capital needs of the business. They are
the financial management expenses as the term is used in Volume I.
Opposed to capital expenses are the capital income or revenue items. These
are the receipts or income from portions of the capital employed otherwise
than in the purchase and sale of commodities; or the income which
represents savings effected through the handling of the funds of the
Capital expenditures may be defined as expenditures of funds or other
assets on capital account. In accounting language, they may be said to be
those expenditures which result in charges to some asset account. They may
sometimes ultimately result in a charge to a liability account by the
conversion of the asset to the decrease of the liability. Expenditures of
capital may be made on account of expenses. This can occur only when
revenues are insufficient to meet all expenses. Such expenditures of capital
bring about an impairment of capital. As the term is generally used,
however, capital expenditures have the meaning first given.
Revenue expenditures may be defined similarly as expenditures of
funds or other assets on revenue account. That is, such expenditures must be
booked as charges to expense accounts. They represent the expenses
incurred in the earning of the revenue, and measure its cost. Just as the
original capital fund, through its expenditure, must provide the plant and
equipment with which to work, so the other expenditures necessary to
prepare and market the product must provide the revenue out of which to
meet these expenditures and secure a margin of profit; else there is
encroachment upon the original capital funds.
A few other terms need definition by way of differentiation from these.
The term “capital receipts” is used to differentiate receipts of funds from the
sale of capital stock or the sale of capital or fixed assets, from funds or
other assets received from revenue or profits sources. Thus, upon the sale of
any asset which was originally purchased out of capital, the receipts
therefor must first be applied to take the place of the capital expended for
the asset, and any balance not used for the first purpose is then a receipt of
revenue.
The term “capital expense” is sometimes used to indicate the group of
expenses incurred in providing the capital needs of the business. They are
the financial management expenses as the term is used in Volume I.
Opposed to capital expenses are the capital income or revenue items. These
are the receipts or income from portions of the capital employed otherwise
than in the purchase and sale of commodities; or the income which
represents savings effected through the handling of the funds of the
Page 101
business as distinguished from income derived from the handling of stock-
in-trade. They are deductions from the financial management expenses.
Capital and revenue expenditures are thus easily differentiated on paper.
It is in the application of the definition to situations as they develop in
practice that difficulty is encountered. Some of these situations will be
examined with the purpose of determining the application to them of the
distinction between revenue and capital expenditure.
Organization Expenses
Upon the organization of a new enterprise the distinction between
capital and revenue expenditures can usually be made without much
difficulty. All costs incurred to put the concern in a position to earn revenue
are properly treated as capital expenditures. Sufficient capital must be
provided to put the undertaking on an earning basis, as otherwise it fails.
These costs will include many items which upon their second incurrence
must be treated as expense charges because the revenue must provide for
keeping the plant in a state of efficient repair. One group of capital
expenditures, usually carried on the books under the title “Organization
Expense,” is often treated as a revenue expenditure as soon as sufficient
revenues have accumulated to care for them conveniently. This is discussed
in detail in Chapter XVIII on intangible assets. It is sufficient to say here
that upon their incurrence organization expenses constitute capital
expenditures, for no other funds are available for the purpose.
Definition of Replacements, Renewals, Maintenance, etc.
Only after the concern becomes a revenue-producer is the chief
difficulty encountered in determining the proper record as between capital
and revenue. In all cases of new construction and additions to the existing
plant or equipment, no question arises as to the legitimacy of such capital
charges. But when replacement, renewal, or betterment of existing
properties take place, difficulty is met in determining the portion chargeable
to the asset and the portion to be charged against revenue. The dividing line
between renewals and repairs, maintenance, and up-keep is a closely drawn
one, and usually an arbitrary working rule suitable to conditions must be
adopted by each concern. R. P. Bolton[11] gives for some of these terms very
suggestive definitions which the author quotes in full:
in-trade. They are deductions from the financial management expenses.
Capital and revenue expenditures are thus easily differentiated on paper.
It is in the application of the definition to situations as they develop in
practice that difficulty is encountered. Some of these situations will be
examined with the purpose of determining the application to them of the
distinction between revenue and capital expenditure.
Organization Expenses
Upon the organization of a new enterprise the distinction between
capital and revenue expenditures can usually be made without much
difficulty. All costs incurred to put the concern in a position to earn revenue
are properly treated as capital expenditures. Sufficient capital must be
provided to put the undertaking on an earning basis, as otherwise it fails.
These costs will include many items which upon their second incurrence
must be treated as expense charges because the revenue must provide for
keeping the plant in a state of efficient repair. One group of capital
expenditures, usually carried on the books under the title “Organization
Expense,” is often treated as a revenue expenditure as soon as sufficient
revenues have accumulated to care for them conveniently. This is discussed
in detail in Chapter XVIII on intangible assets. It is sufficient to say here
that upon their incurrence organization expenses constitute capital
expenditures, for no other funds are available for the purpose.
Definition of Replacements, Renewals, Maintenance, etc.
Only after the concern becomes a revenue-producer is the chief
difficulty encountered in determining the proper record as between capital
and revenue. In all cases of new construction and additions to the existing
plant or equipment, no question arises as to the legitimacy of such capital
charges. But when replacement, renewal, or betterment of existing
properties take place, difficulty is met in determining the portion chargeable
to the asset and the portion to be charged against revenue. The dividing line
between renewals and repairs, maintenance, and up-keep is a closely drawn
one, and usually an arbitrary working rule suitable to conditions must be
adopted by each concern. R. P. Bolton[11] gives for some of these terms very
suggestive definitions which the author quotes in full:
Page 102
“Maintenance is a process of continuous attention to, and supply of,
operating necessaries, including solicitous observation of the condition of
the object cared for, corresponding to the protecting shelter, clothing and
food supplies to living beings, in order to maintain their functions in
operating condition. It includes supplies which form part of the food of the
appliance. Part of the labor in attendance on machinery is involved in this
element of its care.
“Up-keep is a course of partial recreation, involving the expenditure of
time and money in anticipating causes of decay, of failure, or of possible
injury to the object under care, corresponding to hygienic and recreative
methods, often involving considerable expenditures without apparent direct
results, which are or should be followed in safeguarding the general health
and strength of human beings. Thus, welfare and recreation of employees is
a justifiable expense of an industry. It is part of the cost of the human
machine.
“Repair is the course of partial reconstruction, replacement, or renewal
of worn or of injured portions, after the necessity therefor becomes
apparent, and, unless brought about by accident, the need for the process is
brought about by the failure or inability of maintenance, and also of up-
keep, wholly to arrest the progress of decay by age or continued use.
Provisions to preclude accident or to cover the cost of its results are part of
the cost of repair. Health insurance of employees is a repair cost paid in
advance.”
While these definitions were not intended for accounting purposes and
are not fully applicable thereto, they call attention to the basic ideas of the
terms. The distinctions are in some cases too finely drawn. For accounting
purposes the title “maintenance and repairs” usually gives sufficiently
detailed information. Repairs is a part of the process of maintenance, as is
also renewals. Maintenance, from an accounting standpoint, may be defined
as “the act of keeping a property in condition to perform adequately and
efficiently the service for which it is used.” A. Lowes Dickinson[12] defines
repairs and renewals as follows:
“Repairs. This should include all current expenditures recurring from
day to day and from month to month on the general up-keep of the existing
operating necessaries, including solicitous observation of the condition of
the object cared for, corresponding to the protecting shelter, clothing and
food supplies to living beings, in order to maintain their functions in
operating condition. It includes supplies which form part of the food of the
appliance. Part of the labor in attendance on machinery is involved in this
element of its care.
“Up-keep is a course of partial recreation, involving the expenditure of
time and money in anticipating causes of decay, of failure, or of possible
injury to the object under care, corresponding to hygienic and recreative
methods, often involving considerable expenditures without apparent direct
results, which are or should be followed in safeguarding the general health
and strength of human beings. Thus, welfare and recreation of employees is
a justifiable expense of an industry. It is part of the cost of the human
machine.
“Repair is the course of partial reconstruction, replacement, or renewal
of worn or of injured portions, after the necessity therefor becomes
apparent, and, unless brought about by accident, the need for the process is
brought about by the failure or inability of maintenance, and also of up-
keep, wholly to arrest the progress of decay by age or continued use.
Provisions to preclude accident or to cover the cost of its results are part of
the cost of repair. Health insurance of employees is a repair cost paid in
advance.”
While these definitions were not intended for accounting purposes and
are not fully applicable thereto, they call attention to the basic ideas of the
terms. The distinctions are in some cases too finely drawn. For accounting
purposes the title “maintenance and repairs” usually gives sufficiently
detailed information. Repairs is a part of the process of maintenance, as is
also renewals. Maintenance, from an accounting standpoint, may be defined
as “the act of keeping a property in condition to perform adequately and
efficiently the service for which it is used.” A. Lowes Dickinson[12] defines
repairs and renewals as follows:
“Repairs. This should include all current expenditures recurring from
day to day and from month to month on the general up-keep of the existing
Page 103
property without the renewal of any substantial part thereof, and generally
all periodic repairs which are necessarily undertaken within, say, one year.
“(This caption will, of course, include certain renewals of small parts,
etc., such as would be necessary to continue the useful life of any unit of
building, plant, or machinery over the estimated period of its life.)
“Renewals. This should include all expenditures incurred in renewing,
in whole or in part, any unit of building, plant or machinery, which tend to
extend its useful life beyond the average term. These expenditures would in
general be those which would only occur at long intervals of two or three
years, and whose effect would last for a number of years afterwards.”
As distinguished from renewals, a replacement may be defined as “the
act of replacing a plant unit which is going out of service, with a substitute
which may be either identical with the unit replaced or different from it.” In
accounting terminology the terms “renewals” and “replacements” are for
the most part used synonymously and will be so used here.
Treatment of Renewal of Parts
In the maintenance of a property in efficient condition, repairs and
renewals are constantly taking place. When for an old part or plant unit a
new one is substituted, the question of betterment immediately arises. If an
old machine with book value of $500 is replaced by one costing $750, the
excess of $250 is classed as a betterment and is properly a charge to capital.
A renewal of machine parts cannot be handled so easily. The parts of a
machine are subject to diminution in value due to wear, tear, and
obsolescence, along with the machine as a whole. The machine was
purchased for a lump sum. What portion of the cost is applicable to each
individual part is difficult to determine and must usually rest on estimate or
guess. Similarly, the book value, i.e., the present depreciated value of a part,
is not accurately known. Accordingly, the amount of betterment, if any, in
the replacing of an old part by a new part is difficult to determine. It is here
that working rules must be adopted for each concern.
Thus, it has been suggested that only when the renewal involves an
expenditure of $5 or more should there be any attempt to determine the
amount of betterment, every expenditure under $5 to be charged to expense.
In an establishment of any size this is altogether too small an amount. The
all periodic repairs which are necessarily undertaken within, say, one year.
“(This caption will, of course, include certain renewals of small parts,
etc., such as would be necessary to continue the useful life of any unit of
building, plant, or machinery over the estimated period of its life.)
“Renewals. This should include all expenditures incurred in renewing,
in whole or in part, any unit of building, plant or machinery, which tend to
extend its useful life beyond the average term. These expenditures would in
general be those which would only occur at long intervals of two or three
years, and whose effect would last for a number of years afterwards.”
As distinguished from renewals, a replacement may be defined as “the
act of replacing a plant unit which is going out of service, with a substitute
which may be either identical with the unit replaced or different from it.” In
accounting terminology the terms “renewals” and “replacements” are for
the most part used synonymously and will be so used here.
Treatment of Renewal of Parts
In the maintenance of a property in efficient condition, repairs and
renewals are constantly taking place. When for an old part or plant unit a
new one is substituted, the question of betterment immediately arises. If an
old machine with book value of $500 is replaced by one costing $750, the
excess of $250 is classed as a betterment and is properly a charge to capital.
A renewal of machine parts cannot be handled so easily. The parts of a
machine are subject to diminution in value due to wear, tear, and
obsolescence, along with the machine as a whole. The machine was
purchased for a lump sum. What portion of the cost is applicable to each
individual part is difficult to determine and must usually rest on estimate or
guess. Similarly, the book value, i.e., the present depreciated value of a part,
is not accurately known. Accordingly, the amount of betterment, if any, in
the replacing of an old part by a new part is difficult to determine. It is here
that working rules must be adopted for each concern.
Thus, it has been suggested that only when the renewal involves an
expenditure of $5 or more should there be any attempt to determine the
amount of betterment, every expenditure under $5 to be charged to expense.
In an establishment of any size this is altogether too small an amount. The
Page 104
Chicago Traction System through its board of supervising engineers has
established $200 as the minimum charge to capital or renewals. All
transactions involving even a true betterment, if the amount is less than
$200, are to be recorded as maintenance charges. As a means of simplifying
the accounting, a working rule, with a minimum capital charge adapted to
the conditions of each concern, serves a practical and useful purpose.
Treatment of Cost-Cutting Changes
Other kinds of expenditures which cause trouble as to their proper place
of record are those incurred for the purpose of facilitating the handling of
the work. They may result in an increase of capacity to earn revenue
through a speeding up of production, or the result may be simply a
lessening of the expense of turning out the various units of product. A test
frequently applied in such cases is that of increased earning capacity. It is
argued that even though nothing tangible which did not exist before has
been added to the plant, there has been a rearrangement of the factors of
production with a resulting co-ordination of effort, and this has increased
the capacity of the plant, thus making it more valuable. Inasmuch as this
value is measured by earnings, the cost incurred in securing the increase is a
very proper and legitimate charge to capital. Against this argument, it may
be said that plant or structural changes are always made to improve
operation. To make increased earning capacity the sole test is virtually to
capitalize all expenditures of this kind—a policy which would soon lead to
an unconscionable inflation of assets. Only by a policy of very liberal
depreciation can such values if capitalized be kept within reasonable
bounds. The impropriety of charging such expenditures to the current profit
and loss account is generally acknowledged.
The best practice is to handle items of this kind as deferred charges
under suitable descriptive caption, instead of as charges direct to the asset
account where the nature of the items is soon lost from view and the need of
a high depreciation rate to write them off is soon forgotten. Thus, a
rearrangement of the machinery in a plant may bring about a more
economical routing of the product, or the introduction of a new machine
may entail an entirely changed disposition of existing machines—all for the
purpose of, and actually accomplishing, a saving in costs. Rather than a
charge of the costs incurred to the asset account Machinery, a setting of
established $200 as the minimum charge to capital or renewals. All
transactions involving even a true betterment, if the amount is less than
$200, are to be recorded as maintenance charges. As a means of simplifying
the accounting, a working rule, with a minimum capital charge adapted to
the conditions of each concern, serves a practical and useful purpose.
Treatment of Cost-Cutting Changes
Other kinds of expenditures which cause trouble as to their proper place
of record are those incurred for the purpose of facilitating the handling of
the work. They may result in an increase of capacity to earn revenue
through a speeding up of production, or the result may be simply a
lessening of the expense of turning out the various units of product. A test
frequently applied in such cases is that of increased earning capacity. It is
argued that even though nothing tangible which did not exist before has
been added to the plant, there has been a rearrangement of the factors of
production with a resulting co-ordination of effort, and this has increased
the capacity of the plant, thus making it more valuable. Inasmuch as this
value is measured by earnings, the cost incurred in securing the increase is a
very proper and legitimate charge to capital. Against this argument, it may
be said that plant or structural changes are always made to improve
operation. To make increased earning capacity the sole test is virtually to
capitalize all expenditures of this kind—a policy which would soon lead to
an unconscionable inflation of assets. Only by a policy of very liberal
depreciation can such values if capitalized be kept within reasonable
bounds. The impropriety of charging such expenditures to the current profit
and loss account is generally acknowledged.
The best practice is to handle items of this kind as deferred charges
under suitable descriptive caption, instead of as charges direct to the asset
account where the nature of the items is soon lost from view and the need of
a high depreciation rate to write them off is soon forgotten. Thus, a
rearrangement of the machinery in a plant may bring about a more
economical routing of the product, or the introduction of a new machine
may entail an entirely changed disposition of existing machines—all for the
purpose of, and actually accomplishing, a saving in costs. Rather than a
charge of the costs incurred to the asset account Machinery, a setting of
Page 105
them up under the title “Rearrangement Costs of Machinery,” or other
similar title, shows their exact status and makes possible an intelligent
writing down of them periodically in accordance with the estimated life or
continuance of the savings effected. Practically this amounts to treating the
costs as capital expenditures if the saving effected is judged applicable to
more than the current period. The chief difference is that booking such
items as deferred charges calls for specific attention to the need of a speedy
writing off.
Asset Subject to Depreciation a Deferred Charge to Operations
In this connection it may be pointed out that the cost of all assets subject
to depreciation may well be looked upon as deferred charges to operation,
some portion of that cost being charged off at the close of each fiscal
period. “So we see that capital expenditures, as distinguished from
expenses, are at last an arbitrary conception. It begins with the idea that
certain expenditures have an efficiency which reaches over many earning
periods extending indefinitely into the future. But nothing physical would
last so long, and its earning power might have even less permanence. To
meet this condition we arbitrarily designate certain expenditures whose
effect indefinitely outlasts the immediate earning period as ‘capital,’ and
then in the same arbitrary way, through all subsequent vicissitudes, we hold
them to their first value by maintenance, renewal, and depreciation charges
which are borne by other expenses.”[13]
Authorization for Booking Capital Expenditures
As regards a suitable method for handling transactions which involve a
separation into capital and revenue charges or a determination of the status
of the transaction as between capital and revenue, proper authority should
be secured for making the expenditure. Where possible, before its
incurrence, authorization as to its proper booking should be given, even to
the amounts where feasible, and this order becomes thus the voucher
supporting the entries on the books.
Repairs on Second-Hand Plant
In one situation repair charges which are ordinarily an expense must be
capitalized. Where a company takes over a plant which is badly run down
similar title, shows their exact status and makes possible an intelligent
writing down of them periodically in accordance with the estimated life or
continuance of the savings effected. Practically this amounts to treating the
costs as capital expenditures if the saving effected is judged applicable to
more than the current period. The chief difference is that booking such
items as deferred charges calls for specific attention to the need of a speedy
writing off.
Asset Subject to Depreciation a Deferred Charge to Operations
In this connection it may be pointed out that the cost of all assets subject
to depreciation may well be looked upon as deferred charges to operation,
some portion of that cost being charged off at the close of each fiscal
period. “So we see that capital expenditures, as distinguished from
expenses, are at last an arbitrary conception. It begins with the idea that
certain expenditures have an efficiency which reaches over many earning
periods extending indefinitely into the future. But nothing physical would
last so long, and its earning power might have even less permanence. To
meet this condition we arbitrarily designate certain expenditures whose
effect indefinitely outlasts the immediate earning period as ‘capital,’ and
then in the same arbitrary way, through all subsequent vicissitudes, we hold
them to their first value by maintenance, renewal, and depreciation charges
which are borne by other expenses.”[13]
Authorization for Booking Capital Expenditures
As regards a suitable method for handling transactions which involve a
separation into capital and revenue charges or a determination of the status
of the transaction as between capital and revenue, proper authority should
be secured for making the expenditure. Where possible, before its
incurrence, authorization as to its proper booking should be given, even to
the amounts where feasible, and this order becomes thus the voucher
supporting the entries on the books.
Repairs on Second-Hand Plant
In one situation repair charges which are ordinarily an expense must be
capitalized. Where a company takes over a plant which is badly run down
Page 106
and out of repair, the expenditures necessary to bring it to a state of efficient
operation are capital expenditures. Such a plant resembles a partially
completed plant, and the purchase price is supposed to take that fact into
consideration. It is expected that additional capital will have to be sunk to
rehabilitate the property and put it in a condition of repair necessary to earn
revenue. Accordingly the expenditures necessary to do this are rightly
treated as capital charges.
Construction Costs
A final consideration in the distinction between capital and revenue
expenditures has to do with certain costs incurred during the period of
original construction. We may cover the situation by a general statement to
the effect that all costs necessary to produce a complete plant in condition
ready to earn revenue are proper charges against capital. Thus, interest on
moneys borrowed for construction purposes is a proper charge to capital,
and in England it has been held that dividends in the form of interest are
allowable to shareholders during the construction period. Also, such items
as engineering and superintendence, law expenditures, injuries, taxes, etc.,
both preliminary to the construction period and during it, are to be
capitalized. On the other hand, profits on own construction work are never
to be counted as costs. To do so reveals a misunderstanding of the
difference between a profit and a saving. The matter is discussed more at
length elsewhere.
As to whether any portion of the overhead expenses has a rightful place
among the assets must be determined by the conditions in each case. In
original construction work, before operations begin, all overhead charges
constitute a part of the cost of the assets. For betterment work and additions
carried on concurrently with operation, the case is not so clear. A safe
principle is to treat as capital charges all increases in overhead above what
would normally have been incurred for operation only. To free operation of
any portion of the regular overhead just because betterments are in progress
is not recognized as a sound or conservative policy.
Distinction between Capital and Revenue Expenditures often
Based on Opinion
operation are capital expenditures. Such a plant resembles a partially
completed plant, and the purchase price is supposed to take that fact into
consideration. It is expected that additional capital will have to be sunk to
rehabilitate the property and put it in a condition of repair necessary to earn
revenue. Accordingly the expenditures necessary to do this are rightly
treated as capital charges.
Construction Costs
A final consideration in the distinction between capital and revenue
expenditures has to do with certain costs incurred during the period of
original construction. We may cover the situation by a general statement to
the effect that all costs necessary to produce a complete plant in condition
ready to earn revenue are proper charges against capital. Thus, interest on
moneys borrowed for construction purposes is a proper charge to capital,
and in England it has been held that dividends in the form of interest are
allowable to shareholders during the construction period. Also, such items
as engineering and superintendence, law expenditures, injuries, taxes, etc.,
both preliminary to the construction period and during it, are to be
capitalized. On the other hand, profits on own construction work are never
to be counted as costs. To do so reveals a misunderstanding of the
difference between a profit and a saving. The matter is discussed more at
length elsewhere.
As to whether any portion of the overhead expenses has a rightful place
among the assets must be determined by the conditions in each case. In
original construction work, before operations begin, all overhead charges
constitute a part of the cost of the assets. For betterment work and additions
carried on concurrently with operation, the case is not so clear. A safe
principle is to treat as capital charges all increases in overhead above what
would normally have been incurred for operation only. To free operation of
any portion of the regular overhead just because betterments are in progress
is not recognized as a sound or conservative policy.
Distinction between Capital and Revenue Expenditures often
Based on Opinion
Page 107
Thus it is seen that many phases of the problem of capital and revenue
expenditures are extremely difficult of determination and in their final
analysis rest on estimates and opinions rather than definitely established
facts. Too often it is feared that decision in matters of this kind is
“influenced by unsuspected individual caprice and by considerations of the
financial convenience of the moment”; for the allocation of such items may
sometimes represent the margin between a profit or a loss for the current
period. As is said to be true of geometry, so here there is no royal highway
to the solution of these problems.
Main Groups of Asset Items
If, therefore, it can be determined what items are to be included in the
balance sheet and the proper basis for their valuation can be established, the
problem as to its content is well on the way to solution. Having discussed
the elements and factors entering into a determination of cost value, we are
in a position to state the principles of valuation applicable to the main
groups of items as set up in the balance sheet. These may be listed, for the
purpose of this generalization, under three heads, viz.: (1) current assets, (2)
deferred charges to operation, and (3) fixed assets.
1. For the current assets, the principle of valuation may be stated as
valuation on the basis of cost or market, whichever is the lower. Since
speedy realization of the current assets by conversion into cash for its
equivalent is the aim and expectation of every business—for on such
conversion depends the ability to meet the current liabilities and so have
working capital available for another cycle of purchase and sale (another
turnover)—it would seem that the realization price as given by the market
should govern. In the interest of conservatism and as producing certain
other desirable results which will be brought out as each asset is examined
in detail, cost price, if lower than market, is deemed the desirable basis for
the valuation of this group. By way of explanation, it should be said that
working capital as used here is the difference between current assets and
current liabilities and so represents the portion free to be put to the further
pursuit of business.
2. The principle of valuation involved in deferred charges to operation is
simply the principle of equitable prorating between periods on the basis of a
going concern. Here, not sale value, cash surrender value, or forced sale
expenditures are extremely difficult of determination and in their final
analysis rest on estimates and opinions rather than definitely established
facts. Too often it is feared that decision in matters of this kind is
“influenced by unsuspected individual caprice and by considerations of the
financial convenience of the moment”; for the allocation of such items may
sometimes represent the margin between a profit or a loss for the current
period. As is said to be true of geometry, so here there is no royal highway
to the solution of these problems.
Main Groups of Asset Items
If, therefore, it can be determined what items are to be included in the
balance sheet and the proper basis for their valuation can be established, the
problem as to its content is well on the way to solution. Having discussed
the elements and factors entering into a determination of cost value, we are
in a position to state the principles of valuation applicable to the main
groups of items as set up in the balance sheet. These may be listed, for the
purpose of this generalization, under three heads, viz.: (1) current assets, (2)
deferred charges to operation, and (3) fixed assets.
1. For the current assets, the principle of valuation may be stated as
valuation on the basis of cost or market, whichever is the lower. Since
speedy realization of the current assets by conversion into cash for its
equivalent is the aim and expectation of every business—for on such
conversion depends the ability to meet the current liabilities and so have
working capital available for another cycle of purchase and sale (another
turnover)—it would seem that the realization price as given by the market
should govern. In the interest of conservatism and as producing certain
other desirable results which will be brought out as each asset is examined
in detail, cost price, if lower than market, is deemed the desirable basis for
the valuation of this group. By way of explanation, it should be said that
working capital as used here is the difference between current assets and
current liabilities and so represents the portion free to be put to the further
pursuit of business.
2. The principle of valuation involved in deferred charges to operation is
simply the principle of equitable prorating between periods on the basis of a
going concern. Here, not sale value, cash surrender value, or forced sale
Page 108
value govern, but their value to a concern which expects to continue
operations.
3. For the fixed assets, the principle of valuation generally applicable
may be stated as valuation on the basis of cost less depreciation. This group
of assets represents the properties held for operating and without which
operation could not continue. They are the very essence of the enterprise.
Disposal of them would mean abandonment of the undertaking. Hence they
are not held for realization and conversion into cash, and in a going concern
market value has no effect on them. To a going concern they are worth at
any time what they cost less the portion used up in operations to date.
Therefore valuation at cost less depreciation is the proper basis for showing
the fixed assets in the balance sheet.
Valuation of Liability Items
To the liability items of the balance sheet, principles of valuation are not
directly applicable as such, except so far as content or inclusion and
measure of quantity or amount may be said to embody considerations of
valuation.
Over- and Under-Valuation
The need for correct valuations requires no comment and can best be
appreciated as compared with the effects of over- and undervaluations.
Particularly bad and harmful is overvaluation of the assets and
undervaluation of the liabilities. The use of the balance sheet as an index of
financial condition makes apparent the harm of wrongful content or
valuation of the items entering into it.
The Balance Sheet an Expression of Opinion
It is thus seen that the main problem in connection with the presentation
of a true balance sheet is a problem in valuation and content rather than
form. From what has been said it will be evident that valuation in the vast
majority of cases is not an exact science—a process of definite
determination. Rather, from the nature of the data to be handled and the
principles of valuation given as applicable to the various groups of data,
valuation must almost always be an estimate. The determination of the
value of the elements of cost, the proper differentiation between capital and
operations.
3. For the fixed assets, the principle of valuation generally applicable
may be stated as valuation on the basis of cost less depreciation. This group
of assets represents the properties held for operating and without which
operation could not continue. They are the very essence of the enterprise.
Disposal of them would mean abandonment of the undertaking. Hence they
are not held for realization and conversion into cash, and in a going concern
market value has no effect on them. To a going concern they are worth at
any time what they cost less the portion used up in operations to date.
Therefore valuation at cost less depreciation is the proper basis for showing
the fixed assets in the balance sheet.
Valuation of Liability Items
To the liability items of the balance sheet, principles of valuation are not
directly applicable as such, except so far as content or inclusion and
measure of quantity or amount may be said to embody considerations of
valuation.
Over- and Under-Valuation
The need for correct valuations requires no comment and can best be
appreciated as compared with the effects of over- and undervaluations.
Particularly bad and harmful is overvaluation of the assets and
undervaluation of the liabilities. The use of the balance sheet as an index of
financial condition makes apparent the harm of wrongful content or
valuation of the items entering into it.
The Balance Sheet an Expression of Opinion
It is thus seen that the main problem in connection with the presentation
of a true balance sheet is a problem in valuation and content rather than
form. From what has been said it will be evident that valuation in the vast
majority of cases is not an exact science—a process of definite
determination. Rather, from the nature of the data to be handled and the
principles of valuation given as applicable to the various groups of data,
valuation must almost always be an estimate. The determination of the
value of the elements of cost, the proper differentiation between capital and
Page 109
revenue charges, and finally the calculation of the amount of depreciation
necessary to the valuation of fixed assets—all are estimates. It is true, they
are estimates based on experience, but, from their nature and the influence
of local conditions in a given case, no universally applicable law of
experience can be formulated. It is safe to say that two men would seldom,
if ever, arrive at the same estimate of the values of given assets.
Accordingly the conclusion is reached that a balance sheet is not a
statement of fact but always an expression of opinion. If estimates are
carefully made in the light of all available facts applicable thereto, the
expression of opinion in the balance sheet will approximate as nearly as
may be to a statement of fact.
Because depreciation plays so important a part in making these
estimates, it seems necessary, before setting forth the detailed application of
the principles of valuation to the various assets, to devote several chapters
to a full discussion of the subject, chiefly as it is related to the problem of
valuation but also in some of its correlated aspects.
necessary to the valuation of fixed assets—all are estimates. It is true, they
are estimates based on experience, but, from their nature and the influence
of local conditions in a given case, no universally applicable law of
experience can be formulated. It is safe to say that two men would seldom,
if ever, arrive at the same estimate of the values of given assets.
Accordingly the conclusion is reached that a balance sheet is not a
statement of fact but always an expression of opinion. If estimates are
carefully made in the light of all available facts applicable thereto, the
expression of opinion in the balance sheet will approximate as nearly as
may be to a statement of fact.
Because depreciation plays so important a part in making these
estimates, it seems necessary, before setting forth the detailed application of
the principles of valuation to the various assets, to devote several chapters
to a full discussion of the subject, chiefly as it is related to the problem of
valuation but also in some of its correlated aspects.
Page 110
CHAPTER VI
DEPRECIATION—ASPECTS AND
DEFINITIONS OF TERMS
Aspects of Depreciation
Depreciation is intimately related to practically all problems of
valuation. The engineering profession has made many valuable
investigations and contributions to the literature of the subject and constant
reference to them and use of some of their findings will here be made. Most
of their studies relate to the vexed and still unsettled question of the
valuation of public utility properties for the sake of its bearing on the
problem of fair and equitable rates to the user or consumer. Accordingly
much of this material is not applicable to the accounting phases of the
subject. It is purposed here to treat the question from the standpoint of
accounting rather than that of engineering.
Depreciation may be considered from many viewpoints. It is involved in
the problem of rate-making referred to above; it must be considered in the
valuation of fire insurance adjustments; it is bound up with most questions
of taxation, with all transactions involving the purchase and sale of
enterprises, with negotiations for the procuring of loans, for the
determination of the limitation of capitalization; and in all studies of
commercial balance sheets depreciation is found to affect the value of going
concerns. As stated in Chapter V, these are not always separate and distinct
problems of valuation; they may and often do overlap, one basis for
valuation sometimes serving several of the purposes or classes named
above. The treatment of the subject will be limited in this book to the latter
phase of the subject, i.e., going concern valuation, with the object of
establishing certain norms and differentiating this phase of depreciation
clearly from its other relations.
Definitions
DEPRECIATION—ASPECTS AND
DEFINITIONS OF TERMS
Aspects of Depreciation
Depreciation is intimately related to practically all problems of
valuation. The engineering profession has made many valuable
investigations and contributions to the literature of the subject and constant
reference to them and use of some of their findings will here be made. Most
of their studies relate to the vexed and still unsettled question of the
valuation of public utility properties for the sake of its bearing on the
problem of fair and equitable rates to the user or consumer. Accordingly
much of this material is not applicable to the accounting phases of the
subject. It is purposed here to treat the question from the standpoint of
accounting rather than that of engineering.
Depreciation may be considered from many viewpoints. It is involved in
the problem of rate-making referred to above; it must be considered in the
valuation of fire insurance adjustments; it is bound up with most questions
of taxation, with all transactions involving the purchase and sale of
enterprises, with negotiations for the procuring of loans, for the
determination of the limitation of capitalization; and in all studies of
commercial balance sheets depreciation is found to affect the value of going
concerns. As stated in Chapter V, these are not always separate and distinct
problems of valuation; they may and often do overlap, one basis for
valuation sometimes serving several of the purposes or classes named
above. The treatment of the subject will be limited in this book to the latter
phase of the subject, i.e., going concern valuation, with the object of
establishing certain norms and differentiating this phase of depreciation
clearly from its other relations.
Definitions
Page 111
A clear-cut definition of depreciation is desirable. The word in a general
sense means a lessening, a decrease in value; decretion; deterioration.
Various specific definitions are given, among them being: “the loss, arising
from years of service, in the value of the investment in perishable
property”; “expired capital outlay.” These and many other similar
definitions are met with.
The term “depreciation” is frequently used when the term
“amortization” would be more appropriate. R. P. Bolton[14] says: “The
subject of depreciation has been greatly misrepresented, because
depreciation, which is a financial result, has been confused with
obsolescence, which is an economic process, and with deterioration, which
is a physical condition. Either of the latter brings about depreciation, and
the physical process rarely happens to be more rapid than the economic.
“An illustration of the processes involved is that of the physical
deterioration and obsolescence of a work horse, the capacity of which is
definitely connected with its condition, and the value of the labor of which
is discounted by its up-keep and the cost of its supplies and feed. Its age is
productive of reduction of capacity, but this process may be, and often is,
anticipated for commercial reasons by its supersession by some other form
of apparatus. The horse may be in ever so good a condition at the time when
the motor displaces it, but its financial depreciation then is complete, for it
could be maintained only at a loss. All the elements which come into
consideration in connection with machinery will be better understood if
considered in relation to such an animal, the life of which may readily
extend beyond the point at which its commercial value has terminated.”
Authoritative Opinions
The special committee appointed by the American Society of Civil
Engineers for the purpose of formulating principles and methods for the
valuation of railroad property and other public utilities, after a study of the
question covering a five-year period, presented its report at the annual
meeting of the society, January 17, 1917. The question of depreciation
receives full and serious consideration in this report, which although treated
mainly from the rate-making standpoint offers many suggestions for the
valuation of commercial balance sheets. Their statement reads:
sense means a lessening, a decrease in value; decretion; deterioration.
Various specific definitions are given, among them being: “the loss, arising
from years of service, in the value of the investment in perishable
property”; “expired capital outlay.” These and many other similar
definitions are met with.
The term “depreciation” is frequently used when the term
“amortization” would be more appropriate. R. P. Bolton[14] says: “The
subject of depreciation has been greatly misrepresented, because
depreciation, which is a financial result, has been confused with
obsolescence, which is an economic process, and with deterioration, which
is a physical condition. Either of the latter brings about depreciation, and
the physical process rarely happens to be more rapid than the economic.
“An illustration of the processes involved is that of the physical
deterioration and obsolescence of a work horse, the capacity of which is
definitely connected with its condition, and the value of the labor of which
is discounted by its up-keep and the cost of its supplies and feed. Its age is
productive of reduction of capacity, but this process may be, and often is,
anticipated for commercial reasons by its supersession by some other form
of apparatus. The horse may be in ever so good a condition at the time when
the motor displaces it, but its financial depreciation then is complete, for it
could be maintained only at a loss. All the elements which come into
consideration in connection with machinery will be better understood if
considered in relation to such an animal, the life of which may readily
extend beyond the point at which its commercial value has terminated.”
Authoritative Opinions
The special committee appointed by the American Society of Civil
Engineers for the purpose of formulating principles and methods for the
valuation of railroad property and other public utilities, after a study of the
question covering a five-year period, presented its report at the annual
meeting of the society, January 17, 1917. The question of depreciation
receives full and serious consideration in this report, which although treated
mainly from the rate-making standpoint offers many suggestions for the
valuation of commercial balance sheets. Their statement reads:
Page 112
“Perhaps there is no single subject in connection with valuation that has
caused more trouble than depreciation. This has been due to various causes,
perhaps not the least of which has been confusion in the use of the term.
Depreciation is sometimes used to mean decretion, which is loss of service
life; sometimes to mean the money allowance made in the bookkeeping to
offset accruing loss of service life; and sometimes the loss of value existing
at any time due to the loss of service life or any other cause. The committee
will use it only as meaning the loss of value or worth of property units
which are parts of going concerns. Although this may be due to many
causes, the general discussion will include consideration only of those
effects which, like wear and tear, age, use, and obsolescence or inadequacy,
bring a physical property unit gradually to the end of its service life.”
Earl A. Saliers[15] says: “This loss of value, whether tangible or
intangible in form, resulting from physical decay, or from obsolescence or
inadequacy, which indicate functional decay, is known as depreciation. It
necessitates repairs, renewals, and replacements. Did it not occur, every
outlay on plant would add to the investment. It does not result from one
cause but from many causes, and this sometimes leads to the belief that it
cannot be scientifically handled. But some adequate method of handling it
is not merely desirable, but necessary, to a solution of the problems arising
in the valuation of public utility properties, and in the management of
industrial enterprises generally.”
Henry Floy[16] says: “It (depreciation) is used broadly to mean a
reduction in utility value, expressed as a percentage but more usually in
dollars, due to any deterioration in physical plant by reason of: (a) normal
wear and tear, (b) age or physical decay, (c) inadequacy, (d) obsolescence,
(e) deferred maintenance. The term depreciation, always used in connection
with a reduction in value, has, however, four distinct and separate shades of
meaning, so that the term must be qualified when used in order to
distinguish which one of the following meanings is intended:
“First. The annual amount, expressed as a percentage or in dollars, that
should be laid aside to renew or replace the article in question at the time of
its abandonment.
“Second. The annual amount, expressed as a percentage or in dollars,
that should be laid aside to renew or replace the article in question at the
caused more trouble than depreciation. This has been due to various causes,
perhaps not the least of which has been confusion in the use of the term.
Depreciation is sometimes used to mean decretion, which is loss of service
life; sometimes to mean the money allowance made in the bookkeeping to
offset accruing loss of service life; and sometimes the loss of value existing
at any time due to the loss of service life or any other cause. The committee
will use it only as meaning the loss of value or worth of property units
which are parts of going concerns. Although this may be due to many
causes, the general discussion will include consideration only of those
effects which, like wear and tear, age, use, and obsolescence or inadequacy,
bring a physical property unit gradually to the end of its service life.”
Earl A. Saliers[15] says: “This loss of value, whether tangible or
intangible in form, resulting from physical decay, or from obsolescence or
inadequacy, which indicate functional decay, is known as depreciation. It
necessitates repairs, renewals, and replacements. Did it not occur, every
outlay on plant would add to the investment. It does not result from one
cause but from many causes, and this sometimes leads to the belief that it
cannot be scientifically handled. But some adequate method of handling it
is not merely desirable, but necessary, to a solution of the problems arising
in the valuation of public utility properties, and in the management of
industrial enterprises generally.”
Henry Floy[16] says: “It (depreciation) is used broadly to mean a
reduction in utility value, expressed as a percentage but more usually in
dollars, due to any deterioration in physical plant by reason of: (a) normal
wear and tear, (b) age or physical decay, (c) inadequacy, (d) obsolescence,
(e) deferred maintenance. The term depreciation, always used in connection
with a reduction in value, has, however, four distinct and separate shades of
meaning, so that the term must be qualified when used in order to
distinguish which one of the following meanings is intended:
“First. The annual amount, expressed as a percentage or in dollars, that
should be laid aside to renew or replace the article in question at the time of
its abandonment.
“Second. The annual amount, expressed as a percentage or in dollars,
that should be laid aside to renew or replace the article in question at the
Page 113
time of its abandonment, plus the annual expense of maintenance and repair
expended in removing such part of depreciation as is practicable and good
economy.
“Third. The total amount—usually that estimated as necessary to be
expended to put the physical property in perfect operating condition—
determined by the inspection and observation of an experienced engineer,
expressed in a percentage or in dollars, which must be deducted from the
‘original cost’ or the ‘cost to reproduce new,’ in order to determine the
absolute, actual, present value.
“Fourth. The total amount—it may be the sum of several years of
depreciation—computed from ‘expectancy of life’ tables, more or less
authoritative, expressed in a percentage or in dollars, that must be deducted
from the ‘original cost’ or the ‘cost to reproduce new,’ in order to obtain the
theoretical, present, depreciated value. This value may be increased or
reduced by the condition of the property, as determined from inspection.”
The foregoing quotations from authoritative sources not only show the
efforts made to define the term accurately, but also indicate the various
elements included by different writers under the term, and suggest the need
of further effort toward the standardization of its meaning.
Why the Depreciation Factor Arises
The distinction made in Chapter V between capital and revenue charges
draws attention to the fact that the depreciation factor arises only because
the fiscal or other period when information concerning values and costs,
i.e., financial condition, is desired, does not coincide with the expiration of
service life of the properties used in production. If the information just
referred to were not desired at intermediate periods between the date of
acquisition of the asset and the date of its discard or obsolescence, its cost
should be treated solely as an expense of operation to be charged to the
whole period in the same way that the fuel consumed, the raw materials
used, etc., are regarded as revenue charges, or costs of manufacture.
Practically, therefore, depreciation must be considered because a statement
of financial condition is needed at regular stages of the life of the enterprise;
and furthermore because the life of the various assets used in an
undertaking is not uniform in length and their life histories in consequence
expended in removing such part of depreciation as is practicable and good
economy.
“Third. The total amount—usually that estimated as necessary to be
expended to put the physical property in perfect operating condition—
determined by the inspection and observation of an experienced engineer,
expressed in a percentage or in dollars, which must be deducted from the
‘original cost’ or the ‘cost to reproduce new,’ in order to determine the
absolute, actual, present value.
“Fourth. The total amount—it may be the sum of several years of
depreciation—computed from ‘expectancy of life’ tables, more or less
authoritative, expressed in a percentage or in dollars, that must be deducted
from the ‘original cost’ or the ‘cost to reproduce new,’ in order to obtain the
theoretical, present, depreciated value. This value may be increased or
reduced by the condition of the property, as determined from inspection.”
The foregoing quotations from authoritative sources not only show the
efforts made to define the term accurately, but also indicate the various
elements included by different writers under the term, and suggest the need
of further effort toward the standardization of its meaning.
Why the Depreciation Factor Arises
The distinction made in Chapter V between capital and revenue charges
draws attention to the fact that the depreciation factor arises only because
the fiscal or other period when information concerning values and costs,
i.e., financial condition, is desired, does not coincide with the expiration of
service life of the properties used in production. If the information just
referred to were not desired at intermediate periods between the date of
acquisition of the asset and the date of its discard or obsolescence, its cost
should be treated solely as an expense of operation to be charged to the
whole period in the same way that the fuel consumed, the raw materials
used, etc., are regarded as revenue charges, or costs of manufacture.
Practically, therefore, depreciation must be considered because a statement
of financial condition is needed at regular stages of the life of the enterprise;
and furthermore because the life of the various assets used in an
undertaking is not uniform in length and their life histories in consequence
Page 114
overlap. Some assets wear out and have to be replaced, while others have
still many years of useful service in them.
Actual or Absolute Depreciation
Before considering the various elements of depreciation, an explanation
of some related terms will be given. A distinction is sometimes made
between “absolute or actual” and “theoretical” depreciation. Absolute
depreciation is the decrease in value of an asset from its state when new, to
its present condition as viewed either from the standpoint of the amount it
could be sold for or from the standpoint of its serviceability. In the first
place, therefore, absolute depreciation is not applicable to going concern
valuations. A machine after only a short term of service becomes, from the
standpoint of its salability, a second-hand article and suffers a large
decrease in market value. A water-pipe or an underground telephone cable
immediately after its installation and even before it is brought into service
depreciates materially from the standpoint of its salability as a disconnected
unit. But from the standpoint of service and operations, i.e., adaptability to
its intended use, such an asset may really be more valuable than before or
immediately after installation. Again, an asset because of the excellent state
of repair in which it is maintained may, so far as the serviceability required
of it is concerned, be practically as good as new from the date of its
installation until well along towards the end of its life-term. Its actual or
absolute decrease in value is very slight during the early years of its life but
increases rapidly just before it is discarded. This fact is illustrated by the
example of the water-pipe. Slight repairs, the replacement of parts and
small units, keep it for a long period 100% efficient, but the time comes
when it is completely worn out and repairs are no longer economically
advisable. These two examples illustrate absolute or actual depreciation.
Theoretical Depreciation
Theoretical depreciation is based upon, and has reference to, all the
factors which must be considered in taking account of depreciation. As so
considered the subject is viewed from the standpoint of financing the item
of depreciation (sometimes called “accounting depreciation”) rather than
from that of its serviceability. The engineer attempts to determine the
actual, present serviceability of the asset in comparison with its
still many years of useful service in them.
Actual or Absolute Depreciation
Before considering the various elements of depreciation, an explanation
of some related terms will be given. A distinction is sometimes made
between “absolute or actual” and “theoretical” depreciation. Absolute
depreciation is the decrease in value of an asset from its state when new, to
its present condition as viewed either from the standpoint of the amount it
could be sold for or from the standpoint of its serviceability. In the first
place, therefore, absolute depreciation is not applicable to going concern
valuations. A machine after only a short term of service becomes, from the
standpoint of its salability, a second-hand article and suffers a large
decrease in market value. A water-pipe or an underground telephone cable
immediately after its installation and even before it is brought into service
depreciates materially from the standpoint of its salability as a disconnected
unit. But from the standpoint of service and operations, i.e., adaptability to
its intended use, such an asset may really be more valuable than before or
immediately after installation. Again, an asset because of the excellent state
of repair in which it is maintained may, so far as the serviceability required
of it is concerned, be practically as good as new from the date of its
installation until well along towards the end of its life-term. Its actual or
absolute decrease in value is very slight during the early years of its life but
increases rapidly just before it is discarded. This fact is illustrated by the
example of the water-pipe. Slight repairs, the replacement of parts and
small units, keep it for a long period 100% efficient, but the time comes
when it is completely worn out and repairs are no longer economically
advisable. These two examples illustrate absolute or actual depreciation.
Theoretical Depreciation
Theoretical depreciation is based upon, and has reference to, all the
factors which must be considered in taking account of depreciation. As so
considered the subject is viewed from the standpoint of financing the item
of depreciation (sometimes called “accounting depreciation”) rather than
from that of its serviceability. The engineer attempts to determine the
actual, present serviceability of the asset in comparison with its
Page 115
serviceability when new, and so he leaves out of account its expectancy of
life due to whatever causes.
Comparison of Actual and Theoretical Depreciation
The following chart adapted from Henry Floy’s “Value for Rate-
Making” admirably illustrates the difference between actual and theoretical
depreciation.
Chart Showing Actual and
Theoretical Depreciation
life due to whatever causes.
Comparison of Actual and Theoretical Depreciation
The following chart adapted from Henry Floy’s “Value for Rate-
Making” admirably illustrates the difference between actual and theoretical
depreciation.
Chart Showing Actual and
Theoretical Depreciation
Page 116
Curves 1, 2, and 6 representing actual depreciation have been
sufficiently exemplified in the foregoing explanation of actual depreciation.
Curves 1 and 2 may well represent the actual depreciation of two assets as
viewed from the standpoint of salability; whereas curve 6 represents the
actual depreciation of an asset viewed from the standpoint of serviceability,
assuming that maintenance has kept the asset practically 100% efficient
during most of its life-term. Curves 3, 4, and 5 are illustrations of
theoretical depreciation, the different curves representing different bases for
calculating the annual amount of the decrease in value, as will be explained
in Chapter IX, “Depreciation—Methods of Calculating.” To quote from Mr.
Floy’s work at length:
“The curves 3, 4, and 5 indicate several classes of ‘theoretical’
depreciation which have been quite widely used in some cases for
estimating present values, but more often for determining the yearly
theoretical deterioration for purposes of establishing depreciation funds,
which, however, is quite a different subject. Making a theoretical estimate
of the probable, future, average, annually accruing deterioration of certain
property to provide an item in bookkeeping accounts of operating expense
has nothing whatever to do, in making an appraisal, with fixing the definite
amount of absolute, actual, or accrued depreciation which depends upon the
present condition of physical property, determinable from inspection and
not upon historical documents, depreciation funds, or disputed theoretical
conclusions.”
In an opinion filed March 8, 1916, by the Public Service Commission of
Maryland in the matter of the Chesapeake and Potomac Telephone
Company of Baltimore City, an interesting commentary on the relative
merits of actual versus theoretical depreciation is made. While the opinion
concerns primarily depreciation from the rate-making point of view, it
shows well the interrelation between the two kinds and answers so
conclusively the objection often raised to accounting depreciation that it is
here quoted. The statement is:
“Any theory for ascertaining existing depreciation in the plant of a
public utility which confines such depreciation solely to the actual, visible,
physical, demonstrable deterioration which can be seen by the human eye
and measured by the human hand, must of necessity ignore that other
species of deterioration which the experience of the past has demonstrated
sufficiently exemplified in the foregoing explanation of actual depreciation.
Curves 1 and 2 may well represent the actual depreciation of two assets as
viewed from the standpoint of salability; whereas curve 6 represents the
actual depreciation of an asset viewed from the standpoint of serviceability,
assuming that maintenance has kept the asset practically 100% efficient
during most of its life-term. Curves 3, 4, and 5 are illustrations of
theoretical depreciation, the different curves representing different bases for
calculating the annual amount of the decrease in value, as will be explained
in Chapter IX, “Depreciation—Methods of Calculating.” To quote from Mr.
Floy’s work at length:
“The curves 3, 4, and 5 indicate several classes of ‘theoretical’
depreciation which have been quite widely used in some cases for
estimating present values, but more often for determining the yearly
theoretical deterioration for purposes of establishing depreciation funds,
which, however, is quite a different subject. Making a theoretical estimate
of the probable, future, average, annually accruing deterioration of certain
property to provide an item in bookkeeping accounts of operating expense
has nothing whatever to do, in making an appraisal, with fixing the definite
amount of absolute, actual, or accrued depreciation which depends upon the
present condition of physical property, determinable from inspection and
not upon historical documents, depreciation funds, or disputed theoretical
conclusions.”
In an opinion filed March 8, 1916, by the Public Service Commission of
Maryland in the matter of the Chesapeake and Potomac Telephone
Company of Baltimore City, an interesting commentary on the relative
merits of actual versus theoretical depreciation is made. While the opinion
concerns primarily depreciation from the rate-making point of view, it
shows well the interrelation between the two kinds and answers so
conclusively the objection often raised to accounting depreciation that it is
here quoted. The statement is:
“Any theory for ascertaining existing depreciation in the plant of a
public utility which confines such depreciation solely to the actual, visible,
physical, demonstrable deterioration which can be seen by the human eye
and measured by the human hand, must of necessity ignore that other
species of deterioration which the experience of the past has demonstrated
Page 117
beyond peradventure exists in the property of every telephone company,
although it cannot always be seen by the human eye or measured by the
human hand. We refer to that tendency upon the part of all such property to
become inadequate or obsolete with the lapse of time.”
“Accounting” and “Fair” Depreciation
Another distinction is sometimes made between “accounting”
depreciation, previously mentioned, and “fair” depreciation or depreciation
of valuation. Accounting depreciation signifies the depreciation, determined
by whatever method, which has been taken into the accounts, i.e., the
depreciation as shown on the books. This is approximately the same as
theoretical depreciation defined above. Its point of view is that of financing
the loss of value caused by depreciation so as to cover the entire loss by the
time the asset is retired from active service rather than that of establishing a
true actual value of the asset at intermediate periods. On the other hand, fair
depreciation or depreciation of valuation is the “sum that should be
deducted from original cost to date (or from estimated cost of reproduction
new)[17] as a step in finding that which the courts have called ‘fair value.’”
Here the point of view is essentially that of showing the true value of the
asset at a given date. Determination of this is fundamentally an engineering
problem in the solution of which cognizance must be taken of:
1. Accounting depreciation.
2. The managerial policy as to repairs, maintenance,
and renewals.
3. The past performance and expected future
performance of the asset.
4. All other factors locally present which may affect
the determination of the present, existing values in
the asset.
Under certain conditions fair depreciation corresponds roughly with
actual or absolute depreciation as defined above.
Complete and Incomplete Depreciation
although it cannot always be seen by the human eye or measured by the
human hand. We refer to that tendency upon the part of all such property to
become inadequate or obsolete with the lapse of time.”
“Accounting” and “Fair” Depreciation
Another distinction is sometimes made between “accounting”
depreciation, previously mentioned, and “fair” depreciation or depreciation
of valuation. Accounting depreciation signifies the depreciation, determined
by whatever method, which has been taken into the accounts, i.e., the
depreciation as shown on the books. This is approximately the same as
theoretical depreciation defined above. Its point of view is that of financing
the loss of value caused by depreciation so as to cover the entire loss by the
time the asset is retired from active service rather than that of establishing a
true actual value of the asset at intermediate periods. On the other hand, fair
depreciation or depreciation of valuation is the “sum that should be
deducted from original cost to date (or from estimated cost of reproduction
new)[17] as a step in finding that which the courts have called ‘fair value.’”
Here the point of view is essentially that of showing the true value of the
asset at a given date. Determination of this is fundamentally an engineering
problem in the solution of which cognizance must be taken of:
1. Accounting depreciation.
2. The managerial policy as to repairs, maintenance,
and renewals.
3. The past performance and expected future
performance of the asset.
4. All other factors locally present which may affect
the determination of the present, existing values in
the asset.
Under certain conditions fair depreciation corresponds roughly with
actual or absolute depreciation as defined above.
Complete and Incomplete Depreciation
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Depreciation is sometimes classed as “complete” and “incomplete.”
Complete depreciation refers to those assets or properties which have been
discarded because no longer capable of economical service. When their
cycle comes to an end, depreciation is complete. Incomplete depreciation
refers to the amount of the decrement in value of assets which are still in
service. The accounting for complete depreciation requires little
consideration except so far as rates of depreciation are concerned. This
class of depreciation represents the accomplished fact and therefore
furnishes data and statistics by which the expected depreciation of similar
new assets can be calculated. The accountant, therefore, is concerned with it
purely as an experimental means of forecasting the future.
Individual and Composite Depreciation
Again, depreciation is classed as “individual or unit” and “composite.”
Unit depreciation is the amount of the decrease in value of the individual
parts which compose the whole of a property; composite depreciation is the
amount of the decrease in value of the plant or property as a whole. Its
amount in dollars is the sum of all unit depreciations similarly expressed.
Expressed as a percentage it represents the effect of all unit depreciations
weighted by the ratio of the value of each to the whole. Thus a plant as a
whole may be depreciated 20%, but the numerous units of that plant may
have a range of depreciation of from 0% to 100%. Some items may be
ready to be discarded and others will probably have just been newly
installed.
In connection with composite depreciation the term “normal” or
“average” value is used. The normal value of a plant is the average value at
which it must be maintained to give efficient service. Any drop below that
point results in increased cost per unit of service rendered, and is
consequently evidence of poor management. Normal value may sometimes
be expressed in percentage as the difference between 100%, original cost,
and composite depreciation. In the case cited above, where composite
depreciation is 20% the normal value would be 80%, under a proper policy
of management.
Physical and Functional Depreciation
Complete depreciation refers to those assets or properties which have been
discarded because no longer capable of economical service. When their
cycle comes to an end, depreciation is complete. Incomplete depreciation
refers to the amount of the decrement in value of assets which are still in
service. The accounting for complete depreciation requires little
consideration except so far as rates of depreciation are concerned. This
class of depreciation represents the accomplished fact and therefore
furnishes data and statistics by which the expected depreciation of similar
new assets can be calculated. The accountant, therefore, is concerned with it
purely as an experimental means of forecasting the future.
Individual and Composite Depreciation
Again, depreciation is classed as “individual or unit” and “composite.”
Unit depreciation is the amount of the decrease in value of the individual
parts which compose the whole of a property; composite depreciation is the
amount of the decrease in value of the plant or property as a whole. Its
amount in dollars is the sum of all unit depreciations similarly expressed.
Expressed as a percentage it represents the effect of all unit depreciations
weighted by the ratio of the value of each to the whole. Thus a plant as a
whole may be depreciated 20%, but the numerous units of that plant may
have a range of depreciation of from 0% to 100%. Some items may be
ready to be discarded and others will probably have just been newly
installed.
In connection with composite depreciation the term “normal” or
“average” value is used. The normal value of a plant is the average value at
which it must be maintained to give efficient service. Any drop below that
point results in increased cost per unit of service rendered, and is
consequently evidence of poor management. Normal value may sometimes
be expressed in percentage as the difference between 100%, original cost,
and composite depreciation. In the case cited above, where composite
depreciation is 20% the normal value would be 80%, under a proper policy
of management.
Physical and Functional Depreciation
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Finally depreciation is classed as “physical” and “functional,” definition
of which are deferred for treatment in Chapter VII, “Depreciation—Its
Causes.”
Deferred Maintenance and Accrued Depreciation
Other terms needing definition are: “deferred maintenance” and
“accrued depreciation.” The former refers to repairs which at any given
time are needed for the proper up-keep but which for one reason or another
have not yet been made. So long as an asset is giving reasonably
satisfactory service, repairs are usually deferred to a convenient time—such
as when work is slack, or until similar repairs may have accrued elsewhere,
or until weather conditions have changed, or in general until the repairs can
be most economically done. Similarly, accrued depreciation refers to the
depreciation which has taken place between the last time an item was
brought on the books and the present time. The inevitable forces causing
depreciation are constantly at work bringing about the decretion of the asset
day by day, but it is impracticable to reflect such condition daily. Only at
the close of each fiscal period is it deemed necessary to adjust the books so
that they reflect the depreciation which has taken place during the period
just closed.
Attitude of the Law
Before studying the factors of depreciation it is interesting to note the
attitude of the courts towards depreciation. Accountants and engineers
recognized the necessity of taking account of depreciation considerably in
advance of its recognition by the courts of this country. H. R. Hatfield[18]
says: “France, Belgium, Switzerland, Germany, Austria all prescribe in their
statutes that depreciation must be reckoned before showing profits.” The
French Joint-Stock Company Law specifically requires the reservation of
some portion of the company’s surplus for taking care of the depreciation of
the assets. While the method may not be scientific, the principle involved is
recognized as correct. But in an early English case, Lee v. Neuchatel
Company, it was held, in the case of a company operating inherently
wasting assets “that even depreciation by waste is not necessarily a revenue
charge.”
of which are deferred for treatment in Chapter VII, “Depreciation—Its
Causes.”
Deferred Maintenance and Accrued Depreciation
Other terms needing definition are: “deferred maintenance” and
“accrued depreciation.” The former refers to repairs which at any given
time are needed for the proper up-keep but which for one reason or another
have not yet been made. So long as an asset is giving reasonably
satisfactory service, repairs are usually deferred to a convenient time—such
as when work is slack, or until similar repairs may have accrued elsewhere,
or until weather conditions have changed, or in general until the repairs can
be most economically done. Similarly, accrued depreciation refers to the
depreciation which has taken place between the last time an item was
brought on the books and the present time. The inevitable forces causing
depreciation are constantly at work bringing about the decretion of the asset
day by day, but it is impracticable to reflect such condition daily. Only at
the close of each fiscal period is it deemed necessary to adjust the books so
that they reflect the depreciation which has taken place during the period
just closed.
Attitude of the Law
Before studying the factors of depreciation it is interesting to note the
attitude of the courts towards depreciation. Accountants and engineers
recognized the necessity of taking account of depreciation considerably in
advance of its recognition by the courts of this country. H. R. Hatfield[18]
says: “France, Belgium, Switzerland, Germany, Austria all prescribe in their
statutes that depreciation must be reckoned before showing profits.” The
French Joint-Stock Company Law specifically requires the reservation of
some portion of the company’s surplus for taking care of the depreciation of
the assets. While the method may not be scientific, the principle involved is
recognized as correct. But in an early English case, Lee v. Neuchatel
Company, it was held, in the case of a company operating inherently
wasting assets “that even depreciation by waste is not necessarily a revenue
charge.”
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Early decisions in this country likewise fail to sustain the propriety of
depreciation charges. The cases usually cited are The Union Pacific R. R.
Co. v. United States, 99 U. S. 402, and United States v. Kansas Pacific Ry.
Co., 99 U. S. 455 (1878), the first not passing specifically on the question of
depreciation but showing a lack of appreciation of the distinction between
capital and revenue charges, and the latter stating that “only such
expenditures as are actually made can with any propriety be claimed as a
deduction from earnings.” The Supreme Court of California in San Diego
Water Co. v. San Diego, 118 Cal. 556 (1897), and in Redlands, etc., Water
Co. v. Redlands, 212 Cal. 312 (1898), refused all allowances for
depreciation except necessary amounts for “maintenance and repairs during
the year.” However, in Pioneer Tele, and Tele. Co. v. Westenhaver, 118 Pac.
354, the language of the court is not uncertain: “A sufficient sum should be
allowed from the earnings of a utility to make good the depreciation of the
plant and replace the deteriorated portions thereof, when they become so
impaired that they can no longer be made useful by repair.”
Decision of Supreme Court
The United States Supreme Court recognizes the necessity for an
allowance for depreciation in Mayor and Aldermen of the City of
Knoxville, Appt., v. Knoxville Water Co., 212 U. S. 14 (1909), which forms
the basis of judicial attitude towards the question at the present time. The
decision of the court which has been supported and reaffirmed in all
subsequent decisions, reads, in excerpts:
“A water plant with all its additions begins to depreciate in value from
the moment of its use. Before coming to the question of profits at all the
company is entitled to earn a sufficient sum annually to provide not only for
current repairs, but for making good the depreciation and replacing the parts
of the property when they come to the end of their life. The company is not
bound to see its property gradually waste, without making provision out of
earnings for its replacement. It is entitled to see that from earnings the
value of the property invested is kept unimpaired, so that, at the end of any
given term of years, the original investment remains as it was at the
beginning. It is not only the right of the company to make such a provision,
but it is its duty to its bond- and stockholders, and in the case of a public
service corporation, at least its plain duty to the public. If a different course
depreciation charges. The cases usually cited are The Union Pacific R. R.
Co. v. United States, 99 U. S. 402, and United States v. Kansas Pacific Ry.
Co., 99 U. S. 455 (1878), the first not passing specifically on the question of
depreciation but showing a lack of appreciation of the distinction between
capital and revenue charges, and the latter stating that “only such
expenditures as are actually made can with any propriety be claimed as a
deduction from earnings.” The Supreme Court of California in San Diego
Water Co. v. San Diego, 118 Cal. 556 (1897), and in Redlands, etc., Water
Co. v. Redlands, 212 Cal. 312 (1898), refused all allowances for
depreciation except necessary amounts for “maintenance and repairs during
the year.” However, in Pioneer Tele, and Tele. Co. v. Westenhaver, 118 Pac.
354, the language of the court is not uncertain: “A sufficient sum should be
allowed from the earnings of a utility to make good the depreciation of the
plant and replace the deteriorated portions thereof, when they become so
impaired that they can no longer be made useful by repair.”
Decision of Supreme Court
The United States Supreme Court recognizes the necessity for an
allowance for depreciation in Mayor and Aldermen of the City of
Knoxville, Appt., v. Knoxville Water Co., 212 U. S. 14 (1909), which forms
the basis of judicial attitude towards the question at the present time. The
decision of the court which has been supported and reaffirmed in all
subsequent decisions, reads, in excerpts:
“A water plant with all its additions begins to depreciate in value from
the moment of its use. Before coming to the question of profits at all the
company is entitled to earn a sufficient sum annually to provide not only for
current repairs, but for making good the depreciation and replacing the parts
of the property when they come to the end of their life. The company is not
bound to see its property gradually waste, without making provision out of
earnings for its replacement. It is entitled to see that from earnings the
value of the property invested is kept unimpaired, so that, at the end of any
given term of years, the original investment remains as it was at the
beginning. It is not only the right of the company to make such a provision,
but it is its duty to its bond- and stockholders, and in the case of a public
service corporation, at least its plain duty to the public. If a different course
Page 121
were pursued, the only method of providing for replacement of property
which has ceased to be useful would be the investment of new capital and
the issue of new bonds and stock. This course would lead to a constantly
increasing variance between present value and bond and stock capitalization
—a tendency which would inevitably lead to disaster either to the
stockholders or the public, or both.”
Recognition of the Depreciation Factor
Following this decision the rules and regulations of the public service
commissions of practically all the states now require that provision for
depreciation be made. In the case of some of the smaller public service
companies the failure to make this provision is overlooked but the practice
is generally recognized as absolutely necessary. The Interstate Commerce
Commission has led in this respect, although its early rulings relative
thereto were strenuously objected to in some quarters. Private concerns in
their contact with the government now almost invariably see the value, or at
any rate the self-interest, of a deduction for depreciation. In the case of the
Special Excise Tax, a Treasury decision on account of Internal Revenue
provides that “deduction on account of depreciation of property must be
based on lifetime of property, its cost, value, and use, and must be
evidenced by a ledger entry and a like reduction in the plant and property
account with respect to which depreciation is claimed.”
Similarly, the present Federal Income Tax Law recognizes allowances
for depreciation, but perhaps errs in placing too stringent safeguards on the
amounts to be deducted therefor, whereas the Federal Trade Commission
realizes the need of liberal provision. The law reads: “That in computing net
income in the case of a citizen or resident of the United States, for the
purpose of the tax there shall be allowed as deduction a reasonable
allowance for the exhaustion, wear and tear of property arising out of its use
or employment in the business or trade. No deduction shall be allowed for
any amount paid out for new buildings, permanent improvements, or
betterments, made to increase the value of any property or estate, and no
deduction shall be made for any amount of expense of restoring property or
making good the exhaustion thereof for which an allowance is or has been
made.” The depreciation allowed as a deduction from income must have
actually been charged off the books. Many interesting rulings—some
which has ceased to be useful would be the investment of new capital and
the issue of new bonds and stock. This course would lead to a constantly
increasing variance between present value and bond and stock capitalization
—a tendency which would inevitably lead to disaster either to the
stockholders or the public, or both.”
Recognition of the Depreciation Factor
Following this decision the rules and regulations of the public service
commissions of practically all the states now require that provision for
depreciation be made. In the case of some of the smaller public service
companies the failure to make this provision is overlooked but the practice
is generally recognized as absolutely necessary. The Interstate Commerce
Commission has led in this respect, although its early rulings relative
thereto were strenuously objected to in some quarters. Private concerns in
their contact with the government now almost invariably see the value, or at
any rate the self-interest, of a deduction for depreciation. In the case of the
Special Excise Tax, a Treasury decision on account of Internal Revenue
provides that “deduction on account of depreciation of property must be
based on lifetime of property, its cost, value, and use, and must be
evidenced by a ledger entry and a like reduction in the plant and property
account with respect to which depreciation is claimed.”
Similarly, the present Federal Income Tax Law recognizes allowances
for depreciation, but perhaps errs in placing too stringent safeguards on the
amounts to be deducted therefor, whereas the Federal Trade Commission
realizes the need of liberal provision. The law reads: “That in computing net
income in the case of a citizen or resident of the United States, for the
purpose of the tax there shall be allowed as deduction a reasonable
allowance for the exhaustion, wear and tear of property arising out of its use
or employment in the business or trade. No deduction shall be allowed for
any amount paid out for new buildings, permanent improvements, or
betterments, made to increase the value of any property or estate, and no
deduction shall be made for any amount of expense of restoring property or
making good the exhaustion thereof for which an allowance is or has been
made.” The depreciation allowed as a deduction from income must have
actually been charged off the books. Many interesting rulings—some
Page 122
almost absurd if carried to their logical conclusions—have been made by
inspectors and the Treasury Department on points raised as to the
application of the above law to particular cases. A perusal of these decisions
will well repay the student who is interested in the subject.
Distinction between Repairs and Renewals
At this point attention is called again to the need of a careful distinction
between repairs (up-keep and maintenance charges) and renewals
(replacements and betterments). Only a clear definition of the terms and a
strict adherence to an adopted policy can prevent endless confusion and
absolutely misleading results. Such a policy is necessary because in the
practical handling of such items on the books the theoretical aspect of the
distinction between repairs and renewals must always be modified by
reason. The student is referred to the preceding chapter where more detailed
treatment of this point is given.
Depreciation and Plant Efficiency
The relation of depreciation to the efficiency of a plant or an asset will
now be considered. The amount of depreciation is not based on the degree
of efficiency of the service rendered by the asset. In other words, a
depreciation reserve is not in any sense an inverse measure of the
productive efficiency of the asset to which it relates, nor does the sum of all
depreciation reserves either indicate or measure the degree of efficiency of
the whole plant. A comparison of present with normal value (as defined
above) affords some index of productive efficiency, but there is no direct
ratio between the two. In any well-maintained plant, however, the normal
value is the value below which the plant cannot be allowed to fall if the
standard of efficiency is to be maintained; and good management requires
nothing less than this. It has been variously estimated that normal value
ranges from 75% to 90% of the original cost, and in some instances runs as
low as 50%. The composite depreciation of from 10% to 50% represents the
limit beyond which the decrease in value cannot pass if efficient service is
to be given by the plant. Usually the sum of the depreciation reserves for all
the assets of the plant remains fairly constant because the large reserves
against assets that are almost ready to be scrapped are offset by the smaller
reserves of the assets just replaced.
inspectors and the Treasury Department on points raised as to the
application of the above law to particular cases. A perusal of these decisions
will well repay the student who is interested in the subject.
Distinction between Repairs and Renewals
At this point attention is called again to the need of a careful distinction
between repairs (up-keep and maintenance charges) and renewals
(replacements and betterments). Only a clear definition of the terms and a
strict adherence to an adopted policy can prevent endless confusion and
absolutely misleading results. Such a policy is necessary because in the
practical handling of such items on the books the theoretical aspect of the
distinction between repairs and renewals must always be modified by
reason. The student is referred to the preceding chapter where more detailed
treatment of this point is given.
Depreciation and Plant Efficiency
The relation of depreciation to the efficiency of a plant or an asset will
now be considered. The amount of depreciation is not based on the degree
of efficiency of the service rendered by the asset. In other words, a
depreciation reserve is not in any sense an inverse measure of the
productive efficiency of the asset to which it relates, nor does the sum of all
depreciation reserves either indicate or measure the degree of efficiency of
the whole plant. A comparison of present with normal value (as defined
above) affords some index of productive efficiency, but there is no direct
ratio between the two. In any well-maintained plant, however, the normal
value is the value below which the plant cannot be allowed to fall if the
standard of efficiency is to be maintained; and good management requires
nothing less than this. It has been variously estimated that normal value
ranges from 75% to 90% of the original cost, and in some instances runs as
low as 50%. The composite depreciation of from 10% to 50% represents the
limit beyond which the decrease in value cannot pass if efficient service is
to be given by the plant. Usually the sum of the depreciation reserves for all
the assets of the plant remains fairly constant because the large reserves
against assets that are almost ready to be scrapped are offset by the smaller
reserves of the assets just replaced.
Page 123
Unit Efficiency
The efficiency of the unit, however, has a somewhat different relation to
depreciation. Units, i.e., individual assets comprising the plant, are
constantly wearing out and being replaced. The plant, aside from
exceptional cases, never reaches the point where it must be discarded in its
entirety and replaced as a whole. The depreciation of each unit continues
until the point of inefficiency is reached, when it is scrapped and replaced.
The unit frequently is allowed to drop below its margin of efficient service
before being scrapped, and it may be made to render service much longer
than is customary, by means of heavy repairs and a relatively high up-keep
expense. When to scrap a particular unit involves a nice calculation. The
heavy cost of repairs necessary to secure good service from the old unit and
the possible loss through failure to accumulate a sufficient reserve must be
weighed against the cost of a new unit and its up-keep and running expense.
Usually the efficiency of the individual unit is very like the parson’s one-
hoss shay which “ran a hundred years to a day and then of a sudden it went
to pieces all at once.”
The following chart illustrates accurately the relation of efficiency to
uniform depreciation, the XCY line being the efficiency curve and XY the
depreciation curve. Also curve 6 of the chart on page 105 gives a good
illustration of the same point. Inasmuch as the depreciation reserve must
provide for the loss of the entire asset by the time it goes out of service, it is
readily seen that in judging an asset from its bookkeeping record of cost and
reserve there is no measure of efficiency shown therein, since a normal
efficiency must be maintained by repairs at all times. The record is,
however, a good index of the time when the point of inefficiency will be
reached.
The efficiency of the unit, however, has a somewhat different relation to
depreciation. Units, i.e., individual assets comprising the plant, are
constantly wearing out and being replaced. The plant, aside from
exceptional cases, never reaches the point where it must be discarded in its
entirety and replaced as a whole. The depreciation of each unit continues
until the point of inefficiency is reached, when it is scrapped and replaced.
The unit frequently is allowed to drop below its margin of efficient service
before being scrapped, and it may be made to render service much longer
than is customary, by means of heavy repairs and a relatively high up-keep
expense. When to scrap a particular unit involves a nice calculation. The
heavy cost of repairs necessary to secure good service from the old unit and
the possible loss through failure to accumulate a sufficient reserve must be
weighed against the cost of a new unit and its up-keep and running expense.
Usually the efficiency of the individual unit is very like the parson’s one-
hoss shay which “ran a hundred years to a day and then of a sudden it went
to pieces all at once.”
The following chart illustrates accurately the relation of efficiency to
uniform depreciation, the XCY line being the efficiency curve and XY the
depreciation curve. Also curve 6 of the chart on page 105 gives a good
illustration of the same point. Inasmuch as the depreciation reserve must
provide for the loss of the entire asset by the time it goes out of service, it is
readily seen that in judging an asset from its bookkeeping record of cost and
reserve there is no measure of efficiency shown therein, since a normal
efficiency must be maintained by repairs at all times. The record is,
however, a good index of the time when the point of inefficiency will be
reached.
Page 124
From “Principles of Depreciation,” by Earl A. Saliers.
Chart Showing Progress of Uniform Depreciation
and of Diminishing Efficiency
Engineers hold the opinion that machinery as a rule cannot suffer more
than 25% to 50% actual depreciation and give efficient service. A
depreciation reserve of anything more than that does not mean that the point
of inefficiency has been reached, for the reserve is usually estimated and
applied on the basis of theoretical depreciation and so takes cognizance of
all its factors. It has sometimes been stated that inefficiency is a factor of
depreciation distinct from wear and tear, obsolescence, and supersession. It
seems a better statement of the relation to say that the point of inefficient
service is the limit beyond which the three factors named cannot be allowed
to operate or have effect. The need of judging the efficiency of some kinds
of assets is not so apparent as of others. Thus in the case of poles, wires,
conduits, and the like, efficient service is secured until they are worn out,
with very little expense for up-keep. That is, such assets are normally
efficient throughout their whole term of life, and the application of repairs
Chart Showing Progress of Uniform Depreciation
and of Diminishing Efficiency
Engineers hold the opinion that machinery as a rule cannot suffer more
than 25% to 50% actual depreciation and give efficient service. A
depreciation reserve of anything more than that does not mean that the point
of inefficiency has been reached, for the reserve is usually estimated and
applied on the basis of theoretical depreciation and so takes cognizance of
all its factors. It has sometimes been stated that inefficiency is a factor of
depreciation distinct from wear and tear, obsolescence, and supersession. It
seems a better statement of the relation to say that the point of inefficient
service is the limit beyond which the three factors named cannot be allowed
to operate or have effect. The need of judging the efficiency of some kinds
of assets is not so apparent as of others. Thus in the case of poles, wires,
conduits, and the like, efficient service is secured until they are worn out,
with very little expense for up-keep. That is, such assets are normally
efficient throughout their whole term of life, and the application of repairs
Page 125
will not appreciably extend their life nor will it affect their efficiency. In the
case of other assets, such as machinery, telephone switchboards, motors,
etc., the item of up-keep is a very vital one in the determination of the point
or margin between efficient and inefficient service, and that in turn is an
important factor in the determination of the length of service life of the
asset. Thus, although efficiency and depreciation are intimately related, the
degree of depreciation at a given time is not by any means an inverse
measure of the efficiency of the service being rendered by an asset.
Depreciation and Fluctuations in Market Value
The relation of depreciation to fluctuation in value, due to whatever
causes affect the market, also deserves consideration. Depreciation
primarily refers to a decrease in value from a definite cost figure, such
decrease being due to certain well-recognized causes, of which change in
market value is not one. Thus, while it may be correct, through a loose use
of the term, to use the expressions, “depreciation of securities,”
“depreciation of real estate,” and similar phrases, and there may be no
likelihood of any misunderstanding, that is not the sense in which the term
depreciation is used here. Unfortunately, market fluctuations are sometimes
allowed to influence depreciation charges.
Such influence may come about in three ways: (1) In valuation
proceedings for the determination of rates for a public utility company, a
basis frequently used is that of the cost of reproduction or renewal less
depreciation. The theory is that under existing views of private property
such a company has the right to the enjoyment of all increments in its own
properties and therefore has a right to such rates as will earn a fair income
on the present value of those properties. Depreciation based on the present
reproduction cost is in this way influenced by fluctuations in market value,
and the oftener a physical appraisal is made and its determined values
brought upon the books, the greater will be the disturbance of the basis for
the depreciation charge. (2) Occasionally the practice is met with of basing
the present depreciation charge upon the estimated cost to replace the old
asset. This is discussed later and is mentioned here merely to show a
possible relationship between fluctuations and depreciation. (3) Finally, in
the periodic adjustment of depreciation rates and charges, the estimated
scrap value of the asset does affect the amount of the periodic charge.
case of other assets, such as machinery, telephone switchboards, motors,
etc., the item of up-keep is a very vital one in the determination of the point
or margin between efficient and inefficient service, and that in turn is an
important factor in the determination of the length of service life of the
asset. Thus, although efficiency and depreciation are intimately related, the
degree of depreciation at a given time is not by any means an inverse
measure of the efficiency of the service being rendered by an asset.
Depreciation and Fluctuations in Market Value
The relation of depreciation to fluctuation in value, due to whatever
causes affect the market, also deserves consideration. Depreciation
primarily refers to a decrease in value from a definite cost figure, such
decrease being due to certain well-recognized causes, of which change in
market value is not one. Thus, while it may be correct, through a loose use
of the term, to use the expressions, “depreciation of securities,”
“depreciation of real estate,” and similar phrases, and there may be no
likelihood of any misunderstanding, that is not the sense in which the term
depreciation is used here. Unfortunately, market fluctuations are sometimes
allowed to influence depreciation charges.
Such influence may come about in three ways: (1) In valuation
proceedings for the determination of rates for a public utility company, a
basis frequently used is that of the cost of reproduction or renewal less
depreciation. The theory is that under existing views of private property
such a company has the right to the enjoyment of all increments in its own
properties and therefore has a right to such rates as will earn a fair income
on the present value of those properties. Depreciation based on the present
reproduction cost is in this way influenced by fluctuations in market value,
and the oftener a physical appraisal is made and its determined values
brought upon the books, the greater will be the disturbance of the basis for
the depreciation charge. (2) Occasionally the practice is met with of basing
the present depreciation charge upon the estimated cost to replace the old
asset. This is discussed later and is mentioned here merely to show a
possible relationship between fluctuations and depreciation. (3) Finally, in
the periodic adjustment of depreciation rates and charges, the estimated
scrap value of the asset does affect the amount of the periodic charge.
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Changes in market value of scrap, which may be considered as due to
causes which will continue in force rather than to the ups and downs of the
market, may legitimately be reflected in the depreciation charge for the
remaining life-term of the asset and must be so reflected in the interests of
accuracy in any statement of true values.
Distinction between Depreciation and Depletion
Inasmuch as depreciation is not here used to apply to current assets
(with one exception noted below), and fluctuations in the market value of
any asset subject to depreciation need not be considered, it may be well to
state the class of assets to which it does apply. In general the value of all
fixed or capital assets is affected by depreciation. The term frequently used
in this connection is “wasting” assets. Under this nomenclature is included
any asset which wastes away or is used up. For the sake of clarity the author
desires to limit the term depreciation to those assets which are clearly
affected by any of the causes of depreciation as discussed in the following
chapter. For those assets which are used up without any possibility of their
being replaced, and the life of which cannot be prolonged by repairs and
renewals, the term depletion will be used. Accordingly the term
“depreciation” will be applied to mine buildings and machinery;
“depletion,” to the mine. Both are wasting assets, but their waste is due to
somewhat different, although vitally related, causes. No better definition of
wasting assets has been formulated than that by P. D. Leake[19] who says
that they “consist of all forms of exchangeable value which inevitably
diminish while applied to the purpose of seeking profits, increase, or
advantage otherwise than by purchase and sale.”
Effect on Different Kinds of Business
Some types of undertakings are more subject to the effects of wasting
assets than others. Concerns dealing in investments, insurance of all kinds,
brokerage and commission, manufacturers’ agents, banking and financial
houses, professional firms, and the like, only a small portion of whose
capital is tied up in fixed assets, are comparatively unaffected by the charge
for depreciation. Practically all other concerns are subject to it in marked
degree—manufacturers, mines, transportation companies, light, heat, and
power concerns, the telephone, telegraph, and cable, construction
companies, agricultural, etc. Those engaged in extracting raw materials
causes which will continue in force rather than to the ups and downs of the
market, may legitimately be reflected in the depreciation charge for the
remaining life-term of the asset and must be so reflected in the interests of
accuracy in any statement of true values.
Distinction between Depreciation and Depletion
Inasmuch as depreciation is not here used to apply to current assets
(with one exception noted below), and fluctuations in the market value of
any asset subject to depreciation need not be considered, it may be well to
state the class of assets to which it does apply. In general the value of all
fixed or capital assets is affected by depreciation. The term frequently used
in this connection is “wasting” assets. Under this nomenclature is included
any asset which wastes away or is used up. For the sake of clarity the author
desires to limit the term depreciation to those assets which are clearly
affected by any of the causes of depreciation as discussed in the following
chapter. For those assets which are used up without any possibility of their
being replaced, and the life of which cannot be prolonged by repairs and
renewals, the term depletion will be used. Accordingly the term
“depreciation” will be applied to mine buildings and machinery;
“depletion,” to the mine. Both are wasting assets, but their waste is due to
somewhat different, although vitally related, causes. No better definition of
wasting assets has been formulated than that by P. D. Leake[19] who says
that they “consist of all forms of exchangeable value which inevitably
diminish while applied to the purpose of seeking profits, increase, or
advantage otherwise than by purchase and sale.”
Effect on Different Kinds of Business
Some types of undertakings are more subject to the effects of wasting
assets than others. Concerns dealing in investments, insurance of all kinds,
brokerage and commission, manufacturers’ agents, banking and financial
houses, professional firms, and the like, only a small portion of whose
capital is tied up in fixed assets, are comparatively unaffected by the charge
for depreciation. Practically all other concerns are subject to it in marked
degree—manufacturers, mines, transportation companies, light, heat, and
power concerns, the telephone, telegraph, and cable, construction
companies, agricultural, etc. Those engaged in extracting raw materials
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from the ground are, with few exceptions, subject to a charge for depletion.
Those with an investment in any kind of terminating rights, such as leases,
patents, copyrights, non-renewable franchises for a fixed term of years, and
so on, are also subject to it. Opinions differ as to whether good-will and
trade-marks may properly be considered as subject to depreciation. They
will not be so considered here for reasons which will be stated when the
principles of their valuation are discussed.
It will be noted that thus far all examples given have been those of fixed
assets. The exception already referred to is made in the case of the current
asset, merchandise or stock-in-trade. The term depreciation can perhaps
correctly be used in connection with merchandise, which, however, is not to
be classed as a wasting asset. Due to some of the causes discussed in the
next chapter, the stock-in-trade of an undertaking does truly depreciate in
value. The method of accounting for such depreciation differs entirely from
that used for wasting assets. Hence, the treatment of depreciation of
merchandise will be considered at the same time that its valuation is
discussed (see Chapter XIII.)
Having cleared the ground with this definition of terms and the general
statement of what the depreciation problem is, attention will now be
directed to a consideration of the causes of depreciation, to be followed by
the method of accounting for depreciation and a treatment of some points
growing out of the general discussion.
Those with an investment in any kind of terminating rights, such as leases,
patents, copyrights, non-renewable franchises for a fixed term of years, and
so on, are also subject to it. Opinions differ as to whether good-will and
trade-marks may properly be considered as subject to depreciation. They
will not be so considered here for reasons which will be stated when the
principles of their valuation are discussed.
It will be noted that thus far all examples given have been those of fixed
assets. The exception already referred to is made in the case of the current
asset, merchandise or stock-in-trade. The term depreciation can perhaps
correctly be used in connection with merchandise, which, however, is not to
be classed as a wasting asset. Due to some of the causes discussed in the
next chapter, the stock-in-trade of an undertaking does truly depreciate in
value. The method of accounting for such depreciation differs entirely from
that used for wasting assets. Hence, the treatment of depreciation of
merchandise will be considered at the same time that its valuation is
discussed (see Chapter XIII.)
Having cleared the ground with this definition of terms and the general
statement of what the depreciation problem is, attention will now be
directed to a consideration of the causes of depreciation, to be followed by
the method of accounting for depreciation and a treatment of some points
growing out of the general discussion.
Page 128
CHAPTER VII
DEPRECIATION—ITS CAUSES
Analysis of Causes
Most definitions of the term depreciation set the boundaries or limits of its
meaning by naming the causes. These are normally: (1) wear and tear, or
physical factors; (2) inadequacy and obsolescence, or functional factors; and
(3) accidents or contingent causes. This statement of causes applies
specifically only to physical or tangible properties. In the case of intangible
property, consisting for the most part of rights of various sorts, the controlling
cause is usually merely lapse of time. The chart on the following page
analyzes the various causes and shows their detailed ramifications.
Age as a Cause of Depreciation
The physical depreciation of tangible properties arises from two main
causes, viz., the wear and tear from operation and the use of the asset and the
wear and tear of age, known as decrepitude. Immediately upon the installation
of an asset the forces of time and the elements begin their ravages even before
operations begin. As H. R. Hatfield[20] trenchantly puts it, “all machinery is on
an irresistible march to the junk heap,” and the statement is equally applicable
to all other forms of wasting assets. The ties placed on the roadbed of a
railway, conduits put in place for carrying water, gas, steam, electric current,
or oil, rolling stock, poles for telephone and telegraph lines, buildings, even
interior installations of various types—all are subject to the normal ravages of
time and the elements, and nothing which man has been able to devise can do
more than retard the inevitable. Thus, all assets decrease in value through the
inevitable lapse of time. Attention should be here directed to the fact that
decrepitude depends on the normal action of time and the elements, whereas
accidents due to action of the elements (listed in the chart on page 121, under
III, 1, b) are of an abnormal character and cannot usually be taken into full
account at the time of the installation of any particular piece of property.
Causes of Depreciation[21]
DEPRECIATION—ITS CAUSES
Analysis of Causes
Most definitions of the term depreciation set the boundaries or limits of its
meaning by naming the causes. These are normally: (1) wear and tear, or
physical factors; (2) inadequacy and obsolescence, or functional factors; and
(3) accidents or contingent causes. This statement of causes applies
specifically only to physical or tangible properties. In the case of intangible
property, consisting for the most part of rights of various sorts, the controlling
cause is usually merely lapse of time. The chart on the following page
analyzes the various causes and shows their detailed ramifications.
Age as a Cause of Depreciation
The physical depreciation of tangible properties arises from two main
causes, viz., the wear and tear from operation and the use of the asset and the
wear and tear of age, known as decrepitude. Immediately upon the installation
of an asset the forces of time and the elements begin their ravages even before
operations begin. As H. R. Hatfield[20] trenchantly puts it, “all machinery is on
an irresistible march to the junk heap,” and the statement is equally applicable
to all other forms of wasting assets. The ties placed on the roadbed of a
railway, conduits put in place for carrying water, gas, steam, electric current,
or oil, rolling stock, poles for telephone and telegraph lines, buildings, even
interior installations of various types—all are subject to the normal ravages of
time and the elements, and nothing which man has been able to devise can do
more than retard the inevitable. Thus, all assets decrease in value through the
inevitable lapse of time. Attention should be here directed to the fact that
decrepitude depends on the normal action of time and the elements, whereas
accidents due to action of the elements (listed in the chart on page 121, under
III, 1, b) are of an abnormal character and cannot usually be taken into full
account at the time of the installation of any particular piece of property.
Causes of Depreciation[21]
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1. Wear and Tear from Operation
(a) Maintenance Policy
I. Physical
2. Decrepitude
(a) Action of Time and the Elements
1. Inadequacy or Supersession
II. Functional
2. Obsolescence
(a) Negligence
Fire
Lightning
1. Accidents (b) Elements Wind
A. Water
Tangible
Temperature
Property
(c) Structural Defects
(a) Parasites
III. Contingent
(b) Pollution of Water
Mineral
2. Diseases (c) Growths in Water-Mains Vegetable
Animal
(d) Electrolysis
(e) Crystallization
(a) Natural Gas
3. Diminution in Supply
(b) Water
1. Limited in Time
B. Intangible Property—Rights
2. Abandoned
Wear and Tear of Use
The wear and tear due to use or operation usually has a much more potent
effect on the service life of an asset than that due to decrepitude. The
established policy as to repairs and maintenance has an important effect on this
kind of depreciation. Sooner or later every machine becomes unfit for service,
(a) Maintenance Policy
I. Physical
2. Decrepitude
(a) Action of Time and the Elements
1. Inadequacy or Supersession
II. Functional
2. Obsolescence
(a) Negligence
Fire
Lightning
1. Accidents (b) Elements Wind
A. Water
Tangible
Temperature
Property
(c) Structural Defects
(a) Parasites
III. Contingent
(b) Pollution of Water
Mineral
2. Diseases (c) Growths in Water-Mains Vegetable
Animal
(d) Electrolysis
(e) Crystallization
(a) Natural Gas
3. Diminution in Supply
(b) Water
1. Limited in Time
B. Intangible Property—Rights
2. Abandoned
Wear and Tear of Use
The wear and tear due to use or operation usually has a much more potent
effect on the service life of an asset than that due to decrepitude. The
established policy as to repairs and maintenance has an important effect on this
kind of depreciation. Sooner or later every machine becomes unfit for service,
Page 130
due to the friction of its parts, the strains to which it is subject under normal
load, those of much greater effect under abnormal load, the method of
applying its power, etc. It must then either be withdrawn from service and
completely depreciated, or it must be repaired in an effort to lengthen its life. It
should be kept in mind that the determining factor here is efficiency. The
serviceability of the machine must be kept up to a recognized standard through
adequate expenditures for repairs and up-keep until the cost of up-keep is
disproportionate to the service rendered, or until the machine becomes so
decrepid as to make its operation hazardous.
The application of theoretical depreciation to operating wear and tear must
proceed with great care. This is so because of the varying factor of
maintenance. If the cost of maintenance Could be standardized, experience
under such standard would give a reliable basis for the calculation of the
depreciation charge. Since adherence to such a standard is difficult or
impossible under the conditions that are constantly arising in a given
establishment, the depreciation policy must of necessity be based on actual
observation and inspection by experts. The expenditure necessary to restore an
asset to a state of operating efficiency is called “deferred” or “accrued”
maintenance, and it is the amount of this at a given time, estimated by expert
inspection, which compared with normal maintenance forms the basis for an
estimate of the depreciation charge.
Functional Depreciation
Tangible property is subject also to “functional” depreciation. This means a
lessening in worth or service value due to causes, other than those already
treated, which interfere with and operate against the proper functioning of the
asset, making it impossible to render effectively and economically the full
requirements of service expected of it. This inability to fulfil its proper
function may result either from inadequacy or obsolescence. “Thus the
structure may suffer total depreciation and be thrown out of service, not only
because through wear and tear it has reached a condition where further
expenditures for repairs or attempts to make it suitable for the required service
would not be economical or expedient, but also because recent improvements,
or new inventions, new developments and radical changes in service, or the
demands of one kind or another involving sweeping changes in the existing
plant, make abandonment necessary.”[22]
Inadequacy as a Factor
load, those of much greater effect under abnormal load, the method of
applying its power, etc. It must then either be withdrawn from service and
completely depreciated, or it must be repaired in an effort to lengthen its life. It
should be kept in mind that the determining factor here is efficiency. The
serviceability of the machine must be kept up to a recognized standard through
adequate expenditures for repairs and up-keep until the cost of up-keep is
disproportionate to the service rendered, or until the machine becomes so
decrepid as to make its operation hazardous.
The application of theoretical depreciation to operating wear and tear must
proceed with great care. This is so because of the varying factor of
maintenance. If the cost of maintenance Could be standardized, experience
under such standard would give a reliable basis for the calculation of the
depreciation charge. Since adherence to such a standard is difficult or
impossible under the conditions that are constantly arising in a given
establishment, the depreciation policy must of necessity be based on actual
observation and inspection by experts. The expenditure necessary to restore an
asset to a state of operating efficiency is called “deferred” or “accrued”
maintenance, and it is the amount of this at a given time, estimated by expert
inspection, which compared with normal maintenance forms the basis for an
estimate of the depreciation charge.
Functional Depreciation
Tangible property is subject also to “functional” depreciation. This means a
lessening in worth or service value due to causes, other than those already
treated, which interfere with and operate against the proper functioning of the
asset, making it impossible to render effectively and economically the full
requirements of service expected of it. This inability to fulfil its proper
function may result either from inadequacy or obsolescence. “Thus the
structure may suffer total depreciation and be thrown out of service, not only
because through wear and tear it has reached a condition where further
expenditures for repairs or attempts to make it suitable for the required service
would not be economical or expedient, but also because recent improvements,
or new inventions, new developments and radical changes in service, or the
demands of one kind or another involving sweeping changes in the existing
plant, make abandonment necessary.”[22]
Inadequacy as a Factor
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Inadequacy is a condition in which the asset is found unable to meet the
demands made upon it, due usually to growth of business or to some
rearrangement made necessary by changed policy before the asset has reached
the end of This condition is also called “supersession.” For economical
operation the asset must be discarded and superseded by a larger unit. As an
example, dynamos and motors of a capacity sufficient to meet all demands on
them at the date of their installation may, through growth of business, prove
entirely inadequate after a few years to meet the service expected of them.
Inadequacy as a factor of depreciation will have no appreciable effect in cases
where the demand is fairly constant and the market does not permit of much
expansion. Where there is a growing community and (or) a growing
appreciation of the commodity manufactured, demand may increase to a point
where original judgment and expectation will be shown to have been in error
and the equipment will have to be superseded if advantage is to be taken of the
expanding market.
Two main factors or compelling forces may bring about inadequacy, viz.,
those of internal origin and those of external origin. Those of internal origin
may become effective because of: (1) abandonment of original financial
policy, (2) considerations of engineering economy, and (3) unforeseen
development.
Inadequacy through Change of Policy
Perhaps the best illustration of the first type is that of a plant built to
supply a certain commodity to the local community. A change in ownership
brings about an abandonment of the original policy and a determination to
provide neighboring communities with the commodity also. This change in
policy frequently comes about when several smaller plants are merged under
one control and the original units are found to be entirely inadequate to meet
the demand. Again, when through a change in financial policy it is decided to
lower the rates of a public service commodity, the original equipment may
prove inadequate to meet the increased demand. It is not contended here that
this type of inadequacy is to be taken into account in estimating the
depreciation charge. Usually it cannot be foreseen and should therefore be
provided against under the head of a general contingent reserve or
appropriation of profit. If it can be foreseen intelligently, it should be taken
into account in the estimate of depreciation.
Inadequacy through Motives of Economy
demands made upon it, due usually to growth of business or to some
rearrangement made necessary by changed policy before the asset has reached
the end of This condition is also called “supersession.” For economical
operation the asset must be discarded and superseded by a larger unit. As an
example, dynamos and motors of a capacity sufficient to meet all demands on
them at the date of their installation may, through growth of business, prove
entirely inadequate after a few years to meet the service expected of them.
Inadequacy as a factor of depreciation will have no appreciable effect in cases
where the demand is fairly constant and the market does not permit of much
expansion. Where there is a growing community and (or) a growing
appreciation of the commodity manufactured, demand may increase to a point
where original judgment and expectation will be shown to have been in error
and the equipment will have to be superseded if advantage is to be taken of the
expanding market.
Two main factors or compelling forces may bring about inadequacy, viz.,
those of internal origin and those of external origin. Those of internal origin
may become effective because of: (1) abandonment of original financial
policy, (2) considerations of engineering economy, and (3) unforeseen
development.
Inadequacy through Change of Policy
Perhaps the best illustration of the first type is that of a plant built to
supply a certain commodity to the local community. A change in ownership
brings about an abandonment of the original policy and a determination to
provide neighboring communities with the commodity also. This change in
policy frequently comes about when several smaller plants are merged under
one control and the original units are found to be entirely inadequate to meet
the demand. Again, when through a change in financial policy it is decided to
lower the rates of a public service commodity, the original equipment may
prove inadequate to meet the increased demand. It is not contended here that
this type of inadequacy is to be taken into account in estimating the
depreciation charge. Usually it cannot be foreseen and should therefore be
provided against under the head of a general contingent reserve or
appropriation of profit. If it can be foreseen intelligently, it should be taken
into account in the estimate of depreciation.
Inadequacy through Motives of Economy
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The second type of inadequacy may be a foreseen and calculated
inadequacy. In a new community or in the case of a new commodity whose
virtues are little known, it may be the part of economy and business sagacity to
install originally only such equipment as will be adequate to meet the
requirements during the development stage and then when the commodity is
introduced and established to discard the old and install larger and more
adequate structures. Although it may be foreseen with reasonable certitude that
a power plant generating a thousand horse-power will be entirely inadequate in
ten years, yet it may be the better business economy to scrap it at the end of
ten years rather than incur the up-keep and depreciation charges on a larger
plant which would give longer service. Whichever policy, according to best
engineering economy, results in the lowest unit cost of product is usually the
determining factor. If with all the facts and reasonable expectations under view
the smaller plant is decided upon, then assuredly the depreciation due to
inadequacy must be taken into consideration.
Inadequacy Due to Unforeseen Development
The third type of inadequacy, unforeseen development, has been shown to
be due to an unexpected expansion of the market. This may be brought about
by growth in population of the present market, growth in appreciation of the
commodity manufactured, or sometimes by a lowering of transportation rates
whereby new markets are opened. The very fact that this kind of inadequacy is
unexpected and unforeseen makes impossible its inclusion in the current
depreciation charge. This kind of inadequacy is revealed by a post-mortem
determination of causes of which there were no symptoms leading to a correct
diagnosis during life. The loss to be incurred through the scrapping of the
property before its expected termination of service is a loss which must be
borne by the future and not by the past. It is in the nature of a development
cost which must be incurred if the opportunities of the new market are to be
seized, and which must enter into a consideration of the advisability of making
a bid for the new business.
Business policy might or might not dictate that these costs be charged
against reserves of profits from the past. Theoretically they should be spread
somewhat evenly over the future but in neither case can they have any place in
present depreciation charges. It should be thoroughly understood that
depreciation is a charge which relates always to the past, never to the future.
There is no contradiction here in that a consideration of the future must help to
determine the amount of waste which has taken place in the past. P. D.
inadequacy. In a new community or in the case of a new commodity whose
virtues are little known, it may be the part of economy and business sagacity to
install originally only such equipment as will be adequate to meet the
requirements during the development stage and then when the commodity is
introduced and established to discard the old and install larger and more
adequate structures. Although it may be foreseen with reasonable certitude that
a power plant generating a thousand horse-power will be entirely inadequate in
ten years, yet it may be the better business economy to scrap it at the end of
ten years rather than incur the up-keep and depreciation charges on a larger
plant which would give longer service. Whichever policy, according to best
engineering economy, results in the lowest unit cost of product is usually the
determining factor. If with all the facts and reasonable expectations under view
the smaller plant is decided upon, then assuredly the depreciation due to
inadequacy must be taken into consideration.
Inadequacy Due to Unforeseen Development
The third type of inadequacy, unforeseen development, has been shown to
be due to an unexpected expansion of the market. This may be brought about
by growth in population of the present market, growth in appreciation of the
commodity manufactured, or sometimes by a lowering of transportation rates
whereby new markets are opened. The very fact that this kind of inadequacy is
unexpected and unforeseen makes impossible its inclusion in the current
depreciation charge. This kind of inadequacy is revealed by a post-mortem
determination of causes of which there were no symptoms leading to a correct
diagnosis during life. The loss to be incurred through the scrapping of the
property before its expected termination of service is a loss which must be
borne by the future and not by the past. It is in the nature of a development
cost which must be incurred if the opportunities of the new market are to be
seized, and which must enter into a consideration of the advisability of making
a bid for the new business.
Business policy might or might not dictate that these costs be charged
against reserves of profits from the past. Theoretically they should be spread
somewhat evenly over the future but in neither case can they have any place in
present depreciation charges. It should be thoroughly understood that
depreciation is a charge which relates always to the past, never to the future.
There is no contradiction here in that a consideration of the future must help to
determine the amount of waste which has taken place in the past. P. D.
Page 133
Leake[23] says: “It is a misconception to describe the annual provision for
depreciation as a provision for future renewals, as though it has reference to
the future. The annual provision for depreciation has nothing to do with the
future but relates solely to the past. It is a replacement of capital in respect to
past capital outlay expired in the process of carrying on the business.”
Inadequacy Imposed from Without
Inadequacy may be imposed by external forces or authority. In public
service utilities this has often proved a source of expense. In the interests of a
supposedly enlightened opinion—oftentimes a badly mistaken opinion—
present equipment is found inadequate to meet the new demands. This type of
inadequacy merges imperceptibly into obsolescence. Again, a municipality at
the time of repaving the streets may require that the utility company discard
present equipment and install a larger and heavier type; it may require that
overhead wires be carried in underground conduits; and prudence on the part
of the company may lead to the installation of larger carriers than the old.
These losses—and there is almost invariably a loss to the utility company—
must be charged against the future. So also, the passage of laws and ordinances
in the interests of sanitation and fire protection frequently compels the private
owner to discard equipment and devices before their service life has passed
and install more adequate equipment.
Obsolescence as a Cause
The second factor of functional depreciation is obsolescence. By this we
mean that lessening in worth which is brought about by the development of
something new whereby production becomes more economical or is changed
to meet new ideas, fads, or fancies of the consumer. Obsolescence may be
imposed by outside forces through the exercise of the police power under
circumstances analogous to those mentioned under the discussion of
inadequacy brought about by external means. Municipalities and regulating
commissions have speeded up the “irresistible march to the junk heap” in
numberless instances. Cotton-spinning and shoe machinery, lasts and patterns
of all sorts, electrical devices in particular—all have been subject to
obsolescence charges. The horse car gave place to the cable car, which in its
turn was displaced by steam locomotion, and today this has given way to
electrically propelled street cars. The old wooden rail gave way to the rail of
wood capped with a strip of steel, the light “T” steel rail, and the present heavy
steel rails—changes all necessitated by changes and developments in the art
depreciation as a provision for future renewals, as though it has reference to
the future. The annual provision for depreciation has nothing to do with the
future but relates solely to the past. It is a replacement of capital in respect to
past capital outlay expired in the process of carrying on the business.”
Inadequacy Imposed from Without
Inadequacy may be imposed by external forces or authority. In public
service utilities this has often proved a source of expense. In the interests of a
supposedly enlightened opinion—oftentimes a badly mistaken opinion—
present equipment is found inadequate to meet the new demands. This type of
inadequacy merges imperceptibly into obsolescence. Again, a municipality at
the time of repaving the streets may require that the utility company discard
present equipment and install a larger and heavier type; it may require that
overhead wires be carried in underground conduits; and prudence on the part
of the company may lead to the installation of larger carriers than the old.
These losses—and there is almost invariably a loss to the utility company—
must be charged against the future. So also, the passage of laws and ordinances
in the interests of sanitation and fire protection frequently compels the private
owner to discard equipment and devices before their service life has passed
and install more adequate equipment.
Obsolescence as a Cause
The second factor of functional depreciation is obsolescence. By this we
mean that lessening in worth which is brought about by the development of
something new whereby production becomes more economical or is changed
to meet new ideas, fads, or fancies of the consumer. Obsolescence may be
imposed by outside forces through the exercise of the police power under
circumstances analogous to those mentioned under the discussion of
inadequacy brought about by external means. Municipalities and regulating
commissions have speeded up the “irresistible march to the junk heap” in
numberless instances. Cotton-spinning and shoe machinery, lasts and patterns
of all sorts, electrical devices in particular—all have been subject to
obsolescence charges. The horse car gave place to the cable car, which in its
turn was displaced by steam locomotion, and today this has given way to
electrically propelled street cars. The old wooden rail gave way to the rail of
wood capped with a strip of steel, the light “T” steel rail, and the present heavy
steel rails—changes all necessitated by changes and developments in the art
Page 134
and a demand for better service by the public. The stick used by the Indian to
turn the ground and plant his corn has been displaced successively by hand
tools of iron and steel, horse-driven plows, and the big steam and gas tractors
of the present day. No industry has escaped the seemingly inevitable trend
towards the displacement of the old and antiquated but not worn-out
equipment, by newer, more up-to-date, and more economical equipment.
Obviously the last word has not yet been spoken or the last refinement been
made in the development or application of art and science to any industrial
enterprise. Life means development; dry rot and retrogression are the fate of
any art, any industry, any people which has reached the limit of its
development.
Since, therefore, obsolescence is so common an occurrence, so absolutely a
fact of general experience, it would be folly to ignore it. Many writers and
some authorities have said that while obsolescence is as certain and ever
present as the forces of nature, it seldom is more possible of measurement than
are they. However, engineers tell us that in most cases it is possible for
qualified experts to foretell with reasonable certainty the effect of
obsolescence. “Those most familiar with the art know the units which will be
able to serve their entire physical life, and what classes are so uneconomical or
otherwise defective that some improvement must be expected.”
Treatment of Obsolescence
As to the effect of obsolescence, attention should be called to the fact that
it is seldom operative to its full extent. The decision as to the exact time of
discarding the old and installing the new rests on a nice balancing of many
factors. Thus, the safety devices operated by hand on railroads are not
displaced in a wholesale manner by those which operate automatically. In a
large telephone company old switchboards are not discarded for new over the
entire system at the same time. Much of the old is oftentimes allowed to serve
out its life-term, and obsolescence has no effect. Under the circumstances
stated above, and many similar and more complicated conditions, it requires a
nice calculation to determine the actual effect of the factor of obsolescence in
depreciation. Many inaccuracies, even many ridiculous conclusions, in
estimates made by experts are met with, times without number. The novice
thus fears even to guess as to the amount of the depreciation due to this factor.
That is perhaps as it should be; there is no place here for the novice. Inasmuch,
however, as the trend is to estimate the depreciation due to obsolescence, and
such practice has the unqualified approval of many public service boards and
turn the ground and plant his corn has been displaced successively by hand
tools of iron and steel, horse-driven plows, and the big steam and gas tractors
of the present day. No industry has escaped the seemingly inevitable trend
towards the displacement of the old and antiquated but not worn-out
equipment, by newer, more up-to-date, and more economical equipment.
Obviously the last word has not yet been spoken or the last refinement been
made in the development or application of art and science to any industrial
enterprise. Life means development; dry rot and retrogression are the fate of
any art, any industry, any people which has reached the limit of its
development.
Since, therefore, obsolescence is so common an occurrence, so absolutely a
fact of general experience, it would be folly to ignore it. Many writers and
some authorities have said that while obsolescence is as certain and ever
present as the forces of nature, it seldom is more possible of measurement than
are they. However, engineers tell us that in most cases it is possible for
qualified experts to foretell with reasonable certainty the effect of
obsolescence. “Those most familiar with the art know the units which will be
able to serve their entire physical life, and what classes are so uneconomical or
otherwise defective that some improvement must be expected.”
Treatment of Obsolescence
As to the effect of obsolescence, attention should be called to the fact that
it is seldom operative to its full extent. The decision as to the exact time of
discarding the old and installing the new rests on a nice balancing of many
factors. Thus, the safety devices operated by hand on railroads are not
displaced in a wholesale manner by those which operate automatically. In a
large telephone company old switchboards are not discarded for new over the
entire system at the same time. Much of the old is oftentimes allowed to serve
out its life-term, and obsolescence has no effect. Under the circumstances
stated above, and many similar and more complicated conditions, it requires a
nice calculation to determine the actual effect of the factor of obsolescence in
depreciation. Many inaccuracies, even many ridiculous conclusions, in
estimates made by experts are met with, times without number. The novice
thus fears even to guess as to the amount of the depreciation due to this factor.
That is perhaps as it should be; there is no place here for the novice. Inasmuch,
however, as the trend is to estimate the depreciation due to obsolescence, and
such practice has the unqualified approval of many public service boards and
Page 135
at least the silent approval of our courts, it would seem that an attempt should
be made to include it in the depreciation charge. As to its sufficiency or
insufficiency, an amount can be estimated with as much accuracy under the
head of depreciation as under that of a contingent reserve, and the former
course is to be preferred in that an inevitable fact of experience in almost every
industry is thereby recognized. The past, and not the future, is thus burdened
with the accomplished waste. There doubtless will be instances where
depreciation due to obsolescence palpably cannot be foreseen. For such there
is but one of two courses, viz.: either to charge it against profits reserved out of
the past, or burden the future with its cost.
Relative to the inclusion of obsolescence in the depreciation charge, the
Illinois Public Service Commission says in the case of the City of Springfield
v. Springfield Gas and Electric Company, March, 1916: “In view of all the
facts in this case, the Commission finds that it is but reasonable, proper, and
equitable to make deductions from cost new to cover accrued depreciation,
both physical and functional....” The statement of the Maryland Public Service
Commission in the case of the Chesapeake and Potomac Telephone Company
of Baltimore City has already been cited on page 106. Quoting from the report
of the Valuation Committee of the American Society of Civil Engineers: “A
limited search ... indicated that inadequacy and obsolescence were included
either in ascertaining the amount of depreciation to be included in cost, or to
be deducted from earnings ... by the commissions of the following states:
Arizona, California, Colorado, Illinois, Maryland, Massachusetts, New York,
Oregon, South Dakota, Wisconsin.”
Covering this feature, i.e., the depreciation feature, in making returns to the
government under the Federal Income Tax of 1916, the Commissioner ruled as
follows: “The deduction for depreciation should be the estimated amount of
the loss, accrued during the year to which the return relates, in the value of the
property in respect of which such deduction is claimed, that arises from
exhaustion, wear and tear, or obsolescence out of the uses to which the
property is put.... The depreciation allowance, to be deductible, must be, as
nearly as possible, the measure of the loss due to wear and tear, exhaustion,
and obsolescence.”
Although not specifically mentioned, functional depreciation may be said
to have the sanction of the United States Supreme Court in its decisions
covering the Knoxville and Minnesota rate cases. In the case of the Des
be made to include it in the depreciation charge. As to its sufficiency or
insufficiency, an amount can be estimated with as much accuracy under the
head of depreciation as under that of a contingent reserve, and the former
course is to be preferred in that an inevitable fact of experience in almost every
industry is thereby recognized. The past, and not the future, is thus burdened
with the accomplished waste. There doubtless will be instances where
depreciation due to obsolescence palpably cannot be foreseen. For such there
is but one of two courses, viz.: either to charge it against profits reserved out of
the past, or burden the future with its cost.
Relative to the inclusion of obsolescence in the depreciation charge, the
Illinois Public Service Commission says in the case of the City of Springfield
v. Springfield Gas and Electric Company, March, 1916: “In view of all the
facts in this case, the Commission finds that it is but reasonable, proper, and
equitable to make deductions from cost new to cover accrued depreciation,
both physical and functional....” The statement of the Maryland Public Service
Commission in the case of the Chesapeake and Potomac Telephone Company
of Baltimore City has already been cited on page 106. Quoting from the report
of the Valuation Committee of the American Society of Civil Engineers: “A
limited search ... indicated that inadequacy and obsolescence were included
either in ascertaining the amount of depreciation to be included in cost, or to
be deducted from earnings ... by the commissions of the following states:
Arizona, California, Colorado, Illinois, Maryland, Massachusetts, New York,
Oregon, South Dakota, Wisconsin.”
Covering this feature, i.e., the depreciation feature, in making returns to the
government under the Federal Income Tax of 1916, the Commissioner ruled as
follows: “The deduction for depreciation should be the estimated amount of
the loss, accrued during the year to which the return relates, in the value of the
property in respect of which such deduction is claimed, that arises from
exhaustion, wear and tear, or obsolescence out of the uses to which the
property is put.... The depreciation allowance, to be deductible, must be, as
nearly as possible, the measure of the loss due to wear and tear, exhaustion,
and obsolescence.”
Although not specifically mentioned, functional depreciation may be said
to have the sanction of the United States Supreme Court in its decisions
covering the Knoxville and Minnesota rate cases. In the case of the Des
Page 136
Moines Water Company v. City of Des Moines, 192 Fed. 193, September 16,
1911, the court allows both “functional and physical depreciation.”
It would seem, then, that the legality of the practice is pretty well
established and the ability to compute the amount has been recognized. It is
not often the case in matters of business policy and prudence such as this that
the courts lead where business men and some professional men are reluctant to
follow.
Contingent Depreciation
A third factor in depreciation is given in the chart on page 121 as
contingent. The term would seem to indicate on the face of things that it is not
a factor of sufficient definiteness and certainty to make possible its prevision
and therefore the calculation of its effect. Hence it might seem that provision
could be made for it only by means of a general reserve. In many individual
cases and as to its application as a universally operative factor in the same
sense that are use and wear and tear, the position is undoubtedly well taken.
The term contingent, as here used, is meant to cover not only things which
have happened and may happen again, but also things which in given localities
and under known or knowable conditions are more or less inevitable. Hence
while not found present in all cases, where conditions are favorable to the
happening of any of the contingencies, from the standpoint of prudence and an
equitable distribution of the burden of costs, provision should be made for
them as one of the items comprising depreciation. Contingent depreciation
may comprise three classes of contingencies, viz., (1) accidents, (2) diseases,
and (3) diminution in supply.
Accidents. With regard to the first class, M. E. Cooley, in the Milwaukee
Three-cent Fare Case, says: “An engine or a boiler may be wrecked and with it
other machinery. This might, and probably would, involve a considerable
expense for repairs or replacement, besides possibly crippling the plant in part.
Cars may collide or a car may drop through a bridge. A bridge itself may fall
or be carried away by floods. A storm, as a cyclone, may work havoc, entailing
costs in excess of those proper to be charged to ordinary maintenance of
property.” Accidents may happen either as a result of negligence or as a so-
called “act of God,” i.e., the elements, or a hidden defect in the structure. With
regard to depreciation from accidents it may be quoted, “There is always a
certain amount of loss by accident which seems to be inseparable from the
business. Usually it can be counted on in advance, and no amount of care and
1911, the court allows both “functional and physical depreciation.”
It would seem, then, that the legality of the practice is pretty well
established and the ability to compute the amount has been recognized. It is
not often the case in matters of business policy and prudence such as this that
the courts lead where business men and some professional men are reluctant to
follow.
Contingent Depreciation
A third factor in depreciation is given in the chart on page 121 as
contingent. The term would seem to indicate on the face of things that it is not
a factor of sufficient definiteness and certainty to make possible its prevision
and therefore the calculation of its effect. Hence it might seem that provision
could be made for it only by means of a general reserve. In many individual
cases and as to its application as a universally operative factor in the same
sense that are use and wear and tear, the position is undoubtedly well taken.
The term contingent, as here used, is meant to cover not only things which
have happened and may happen again, but also things which in given localities
and under known or knowable conditions are more or less inevitable. Hence
while not found present in all cases, where conditions are favorable to the
happening of any of the contingencies, from the standpoint of prudence and an
equitable distribution of the burden of costs, provision should be made for
them as one of the items comprising depreciation. Contingent depreciation
may comprise three classes of contingencies, viz., (1) accidents, (2) diseases,
and (3) diminution in supply.
Accidents. With regard to the first class, M. E. Cooley, in the Milwaukee
Three-cent Fare Case, says: “An engine or a boiler may be wrecked and with it
other machinery. This might, and probably would, involve a considerable
expense for repairs or replacement, besides possibly crippling the plant in part.
Cars may collide or a car may drop through a bridge. A bridge itself may fall
or be carried away by floods. A storm, as a cyclone, may work havoc, entailing
costs in excess of those proper to be charged to ordinary maintenance of
property.” Accidents may happen either as a result of negligence or as a so-
called “act of God,” i.e., the elements, or a hidden defect in the structure. With
regard to depreciation from accidents it may be quoted, “There is always a
certain amount of loss by accident which seems to be inseparable from the
business. Usually it can be counted on in advance, and no amount of care and
Page 137
precaution will entirely eliminate it.”[24] The Railway Library for 1910 says
that of 899 railroad accidents the various causes were:
Malicious acts 30 accidents
Elements 104 ”
Structural defects 117 ”
Various forms of negligence 648 ”
In a large concern where past experience may serve as a guide to the
future, depreciation of this sort can be rather accurately estimated. In the case
of the rolling stock of a railroad, statistics make available the yearly loss due to
accidents from whatever cause. It is argued that such losses are fairly uniform
from year to year in a large system of that sort, and each year’s operation
carries the burden simply by charging all repairs incident thereto against the
revenues of that period. This is, of course, true in the main and may give
sufficiently accurate results. The same treatment may also be applied to
replacements, and if the units are sufficiently small in value in comparison
with their number, practically no inequity as between periods will result.
However, the Interstate Commerce Commission has ordered that depreciation
reserves shall be set up for the proper handling of such accidents and this
seems the better method. Statistics are available as to how frequently
explosions in powder factories are apt to occur and the losses due to them, so
that a manager can calculate the provision to be made on that account. Those
are simply the risks of the particular business, and wherever it is known that
they are applicable to any kind or group of equipment or other assets, certainly
the current operations should bear their share.
After all, depreciation charges due to any causes are much of the nature of
insurance which has to be carried by the enterprise itself because the risks have
not yet been reduced to an insurable basis. Much as a proprietor may dislike to
carry his own depreciation insurance, he is compelled to. In connection with
accidents as a part of the depreciation charge, it should be noted that the
product should not be charged twice for this item. If regular insurance is
carried for fire, flood, tornado, earthquake, and the like, certainly those
elements should be omitted from the insurance risk carried as depreciation by
the concern itself.
Disease. Under certain conditions as to climate and local environment, the
ravages of disease must be reckoned with. Diseases are caused by:
that of 899 railroad accidents the various causes were:
Malicious acts 30 accidents
Elements 104 ”
Structural defects 117 ”
Various forms of negligence 648 ”
In a large concern where past experience may serve as a guide to the
future, depreciation of this sort can be rather accurately estimated. In the case
of the rolling stock of a railroad, statistics make available the yearly loss due to
accidents from whatever cause. It is argued that such losses are fairly uniform
from year to year in a large system of that sort, and each year’s operation
carries the burden simply by charging all repairs incident thereto against the
revenues of that period. This is, of course, true in the main and may give
sufficiently accurate results. The same treatment may also be applied to
replacements, and if the units are sufficiently small in value in comparison
with their number, practically no inequity as between periods will result.
However, the Interstate Commerce Commission has ordered that depreciation
reserves shall be set up for the proper handling of such accidents and this
seems the better method. Statistics are available as to how frequently
explosions in powder factories are apt to occur and the losses due to them, so
that a manager can calculate the provision to be made on that account. Those
are simply the risks of the particular business, and wherever it is known that
they are applicable to any kind or group of equipment or other assets, certainly
the current operations should bear their share.
After all, depreciation charges due to any causes are much of the nature of
insurance which has to be carried by the enterprise itself because the risks have
not yet been reduced to an insurable basis. Much as a proprietor may dislike to
carry his own depreciation insurance, he is compelled to. In connection with
accidents as a part of the depreciation charge, it should be noted that the
product should not be charged twice for this item. If regular insurance is
carried for fire, flood, tornado, earthquake, and the like, certainly those
elements should be omitted from the insurance risk carried as depreciation by
the concern itself.
Disease. Under certain conditions as to climate and local environment, the
ravages of disease must be reckoned with. Diseases are caused by:
Page 138
1. Parasites
2. Water pollution
3. Growths in water mains
4. Electrolysis
5. Crystallization[25]
Losses and deterioration from these causes are quite appreciable in some
enterprises. Telephone poles are subject to attack by borers and woodpeckers.
“More than 50% of the weight of the wood may be removed ... without being
greatly manifested upon the surface.” “At least 10% of the chestnut poles reset
or replaced are injured by insects.” Railroad trestles, bridges, docks, piers,
wooden shipping, and structures of all sorts are more or less subject to this
kind of depreciation. Minute vegetable growths known as algae may cause a
marked depreciation in a water utility. Other forms of vegetable and animal
organisms sometimes cause growths in water-pipes, resulting in a partial
shutting off of the capacity. Similarly, mineral growths may produce like
effects. Iron oxide (common rust) and lime deposits or scale are frequent
causes.
Electrolysis. Depreciation caused by electrolysis is a highly technical
subject, discussion of which will not be attempted here. “Electrolysis is a
chemical decomposition produced by an electric current. As applied to
utilities, electrolysis is the disintegration of metal structure caused by the
electrolytic action produced by stray electric currents, generally from the
return circuits of single trolley electric railways.” The damage, both direct as
above stated, and indirect as in the leaking of water, gas, etc., or in the
flooding of adjacent premises or injury through gas explosions, is recognized
by the courts, but the satisfaction granted is limited to enjoining a continuance
of the injury.
Molecular Change. In some kinds of machinery subject to heavy strain and
shock when in use, a disintegration of the structure itself takes place whereby
its resisting power and therefore its efficiency are greatly impaired. This
condition is known as a crystallization of the molecules.
Depletion. Finally depreciation due to contingent causes may be brought
about by a diminution in the supply. This is more in the nature of a depletion
charge and will be fully considered in connection with that subject treated on
page 117.
2. Water pollution
3. Growths in water mains
4. Electrolysis
5. Crystallization[25]
Losses and deterioration from these causes are quite appreciable in some
enterprises. Telephone poles are subject to attack by borers and woodpeckers.
“More than 50% of the weight of the wood may be removed ... without being
greatly manifested upon the surface.” “At least 10% of the chestnut poles reset
or replaced are injured by insects.” Railroad trestles, bridges, docks, piers,
wooden shipping, and structures of all sorts are more or less subject to this
kind of depreciation. Minute vegetable growths known as algae may cause a
marked depreciation in a water utility. Other forms of vegetable and animal
organisms sometimes cause growths in water-pipes, resulting in a partial
shutting off of the capacity. Similarly, mineral growths may produce like
effects. Iron oxide (common rust) and lime deposits or scale are frequent
causes.
Electrolysis. Depreciation caused by electrolysis is a highly technical
subject, discussion of which will not be attempted here. “Electrolysis is a
chemical decomposition produced by an electric current. As applied to
utilities, electrolysis is the disintegration of metal structure caused by the
electrolytic action produced by stray electric currents, generally from the
return circuits of single trolley electric railways.” The damage, both direct as
above stated, and indirect as in the leaking of water, gas, etc., or in the
flooding of adjacent premises or injury through gas explosions, is recognized
by the courts, but the satisfaction granted is limited to enjoining a continuance
of the injury.
Molecular Change. In some kinds of machinery subject to heavy strain and
shock when in use, a disintegration of the structure itself takes place whereby
its resisting power and therefore its efficiency are greatly impaired. This
condition is known as a crystallization of the molecules.
Depletion. Finally depreciation due to contingent causes may be brought
about by a diminution in the supply. This is more in the nature of a depletion
charge and will be fully considered in connection with that subject treated on
page 117.
Page 139
Terminable Rights
The intangible property subject to depreciation consists of terminable or
limited rights. Rights given or held for a definite period of time expire or
waste away through the lapse of time. Decrepitude is the controlling factor
here, and because of the definiteness of the length of time, the depreciation
charge is easily calculated. Therefore provision must be made for it. Various
methods, resulting in quite different charges to each period, are sometimes
employed. These methods will be discussed in Chapters IX and X. Rights
which are not terminable or limited—and even limited rights—may, however,
be given up or abandoned. This is a situation which cannot usually be foreseen
and therefore cannot be provided against except by means of a general reserve.
Effective Depreciation
One final point in connection with the causes of depreciation needs
consideration. Though all of these various causes or kinds of depreciation are
seldom found operative on a given asset, frequently several of them are so
operative. Where this is the case their effect is not cumulative. One or the other
will prove a controlling factor in determining the service life of the asset and
thus the amount of its periodic depreciation. There is a close relation between
the operation of the chief factors in depreciation and the scrap value of the
asset. Thus, if it is estimated that physical depreciation will be complete in 8
years, obsolescence in 10 years, and inadequacy in 12 years, scrap value would
be slight. If, however, inadequacy is the controlling factor, becoming operative
in 8 years, with obsolescence in 10 years, and physical depreciation in 12
years, clearly scrap value might be quite appreciable. Whichever factor is the
controlling one, that factor is said in a given case to constitute the effective
depreciation for that asset. Thus, in the first case mentioned, physical
depreciation constitutes effective depreciation and would form the basis for the
estimated charge, while in the second case inadequacy is the effective factor.
The intangible property subject to depreciation consists of terminable or
limited rights. Rights given or held for a definite period of time expire or
waste away through the lapse of time. Decrepitude is the controlling factor
here, and because of the definiteness of the length of time, the depreciation
charge is easily calculated. Therefore provision must be made for it. Various
methods, resulting in quite different charges to each period, are sometimes
employed. These methods will be discussed in Chapters IX and X. Rights
which are not terminable or limited—and even limited rights—may, however,
be given up or abandoned. This is a situation which cannot usually be foreseen
and therefore cannot be provided against except by means of a general reserve.
Effective Depreciation
One final point in connection with the causes of depreciation needs
consideration. Though all of these various causes or kinds of depreciation are
seldom found operative on a given asset, frequently several of them are so
operative. Where this is the case their effect is not cumulative. One or the other
will prove a controlling factor in determining the service life of the asset and
thus the amount of its periodic depreciation. There is a close relation between
the operation of the chief factors in depreciation and the scrap value of the
asset. Thus, if it is estimated that physical depreciation will be complete in 8
years, obsolescence in 10 years, and inadequacy in 12 years, scrap value would
be slight. If, however, inadequacy is the controlling factor, becoming operative
in 8 years, with obsolescence in 10 years, and physical depreciation in 12
years, clearly scrap value might be quite appreciable. Whichever factor is the
controlling one, that factor is said in a given case to constitute the effective
depreciation for that asset. Thus, in the first case mentioned, physical
depreciation constitutes effective depreciation and would form the basis for the
estimated charge, while in the second case inadequacy is the effective factor.
Page 140
CHAPTER VIII
DEPRECIATION—FACTORS OF
RATE DETERMINATION
Fundamental Purpose of Depreciation
Under the head of accounting for depreciation, which forms the subject of this and
following chapters, will be considered:
1. The purpose of the depreciation charge.
2. Rates of depreciation and their relation to repairs, renewals, and
replacements.
3. Methods of reckoning depreciation and their effects.
4. Handling depreciation on the books.
5. Financing depreciation and some related problems.
Though much has been written about the causes and kinds of depreciation, the necessity of
considering it, and methods of calculating its amount, so far as the author knows there has been
no adequate presentation of the fundamental purpose of the depreciation charge viewed both
from the valuation or balance sheet point of view and the operation or profit and loss
standpoint. The statement is frequently made that the purpose of depreciation and the necessity
for considering it is to maintain intact the value of the original capital invested. In so far,
therefore, as this necessitates a periodic charge against revenue, resulting in a retention in the
business, either in a specific or floating form, of some of the revenue-producing assets, the
operating or profit and loss phase of the business is affected. This secures the integrity of the
original fund of capital by making the revenue receipts unavailable for distribution among the
stockholders until the portion of the assets wasted away has been made good. This view of
depreciation has as its actuating purpose a showing of correct values in the balance sheet, with
little regard to the purposes to be served by the depreciation charge against operations. This
emphasis of the problem of valuation is usually looked upon as primarily the engineering
viewpoint.
Depreciation a Cost of Operation
On the other hand, many students of the problem view the depreciation charge as incurred
for the sole purpose of determining the correct costs of doing business. Unquestionably,
depreciation is a cost of production. A portion of the service life of equipment goes into each
unit of the product, and depreciation constitutes a cost which must be borne by the product
with as much reason as the labor power that fashions and forms it and the raw material out of
which it is made. To determine a cost of production and a profit without the inclusion of the
depreciation charge would be, as R. H. Montgomery[26] says, just as logical as “to state that a
candy manufacturer had earned a net profit of $100,000 and that out of said $100,000 there had
been set aside $20,000 to pay for the sugar consumed in the manufacture of the product. The
DEPRECIATION—FACTORS OF
RATE DETERMINATION
Fundamental Purpose of Depreciation
Under the head of accounting for depreciation, which forms the subject of this and
following chapters, will be considered:
1. The purpose of the depreciation charge.
2. Rates of depreciation and their relation to repairs, renewals, and
replacements.
3. Methods of reckoning depreciation and their effects.
4. Handling depreciation on the books.
5. Financing depreciation and some related problems.
Though much has been written about the causes and kinds of depreciation, the necessity of
considering it, and methods of calculating its amount, so far as the author knows there has been
no adequate presentation of the fundamental purpose of the depreciation charge viewed both
from the valuation or balance sheet point of view and the operation or profit and loss
standpoint. The statement is frequently made that the purpose of depreciation and the necessity
for considering it is to maintain intact the value of the original capital invested. In so far,
therefore, as this necessitates a periodic charge against revenue, resulting in a retention in the
business, either in a specific or floating form, of some of the revenue-producing assets, the
operating or profit and loss phase of the business is affected. This secures the integrity of the
original fund of capital by making the revenue receipts unavailable for distribution among the
stockholders until the portion of the assets wasted away has been made good. This view of
depreciation has as its actuating purpose a showing of correct values in the balance sheet, with
little regard to the purposes to be served by the depreciation charge against operations. This
emphasis of the problem of valuation is usually looked upon as primarily the engineering
viewpoint.
Depreciation a Cost of Operation
On the other hand, many students of the problem view the depreciation charge as incurred
for the sole purpose of determining the correct costs of doing business. Unquestionably,
depreciation is a cost of production. A portion of the service life of equipment goes into each
unit of the product, and depreciation constitutes a cost which must be borne by the product
with as much reason as the labor power that fashions and forms it and the raw material out of
which it is made. To determine a cost of production and a profit without the inclusion of the
depreciation charge would be, as R. H. Montgomery[26] says, just as logical as “to state that a
candy manufacturer had earned a net profit of $100,000 and that out of said $100,000 there had
been set aside $20,000 to pay for the sugar consumed in the manufacture of the product. The
Page 141
use of that which is consumed is a loss or expense. Machinery is consumed; sugar is consumed.
You cannot say that one is an operating expense and the other is an item which need not be
ascertained nor taken into account until the net profit is shown.... If the provision for
depreciation is an item which cannot be included among the costs of operation, there is
something wrong.”
This view of depreciation attempts to show the correct costs in the profit and loss statement
of operations, without much regard to its effect on the balance sheet except that, in so far as
every charge against operations is reflected among the assets, the fact of its inclusion as an
operating cost automatically works also as a means of declaring correct values. Under this view
—which may, without any misstatement perhaps, be called the accountant’s viewpoint—the
emphasis is placed on the effort to show true costs of the product, and only incidentally a true
valuation of the assets.
Complication of Short Fiscal Periods
Theoretically there is no conflict of views here—only a difference in emphasis. It is
purposed, however, to show some of the practical difficulties encountered in the full
application of either view. As has been stated in an earlier chapter, the ideal time in so far as
depreciation is involved for the determination of financial results would be the time when all
the elements of production entering into the product have been completely used up—if this
were possible. There would then be no troublesome problems as to inventories, accruals, or
deferred charges. The fiscal period would coincide with the natural service-life periods of all
the producing elements. The problem of depreciation would then be a simple one, and the
entire value of the equipment would be a charge to the product turned out during its life-period.
Such a method of determining the financial results of an enterprise is, of course, merely
fanciful. There is always, and will be always, an overlapping of the life-periods of the various
units of a plant. Furthermore the practical necessities of modern business and competition
require a much shorter fiscal period with a more frequent figuring of results and showing of
condition. It is due to this shortening of the fiscal period to one month, six months, or a year
that the difficulties of the depreciation problem arise and inaccuracies of statement are
consciously or unconsciously made.
The handling of the problem hinges on the answer to the question as to the correct basis for
the distribution of the depreciation charge. Shall a fiscal period of arbitrary length be used as
the basis for determination of the service life of the operating equipment? Or shall the life of
inanimate equipment be measured in terms of units produced, service rendered, results
achieved, just as human life and age may be measured in terms of intensity of thought and
action? It is unfortunately true that once the depreciation charge is settled, this same charge is
constantly applied with little adjustment to changing conditions. Thus, varying intensity of
service is not reflected in the periodic charge.
The Factor of Idle Time
Were it possible to foretell length of service life in terms of units of product instead of units
of time, a much better approximation to actual results would be secured. And this very thing is
attempted under almost all methods of estimating depreciation. The life-period of the
equipment is estimated on an assumption of average, normal use of the equipment—an
assumption which will give good practical results when and so long as operations are normal or
You cannot say that one is an operating expense and the other is an item which need not be
ascertained nor taken into account until the net profit is shown.... If the provision for
depreciation is an item which cannot be included among the costs of operation, there is
something wrong.”
This view of depreciation attempts to show the correct costs in the profit and loss statement
of operations, without much regard to its effect on the balance sheet except that, in so far as
every charge against operations is reflected among the assets, the fact of its inclusion as an
operating cost automatically works also as a means of declaring correct values. Under this view
—which may, without any misstatement perhaps, be called the accountant’s viewpoint—the
emphasis is placed on the effort to show true costs of the product, and only incidentally a true
valuation of the assets.
Complication of Short Fiscal Periods
Theoretically there is no conflict of views here—only a difference in emphasis. It is
purposed, however, to show some of the practical difficulties encountered in the full
application of either view. As has been stated in an earlier chapter, the ideal time in so far as
depreciation is involved for the determination of financial results would be the time when all
the elements of production entering into the product have been completely used up—if this
were possible. There would then be no troublesome problems as to inventories, accruals, or
deferred charges. The fiscal period would coincide with the natural service-life periods of all
the producing elements. The problem of depreciation would then be a simple one, and the
entire value of the equipment would be a charge to the product turned out during its life-period.
Such a method of determining the financial results of an enterprise is, of course, merely
fanciful. There is always, and will be always, an overlapping of the life-periods of the various
units of a plant. Furthermore the practical necessities of modern business and competition
require a much shorter fiscal period with a more frequent figuring of results and showing of
condition. It is due to this shortening of the fiscal period to one month, six months, or a year
that the difficulties of the depreciation problem arise and inaccuracies of statement are
consciously or unconsciously made.
The handling of the problem hinges on the answer to the question as to the correct basis for
the distribution of the depreciation charge. Shall a fiscal period of arbitrary length be used as
the basis for determination of the service life of the operating equipment? Or shall the life of
inanimate equipment be measured in terms of units produced, service rendered, results
achieved, just as human life and age may be measured in terms of intensity of thought and
action? It is unfortunately true that once the depreciation charge is settled, this same charge is
constantly applied with little adjustment to changing conditions. Thus, varying intensity of
service is not reflected in the periodic charge.
The Factor of Idle Time
Were it possible to foretell length of service life in terms of units of product instead of units
of time, a much better approximation to actual results would be secured. And this very thing is
attempted under almost all methods of estimating depreciation. The life-period of the
equipment is estimated on an assumption of average, normal use of the equipment—an
assumption which will give good practical results when and so long as operations are normal or
Page 142
average. When, however, a period of depression comes and much of the equipment is idle, it is
clear that that period would be burdened unduly with a depreciation charge based on years or
months of service life. On the other hand, a period of feverish activity would not bear its just
share of the burden of wasting assets. The period which is really overburdened must
necessarily reflect it as an undervaluation of the assets—more has been charged off than has
been used up; while the opposite is true of an underburdened period. Of course, on the theory
of averages, by the end of the life-period of an asset all inequalities would be ironed out. Some
methods of cost-keeping take this factor of intensity into account and spread the depreciation
charge on a man-hour or machine-hour basis, which proportions it somewhat equitably to the
product turned out by the use made of the machine and not to its elapsed life in days or months.
The best that can be hoped for is as near an approximation to the truth as possible.
Depreciation a Means of Financing
Another view of the purpose of the depreciation charge is that it is a method or means of
financing depreciation as it is sometimes termed. Under this view the effect of the depreciation
charge on intermediate periods is lost sight of and it is used solely as a means of securing a
sufficient contribution in hand at the end of the service life of the asset to finance its
replacement. In other words, no attempt is made through the periodic depreciation charge to
secure an accurate or necessarily true statement of the values of the assets, nor to see that the
product of a given period is burdened with its just share of all costs, though this may be an
incidental purpose. H. V. Hayes[27] in discussing this phase of depreciation says:
“It is argued that the plant unit ‘deteriorates’ year by year and that this ‘deterioration’ is the
true measure of the ‘depreciation’ in the value of the unit during the intermediate years of its
life, and, being a physical condition of the plant, can in no way be measured by the purely
financial considerations upon which the reserves for depreciation necessarily must be based.
Such a line of reasoning is absolutely faulty. Any attempt to reconcile ‘deterioration’ with
‘depreciation’ at any intermediate period in the life of the plant of an undertaking, is not only
unnecessary but futile. The error in such an attempt arises from a failure ... to recognize the fact
that ... if definite agreement has been reached as to the serviceable life (of the asset), the
physical ‘deterioration’ of the unit, at any time during its life, can be a matter affecting its
intrinsic value in no way whatever.”
Danger of the Financing Viewpoint
The above statement is a fair presentation of the case for depreciation as a financing device.
It would seem, however, that the exponents of this view lose sight of the inevitable fact that the
depreciation charge is pro tanto an evaluator of the wasting asset during the intermediate
period of its life. Therefore a logical conclusion to be drawn from the view as expressed in the
quotation above, would be the countenancing of any method by means of which provision
could be made to replace the asset by the end of its life, no matter whether the charge was
spread evenly over its life, was made all in one year, or was made to depend on the amount of
the net profits at the end of a given year. This latter alternative is a dangerous policy, always to
be deprecated, for depreciation is a cost of production to be taken account of before profits can
be determined.
After all, it may be said without fear of serious contradiction that all three views, i.e., the
engineering, the accounting, and the financing viewpoints, must be held in mind in any
clear that that period would be burdened unduly with a depreciation charge based on years or
months of service life. On the other hand, a period of feverish activity would not bear its just
share of the burden of wasting assets. The period which is really overburdened must
necessarily reflect it as an undervaluation of the assets—more has been charged off than has
been used up; while the opposite is true of an underburdened period. Of course, on the theory
of averages, by the end of the life-period of an asset all inequalities would be ironed out. Some
methods of cost-keeping take this factor of intensity into account and spread the depreciation
charge on a man-hour or machine-hour basis, which proportions it somewhat equitably to the
product turned out by the use made of the machine and not to its elapsed life in days or months.
The best that can be hoped for is as near an approximation to the truth as possible.
Depreciation a Means of Financing
Another view of the purpose of the depreciation charge is that it is a method or means of
financing depreciation as it is sometimes termed. Under this view the effect of the depreciation
charge on intermediate periods is lost sight of and it is used solely as a means of securing a
sufficient contribution in hand at the end of the service life of the asset to finance its
replacement. In other words, no attempt is made through the periodic depreciation charge to
secure an accurate or necessarily true statement of the values of the assets, nor to see that the
product of a given period is burdened with its just share of all costs, though this may be an
incidental purpose. H. V. Hayes[27] in discussing this phase of depreciation says:
“It is argued that the plant unit ‘deteriorates’ year by year and that this ‘deterioration’ is the
true measure of the ‘depreciation’ in the value of the unit during the intermediate years of its
life, and, being a physical condition of the plant, can in no way be measured by the purely
financial considerations upon which the reserves for depreciation necessarily must be based.
Such a line of reasoning is absolutely faulty. Any attempt to reconcile ‘deterioration’ with
‘depreciation’ at any intermediate period in the life of the plant of an undertaking, is not only
unnecessary but futile. The error in such an attempt arises from a failure ... to recognize the fact
that ... if definite agreement has been reached as to the serviceable life (of the asset), the
physical ‘deterioration’ of the unit, at any time during its life, can be a matter affecting its
intrinsic value in no way whatever.”
Danger of the Financing Viewpoint
The above statement is a fair presentation of the case for depreciation as a financing device.
It would seem, however, that the exponents of this view lose sight of the inevitable fact that the
depreciation charge is pro tanto an evaluator of the wasting asset during the intermediate
period of its life. Therefore a logical conclusion to be drawn from the view as expressed in the
quotation above, would be the countenancing of any method by means of which provision
could be made to replace the asset by the end of its life, no matter whether the charge was
spread evenly over its life, was made all in one year, or was made to depend on the amount of
the net profits at the end of a given year. This latter alternative is a dangerous policy, always to
be deprecated, for depreciation is a cost of production to be taken account of before profits can
be determined.
After all, it may be said without fear of serious contradiction that all three views, i.e., the
engineering, the accounting, and the financing viewpoints, must be held in mind in any
Page 143
adequate treatment of the depreciation charge. The important point from the commercial and
accounting standpoint is to secure a fair and equitable charge to each unit of product, regardless
of whether or not the burdens of each fiscal period are equal. This is particularly evident when
wear and tear from use is the effective factor in depreciation—and it is also contended that the
factors of obsolescence and inadequacy may be as successfully and relevantly estimated in
terms of business output as in years. If this results in an accurate valuation of the asset—and it
is conceded that from the engineering viewpoint it may sometimes so result—the inaccuracy is
of minor importance. According to the general law for the valuation of fixed assets, changes in
the market need not and should not, as a general thing, affect the values at which the assets are
carried on the books of a going concern. It is, of course, a corollary to the main proposition that
this treatment also makes adequate provision for financing the fact of depreciation. Various
methods and means for the accomplishment of these purposes are given in Chapter IX.
The Standardization of Depreciation Rates
The determination of the rate of depreciation of a given asset is essentially an engineering
problem. But as the accounting for depreciation is dependent on the rate, and the records of the
accounting department must furnish much of the information for estimating the rate, the whole
problem of fixing depreciation rates will be considered under the one head. Much study and
effort to reduce all the conditions under which assets depreciate to a common basis and so to a
definitely stated rate for each set of conditions, have, so far, come to naught and all qualified
experts say without reserve that the rate of depreciation is an individual problem. It is to be
hoped that a further gathering of statistics as to expectations of life of different assets under
varying conditions will ultimately furnish tabulations, corresponding to insurance tables,
according to which under known and expected conditions a fairly accurate rate of depreciation
for a particular asset may be made. Unlike insurance rates, however, the depreciation rate once
established will not necessarily remain constant, but must be subject to a periodic revision in
the light of new data and conditions.
Effect of Local Conditions
Many factors enter into the rate of depreciation. They may be classed roughly as “stable or
normal” factors and “contingent” factors. It should be constantly borne in mind that in the
present state of the actuarial development of the subject, general rates, i.e., rates which will
apply without readjustment, cannot be determined. For the determination of individual rates
local conditions are always the controlling factor. An illustration in point is given by Henry
Floy,[28] showing the varying rates used by thirty-one different concerns for the depreciation of
their rolling stock equipment. The methods vary in almost every case, comprising annual
charges of an arbitrary amount, per cent of the original cost, cents per car mile, arbitrary
deductions from income irregularly applied, per cent of gross earnings, per cent of present
estimated values. Reduced to a common basis, the per cent methods show a range of expected
life varying between ten and one hundred years. While it is improbable that had the
determination of the depreciation rate for the different concerns been in the hands of the same
expert, there would have resulted these bewildering variations in method, still it does bring out
in strong relief the fact, well recognized by experts but so often lost sight of by those
unacquainted with the technical phases of the problem, that local conditions are a controlling
factor; and that until local conditions can be somewhat standardized there is no hope of
establishing rates of depreciation which will be of general application.
accounting standpoint is to secure a fair and equitable charge to each unit of product, regardless
of whether or not the burdens of each fiscal period are equal. This is particularly evident when
wear and tear from use is the effective factor in depreciation—and it is also contended that the
factors of obsolescence and inadequacy may be as successfully and relevantly estimated in
terms of business output as in years. If this results in an accurate valuation of the asset—and it
is conceded that from the engineering viewpoint it may sometimes so result—the inaccuracy is
of minor importance. According to the general law for the valuation of fixed assets, changes in
the market need not and should not, as a general thing, affect the values at which the assets are
carried on the books of a going concern. It is, of course, a corollary to the main proposition that
this treatment also makes adequate provision for financing the fact of depreciation. Various
methods and means for the accomplishment of these purposes are given in Chapter IX.
The Standardization of Depreciation Rates
The determination of the rate of depreciation of a given asset is essentially an engineering
problem. But as the accounting for depreciation is dependent on the rate, and the records of the
accounting department must furnish much of the information for estimating the rate, the whole
problem of fixing depreciation rates will be considered under the one head. Much study and
effort to reduce all the conditions under which assets depreciate to a common basis and so to a
definitely stated rate for each set of conditions, have, so far, come to naught and all qualified
experts say without reserve that the rate of depreciation is an individual problem. It is to be
hoped that a further gathering of statistics as to expectations of life of different assets under
varying conditions will ultimately furnish tabulations, corresponding to insurance tables,
according to which under known and expected conditions a fairly accurate rate of depreciation
for a particular asset may be made. Unlike insurance rates, however, the depreciation rate once
established will not necessarily remain constant, but must be subject to a periodic revision in
the light of new data and conditions.
Effect of Local Conditions
Many factors enter into the rate of depreciation. They may be classed roughly as “stable or
normal” factors and “contingent” factors. It should be constantly borne in mind that in the
present state of the actuarial development of the subject, general rates, i.e., rates which will
apply without readjustment, cannot be determined. For the determination of individual rates
local conditions are always the controlling factor. An illustration in point is given by Henry
Floy,[28] showing the varying rates used by thirty-one different concerns for the depreciation of
their rolling stock equipment. The methods vary in almost every case, comprising annual
charges of an arbitrary amount, per cent of the original cost, cents per car mile, arbitrary
deductions from income irregularly applied, per cent of gross earnings, per cent of present
estimated values. Reduced to a common basis, the per cent methods show a range of expected
life varying between ten and one hundred years. While it is improbable that had the
determination of the depreciation rate for the different concerns been in the hands of the same
expert, there would have resulted these bewildering variations in method, still it does bring out
in strong relief the fact, well recognized by experts but so often lost sight of by those
unacquainted with the technical phases of the problem, that local conditions are a controlling
factor; and that until local conditions can be somewhat standardized there is no hope of
establishing rates of depreciation which will be of general application.
Page 144
Factors in Determining Depreciation Rate
In the determination of rates the factors to be taken into account are:
1. Normal operating conditions.
2. Normal load or normal intensity of operation.
3. Normal repairs policy.
4. Normal climatic conditions.
These constitute the most important stable or normal factors. Among the contingent
elements, the most important are:
5. Probable misuse and neglect brought about by the demands of the
trade, resulting in a change in the factor of normal intensity.
6. Probable change in ownership and consequent change in policy.
7. Probable change in the requirements of the market, necessitating
an adaptation of the equipment to uses for which it was not
originally intended.
At the time of installation the rate of depreciation must be based only on the normal factors
—things which can with reasonable certainty be counted on. At intermediate periods in the life
of the asset, a physical inspection should be made to compare the actual depreciation of the
property with the estimated. If, then, it is found that any contingent factors have become real or
reached the point of reasonable expectancy, these provide the basis for an adjustment of the
rate for the remaining life-term of the asset.
Basis of Normal Rate
With regard to the normal rate, the following items demand first consideration:
“1. Exterior or movable apparatus
(a) Abuse
(b) Neglect
(c) Temperatures
(d) Oxidation
(e) Irregular shocks in use, such as starting
or braking, also road or rail defects
2. Installed operating and generating machinery
(a) Reversals, increased by rapidity and aggravated by shock
(b) Irregular loads or service, aggravated by speedand sudden character
(c) Excessive usage, resulting in increase of temperature of parts
3. Fixed equipment including boilers and piping
In the determination of rates the factors to be taken into account are:
1. Normal operating conditions.
2. Normal load or normal intensity of operation.
3. Normal repairs policy.
4. Normal climatic conditions.
These constitute the most important stable or normal factors. Among the contingent
elements, the most important are:
5. Probable misuse and neglect brought about by the demands of the
trade, resulting in a change in the factor of normal intensity.
6. Probable change in ownership and consequent change in policy.
7. Probable change in the requirements of the market, necessitating
an adaptation of the equipment to uses for which it was not
originally intended.
At the time of installation the rate of depreciation must be based only on the normal factors
—things which can with reasonable certainty be counted on. At intermediate periods in the life
of the asset, a physical inspection should be made to compare the actual depreciation of the
property with the estimated. If, then, it is found that any contingent factors have become real or
reached the point of reasonable expectancy, these provide the basis for an adjustment of the
rate for the remaining life-term of the asset.
Basis of Normal Rate
With regard to the normal rate, the following items demand first consideration:
“1. Exterior or movable apparatus
(a) Abuse
(b) Neglect
(c) Temperatures
(d) Oxidation
(e) Irregular shocks in use, such as starting
or braking, also road or rail defects
2. Installed operating and generating machinery
(a) Reversals, increased by rapidity and aggravated by shock
(b) Irregular loads or service, aggravated by speedand sudden character
(c) Excessive usage, resulting in increase of temperature of parts
3. Fixed equipment including boilers and piping
Page 145
(a) Excessive and irregular strains
(b) Interior causes of decay
(c) Chemical action
—all these being of greater or less effect, according to the time of daily usage and lack of
periods of rest.”[29]
Policies as to Repairs
Without doubt the most important single factor in the determination of the depreciation rate
is the normal policy as to repairs and maintenance. Physical deterioration is constantly at work.
If this is counteracted by a liberal maintenance policy, not only is more efficient service
secured but a longer service life is thereby insured. As soon as repairs are needed, although the
efficiency of the asset may not be immediately impaired, the rate of deterioration is much
accelerated unless the condition is corrected. Deterioration takes place day by day, but repairs
obviously cannot be made at such short intervals—both because of the difficulty of detection
and also because such a policy would not be economically practical. Every concern must
consider its own peculiar problems and determine from these what shall constitute its normal
repairs policy, and so far as possible this should be adhered to. The charges for repairs are
bound to be of a more or less irregular character. Their handling is discussed on page 147.
Regardless of what the established policy as to repairs may be, conditions are sure to arise
which make strict adherence to it impossible. There may occasionally be lack of funds at the
time repairs are customarily attended to; it may be impossible to get the expert labor needed or
the parts to replace worn-out units; or, and of oftenest occurrence, the need of repairs may
coincide with a period of intense activity when the plant is being worked to its limit and in
consequence there is no opportunity for making repairs. It is clear that rates based on one shift
and the normal use of equipment during eight hours would be inadequate for three shifts and
twenty-four hours of use; for in addition to a threefold intensity of operation this makes
impossible adherence to the normal repairs policy based on an eight-hour schedule.
Depreciation Rate an Engineering Problem
From the above discussion it is apparent that the determination of rates is essentially an
engineering problem. The accountant, however, needs a knowledge of the fundamental
considerations and requirements of fixing depreciation rates and an appreciation of the
difficulties of the problem. As Henry Floy[30] says: “What engineer is able to foretell the
misuse and neglect or care and high degree of maintenance that any given apparatus or ...
property as a whole will receive, even during the next five or ten years, with vicissitudes of
climate, load conditions, changes of management, and requirements of the public?” On the
other hand, in the opinion of another prominent engineer, “Consideration of these matters
(misuse, neglect, etc.) may eventually form the basis for a systematic appraisal of the
probabilities of life, or average of the risks, which would provide a method for the insurance of
the life of machinery.”
The author does not attempt to discuss the relative merits of the two contentions other than
to point out the fact that engineers are not discouraged in spite of the many contingencies and
uncertainties inherent in the problem. They are constantly gathering data from which
(b) Interior causes of decay
(c) Chemical action
—all these being of greater or less effect, according to the time of daily usage and lack of
periods of rest.”[29]
Policies as to Repairs
Without doubt the most important single factor in the determination of the depreciation rate
is the normal policy as to repairs and maintenance. Physical deterioration is constantly at work.
If this is counteracted by a liberal maintenance policy, not only is more efficient service
secured but a longer service life is thereby insured. As soon as repairs are needed, although the
efficiency of the asset may not be immediately impaired, the rate of deterioration is much
accelerated unless the condition is corrected. Deterioration takes place day by day, but repairs
obviously cannot be made at such short intervals—both because of the difficulty of detection
and also because such a policy would not be economically practical. Every concern must
consider its own peculiar problems and determine from these what shall constitute its normal
repairs policy, and so far as possible this should be adhered to. The charges for repairs are
bound to be of a more or less irregular character. Their handling is discussed on page 147.
Regardless of what the established policy as to repairs may be, conditions are sure to arise
which make strict adherence to it impossible. There may occasionally be lack of funds at the
time repairs are customarily attended to; it may be impossible to get the expert labor needed or
the parts to replace worn-out units; or, and of oftenest occurrence, the need of repairs may
coincide with a period of intense activity when the plant is being worked to its limit and in
consequence there is no opportunity for making repairs. It is clear that rates based on one shift
and the normal use of equipment during eight hours would be inadequate for three shifts and
twenty-four hours of use; for in addition to a threefold intensity of operation this makes
impossible adherence to the normal repairs policy based on an eight-hour schedule.
Depreciation Rate an Engineering Problem
From the above discussion it is apparent that the determination of rates is essentially an
engineering problem. The accountant, however, needs a knowledge of the fundamental
considerations and requirements of fixing depreciation rates and an appreciation of the
difficulties of the problem. As Henry Floy[30] says: “What engineer is able to foretell the
misuse and neglect or care and high degree of maintenance that any given apparatus or ...
property as a whole will receive, even during the next five or ten years, with vicissitudes of
climate, load conditions, changes of management, and requirements of the public?” On the
other hand, in the opinion of another prominent engineer, “Consideration of these matters
(misuse, neglect, etc.) may eventually form the basis for a systematic appraisal of the
probabilities of life, or average of the risks, which would provide a method for the insurance of
the life of machinery.”
The author does not attempt to discuss the relative merits of the two contentions other than
to point out the fact that engineers are not discouraged in spite of the many contingencies and
uncertainties inherent in the problem. They are constantly gathering data from which
Page 146
conclusions as to rates are being formed, the use of which is being compelled by regulating
bodies. It is possible that the problem will ultimately be worked out on some kind of an
insurance basis.
Attitude of Regulatory Bodies
At the present time the attitude of most regulatory bodies—public service boards, federal
commissions, and tax officials—is well expressed by a regulation of the Public Utility
Commission of New Jersey which says that, “Until otherwise prescribed, the amount estimated
to be necessary to cover such wear and tear and obsolescence and inadequacy as have accrued
during any month shall be based on a rule to be determined by the accounting corporation; such
rule may be derived from a consideration of the said corporation’s history and experience. A
general statement of the rule in use by each company, together with the general information
upon which it is based, is to be filed with the Board of Public Utility Commissioners.” The
trend at the present time is towards a more thorough supervision of depreciation rates on the
part of many public service boards, and the future will undoubtedly see interesting
developments.
Methods of Handling Repairs
Three distinct practices are met with in handling repairs and renewals on the books. The
most general method is dictated by ease of application and rests on the theory of averages, viz.:
that the amount of repairs annually recurring for depreciating equipment in all degrees of
deterioration and all stages of decay and age is a fairly constant figure which secures an
equitable distribution over the product of the different years. The larger the plant and the
greater the variety of the equipment used, the more nearly does this work out as expected.
Further consideration will be given to this point in the discussion in Chapter X of the effect
of the various methods used for calculating depreciation on the equality of the distribution of
the charge.
Another method, used in plants where a very accurate determination of the costs of
production is desired, has as an outstanding feature a preliminary estimate, made at the time of
installation, of the expected amount of repairs needed during the entire life of the asset.
Periodically this estimate, or proportional share thereof, is brought on the books as a charge to
Repairs and credit to Reserve for Repairs and so is spread evenly over the service life of the
asset. As repairs are actually made, the cost of these is not charged against operation but
against the reserve created for that very purpose. At a given time, the status of the reserve
account shows: (1) if the equipment has just been placed in a normal state of repair, the under-
or over-estimate of the amount of actual repairs needed, or (2) if the equipment is not in repair,
the reserve account gives an index of the probable amount of deferred maintenance. Both items
of information are of value in the proper management of properties. It is to be expected, of
course, that during the early years of the life of an asset there will be a fairly large credit
balance in the reserve because repair charges are light. The credit balance so accumulated will
be needed during the later years when the costs of maintenance become heavier.
The third method, which is a variation of the second, has as its characteristic feature the
inclusion of the repairs cost with the depreciation charge. This likewise necessitates a
preliminary estimate of the amount of expected repairs during the life of the asset. Instead of
being handled separately, it is added to the depreciation rate and in this way charged against the
bodies. It is possible that the problem will ultimately be worked out on some kind of an
insurance basis.
Attitude of Regulatory Bodies
At the present time the attitude of most regulatory bodies—public service boards, federal
commissions, and tax officials—is well expressed by a regulation of the Public Utility
Commission of New Jersey which says that, “Until otherwise prescribed, the amount estimated
to be necessary to cover such wear and tear and obsolescence and inadequacy as have accrued
during any month shall be based on a rule to be determined by the accounting corporation; such
rule may be derived from a consideration of the said corporation’s history and experience. A
general statement of the rule in use by each company, together with the general information
upon which it is based, is to be filed with the Board of Public Utility Commissioners.” The
trend at the present time is towards a more thorough supervision of depreciation rates on the
part of many public service boards, and the future will undoubtedly see interesting
developments.
Methods of Handling Repairs
Three distinct practices are met with in handling repairs and renewals on the books. The
most general method is dictated by ease of application and rests on the theory of averages, viz.:
that the amount of repairs annually recurring for depreciating equipment in all degrees of
deterioration and all stages of decay and age is a fairly constant figure which secures an
equitable distribution over the product of the different years. The larger the plant and the
greater the variety of the equipment used, the more nearly does this work out as expected.
Further consideration will be given to this point in the discussion in Chapter X of the effect
of the various methods used for calculating depreciation on the equality of the distribution of
the charge.
Another method, used in plants where a very accurate determination of the costs of
production is desired, has as an outstanding feature a preliminary estimate, made at the time of
installation, of the expected amount of repairs needed during the entire life of the asset.
Periodically this estimate, or proportional share thereof, is brought on the books as a charge to
Repairs and credit to Reserve for Repairs and so is spread evenly over the service life of the
asset. As repairs are actually made, the cost of these is not charged against operation but
against the reserve created for that very purpose. At a given time, the status of the reserve
account shows: (1) if the equipment has just been placed in a normal state of repair, the under-
or over-estimate of the amount of actual repairs needed, or (2) if the equipment is not in repair,
the reserve account gives an index of the probable amount of deferred maintenance. Both items
of information are of value in the proper management of properties. It is to be expected, of
course, that during the early years of the life of an asset there will be a fairly large credit
balance in the reserve because repair charges are light. The credit balance so accumulated will
be needed during the later years when the costs of maintenance become heavier.
The third method, which is a variation of the second, has as its characteristic feature the
inclusion of the repairs cost with the depreciation charge. This likewise necessitates a
preliminary estimate of the amount of expected repairs during the life of the asset. Instead of
being handled separately, it is added to the depreciation rate and in this way charged against the
Page 147
product. This method has been prescribed in the case of some utilities in England but is not
much used here. Under this method two depreciation estimates of probable life are necessary,
viz.: (1) maximum life brought about by an inclusion of repairs, renewals, etc., and (2)
minimum life without such repairs. By this it is not meant that other methods of calculating the
depreciation rates fail to take cognizance of the repairs factor, but that this method specifically
calls attention to it and includes it in the charge made. It seems best for regulatory boards to
make a separate book record of repairs and depreciation, thus insuring against any oversight of
the factors of depreciation and also insuring the correctness of a statement of condition.
much used here. Under this method two depreciation estimates of probable life are necessary,
viz.: (1) maximum life brought about by an inclusion of repairs, renewals, etc., and (2)
minimum life without such repairs. By this it is not meant that other methods of calculating the
depreciation rates fail to take cognizance of the repairs factor, but that this method specifically
calls attention to it and includes it in the charge made. It seems best for regulatory boards to
make a separate book record of repairs and depreciation, thus insuring against any oversight of
the factors of depreciation and also insuring the correctness of a statement of condition.
Page 148
CHAPTER IX
DEPRECIATION—METHODS OF
CALCULATING
Methods of Calculation
Many methods of reckoning depreciation have been devised; some good, some bad, and some too
theoretical and involved ever to serve the practical needs of business. It is proposed here to explain
those methods which have found most favor and, in Chapter X, to discuss their effects from the
standpoint of the true purpose of any scheme of depreciation.
There are several ways in which the depreciation calculation can be made, and the methods may
be classified broadly, though with some overlapping, under four heads. These classes are:
1. Proportional Methods
2. Variable Percentage Methods
3. Compound Interest Methods
4. Miscellaneous Methods
Factors of Calculation
The factors which must be known under most methods of calculation are:
1. Original cost of the asset
2. Scrap or residual value
3. Estimated service life
4. Under some methods, an arbitrary interest rate
By original cost is meant full cost of the asset in position ready for use. By scrap value is meant
the estimated value of the asset at the time of its discard, when removed from position and ready for
sale or other mode of disposal. This is sometimes called its salvage value as distinguished from its
value while still in position to render service but awaiting discard or break-up. By estimated service
life is meant the time during which the asset will be used for service. This may be expressed in
ordinary units of calendar time, such as the year; or in units of service time, such as working hours;
or finally in units of output, such as tons, cubic feet, kilowatt hours, etc.
Symbols to be Used
For purposes of notation and reference the following symbols will be used:
V = original cost
V₁ = depreciated value at end of first period
V₂ = ” ” ” ” ” second period
Vₙ = ” ” ” ” ” last period, i.e., scrap value
n = length of service life
DEPRECIATION—METHODS OF
CALCULATING
Methods of Calculation
Many methods of reckoning depreciation have been devised; some good, some bad, and some too
theoretical and involved ever to serve the practical needs of business. It is proposed here to explain
those methods which have found most favor and, in Chapter X, to discuss their effects from the
standpoint of the true purpose of any scheme of depreciation.
There are several ways in which the depreciation calculation can be made, and the methods may
be classified broadly, though with some overlapping, under four heads. These classes are:
1. Proportional Methods
2. Variable Percentage Methods
3. Compound Interest Methods
4. Miscellaneous Methods
Factors of Calculation
The factors which must be known under most methods of calculation are:
1. Original cost of the asset
2. Scrap or residual value
3. Estimated service life
4. Under some methods, an arbitrary interest rate
By original cost is meant full cost of the asset in position ready for use. By scrap value is meant
the estimated value of the asset at the time of its discard, when removed from position and ready for
sale or other mode of disposal. This is sometimes called its salvage value as distinguished from its
value while still in position to render service but awaiting discard or break-up. By estimated service
life is meant the time during which the asset will be used for service. This may be expressed in
ordinary units of calendar time, such as the year; or in units of service time, such as working hours;
or finally in units of output, such as tons, cubic feet, kilowatt hours, etc.
Symbols to be Used
For purposes of notation and reference the following symbols will be used:
V = original cost
V₁ = depreciated value at end of first period
V₂ = ” ” ” ” ” second period
Vₙ = ” ” ” ” ” last period, i.e., scrap value
n = length of service life
Page 149
d = rate of depreciation per period
D = total amount of depreciation, i.e., V - Vₙ
D₁ = amount of depreciation during first period
Dₙ = ” ” ” ” last ”
r = rate of interest
R = 1 + r, i.e., 100% plus the rate
1 - r = 100% minus the rate
A = annual amount to be paid under the compound interest methods
It should be noted that the foregoing factors are all estimates, with the exception of original cost,
and that when making these estimates the principles of depreciation as discussed in preceding
chapters must be taken into consideration. Thus, a decision must be made as to whether physical or
functional depreciation is the controlling factor in determining service life. In the determination of
service life, the policy as to repairs, renewals, and maintenance has a very important bearing. In
fixing the scrap value, the relation of inadequacy, obsolescence, wear and tear, and age to the values
remaining in the asset must be considered.
1. Proportional Methods
Proportional methods include all those in which the periodic depreciation is calculated as a
proportional part of some fixed basic value. These may be grouped under the following subclass
titles, each of which will be separately considered:
(a) Straight Line
(b) Working Hours
(c) Composite Life
(d) Service Output
(a) Straight Line Method
The “Straight Line” method, so called because its graphical representation is a straight line, is
perhaps the simplest of all methods for calculating the periodic depreciation charge and is therefore
the most widely used. Under it the loss of value for each period is proportioned to the length of
service life. Thus, an asset whose service life is reckoned as 10 years will have depreciated one-tenth
by the end of the first year, two-tenths by the end of the second year, and so on. The depreciation for
each year is the same. Shown by formula, using the notation above, this will be:
(V - Vₙ) D
D₁ = or and, evidently,
n n
V₁ = V - D₁; V₂ = V₁ - D₂; etc.
From these formulas a schedule of appraisal for a given asset may be made up showing its values
as at the end of each year of its estimated life. For an asset costing $150, of which the service life is 5
periods and the scrap value, due to inadequacy, is $50, such an appraisal schedule would work out as
follows:
D = total amount of depreciation, i.e., V - Vₙ
D₁ = amount of depreciation during first period
Dₙ = ” ” ” ” last ”
r = rate of interest
R = 1 + r, i.e., 100% plus the rate
1 - r = 100% minus the rate
A = annual amount to be paid under the compound interest methods
It should be noted that the foregoing factors are all estimates, with the exception of original cost,
and that when making these estimates the principles of depreciation as discussed in preceding
chapters must be taken into consideration. Thus, a decision must be made as to whether physical or
functional depreciation is the controlling factor in determining service life. In the determination of
service life, the policy as to repairs, renewals, and maintenance has a very important bearing. In
fixing the scrap value, the relation of inadequacy, obsolescence, wear and tear, and age to the values
remaining in the asset must be considered.
1. Proportional Methods
Proportional methods include all those in which the periodic depreciation is calculated as a
proportional part of some fixed basic value. These may be grouped under the following subclass
titles, each of which will be separately considered:
(a) Straight Line
(b) Working Hours
(c) Composite Life
(d) Service Output
(a) Straight Line Method
The “Straight Line” method, so called because its graphical representation is a straight line, is
perhaps the simplest of all methods for calculating the periodic depreciation charge and is therefore
the most widely used. Under it the loss of value for each period is proportioned to the length of
service life. Thus, an asset whose service life is reckoned as 10 years will have depreciated one-tenth
by the end of the first year, two-tenths by the end of the second year, and so on. The depreciation for
each year is the same. Shown by formula, using the notation above, this will be:
(V - Vₙ) D
D₁ = or and, evidently,
n n
V₁ = V - D₁; V₂ = V₁ - D₂; etc.
From these formulas a schedule of appraisal for a given asset may be made up showing its values
as at the end of each year of its estimated life. For an asset costing $150, of which the service life is 5
periods and the scrap value, due to inadequacy, is $50, such an appraisal schedule would work out as
follows:
Page 150
Age in Periodic Depreciated or Total Accumulated
Periods Depreciation Appraised Value Depreciation
0 $..... $150.00 $.....
1 20.00 130.00 20.00
2 20.00 110.00 40.00
3 20.00 90.00 60.00
4 20.00 70.00 80.00
5 20.00 50.00 100.00
Here, the fixed depreciation base, i.e., the amount to be written off over the 5 periods, is $100
($150-$50). Graphically presented below, we have the straight line AB representing the periodic
appraised values, and the line OC, the accumulating depreciation.
Graphic Chart—Straight Line Method
(b) Working Hours Method
Where the “Working Hours” method is used, the life of the asset, instead of being estimated in
calendar units of time, is given in service units as so many working hours. Thus, if it is estimated that
a machine will stand 12,000 hours of operation, its service life is stated as 12,000 working hours.
Record is kept of the number of hours the machine is operated during each fiscal period and
compared with the estimated length of service life (also in working hours) to give the proportion of
the total depreciation which must be charged to a given period. Using the same example—an asset
costing $150, with scrap value of $50, and service life of 12,000 working hours—the appraisal
schedule will be as shown below, assuming that during the first fiscal period the asset was used 3,000
Periods Depreciation Appraised Value Depreciation
0 $..... $150.00 $.....
1 20.00 130.00 20.00
2 20.00 110.00 40.00
3 20.00 90.00 60.00
4 20.00 70.00 80.00
5 20.00 50.00 100.00
Here, the fixed depreciation base, i.e., the amount to be written off over the 5 periods, is $100
($150-$50). Graphically presented below, we have the straight line AB representing the periodic
appraised values, and the line OC, the accumulating depreciation.
Graphic Chart—Straight Line Method
(b) Working Hours Method
Where the “Working Hours” method is used, the life of the asset, instead of being estimated in
calendar units of time, is given in service units as so many working hours. Thus, if it is estimated that
a machine will stand 12,000 hours of operation, its service life is stated as 12,000 working hours.
Record is kept of the number of hours the machine is operated during each fiscal period and
compared with the estimated length of service life (also in working hours) to give the proportion of
the total depreciation which must be charged to a given period. Using the same example—an asset
costing $150, with scrap value of $50, and service life of 12,000 working hours—the appraisal
schedule will be as shown below, assuming that during the first fiscal period the asset was used 3,000
Page 151
hours, during the second 4,500 hours, the third 2,700, the fourth 1,200, and that it was scrapped some
time during the fifth fiscal period after another 600 hours of operation.
Age in Service Depreciated or Depreciation Total Accumulated
Periods Hours Appraised Value Rate % Depreciation
0 ..... ..... $150.00 $ ........
1 3,000 25 125.00 25.00
2 4,500 37½ 87.50 62.50
3 2,700 22½ 65.00 85.00
4 1,200 10 55.00 95.00
5 600 5 50.00 100.00
12,000 100
The following chart shows graphically the appraised values and the accumulated depreciation as
at the end of successive fiscal periods. The character of the curves here has no relation to the lapse of
calendar time, i.e., fiscal periods, but depends entirely on the degree of intensity of operation of the
asset, i.e., its service life in working hours. The above curves are true, therefore, only for the
particular data assumed and do not, in any way, indicate a characteristic tendency of this method.
Were the bottom line of the chart, the abscissa, laid off proportionately on the basis of working hours
instead of fiscal periods, both graphs would, of course, become straight lines. It is only because
information as to values is desired at the close of each fiscal period that the curves representing
values become broken lines.
Graphic Chart—Working Hours Method
time during the fifth fiscal period after another 600 hours of operation.
Age in Service Depreciated or Depreciation Total Accumulated
Periods Hours Appraised Value Rate % Depreciation
0 ..... ..... $150.00 $ ........
1 3,000 25 125.00 25.00
2 4,500 37½ 87.50 62.50
3 2,700 22½ 65.00 85.00
4 1,200 10 55.00 95.00
5 600 5 50.00 100.00
12,000 100
The following chart shows graphically the appraised values and the accumulated depreciation as
at the end of successive fiscal periods. The character of the curves here has no relation to the lapse of
calendar time, i.e., fiscal periods, but depends entirely on the degree of intensity of operation of the
asset, i.e., its service life in working hours. The above curves are true, therefore, only for the
particular data assumed and do not, in any way, indicate a characteristic tendency of this method.
Were the bottom line of the chart, the abscissa, laid off proportionately on the basis of working hours
instead of fiscal periods, both graphs would, of course, become straight lines. It is only because
information as to values is desired at the close of each fiscal period that the curves representing
values become broken lines.
Graphic Chart—Working Hours Method
Page 152
(c) Composite Life Method
Another proportional method, which in its operation is similar to the straight line method, is
known as the “Composite Life” method. Its feature is the calculation of depreciation on the plant as a
whole, rather than on each individual asset. Under it what is known as the mean life of the plant is
calculated. Depreciation may then be estimated, on the straight line or other basis, for the entire
plant. To determine mean life it is necessary to “weight” the life of each individual asset with its
value and so get a common basis, the dollar-year, for all assets. The process of calculating mean life
will be explained in Chapter XI where also its use and adaptability are discussed. Aside from the
determination of mean life, the method does not differ from others which have been or will be
discussed.
(d) Service Output Method
A fourth type of proportional method is known as the “Service Output” method. Under it, the life
of the asset is reckoned in terms of quantity of output. This is very similar to the working hours
method but differs in the unit of measurement for service life. The life of the asset is measured by its
product. Thus, the life of a water filter may be given in terms of gallons or cubic feet of water run
through it; that of a rock crusher in terms of the cubic feet of rock handled; that of a freight car or
engine in terms of car miles; and so on. If, therefore, record is kept of the performance of such an
asset for the fiscal period, the amount of depreciation to be charged off is readily calculated, being
such a portion of the total depreciation as the units of output for the current period bear to the total
units of life output. It is thus a straight proportional method. Its appraisal schedule and graphical
representation are exactly similar to those of the working hours method. It should be said, however,
that sometimes the service output method is operated on a sinking fund basis instead of on a total
depreciation basis. When the sinking fund basis is used, the total payments into the fund, excluding
all interest accretions, constitute the total amount of depreciation to be distributed over the service
output.
2. Variable Percentage Methods
The second main classification of methods, called for want of a better title, “Variable Percentage”
methods, differs from the proportional methods in that either the base or the percentage rate varies
for each estimate of depreciation. The various proportional methods can all be expressed as
percentages but their base remains fixed and is always the total amount of depreciation to be charged
off. Under the variable percentage methods, if the percentage is fixed, the base varies; and if the base
is fixed, the percentage varies. The subclasses here are:
(a) Fixed Percentage of Diminishing Value Method
(b) “Changing Percentage of Cost Less Scrap” Method (sometimes
known as the “Sum of Expected Life-Periods” Method)
(c) Arbitrary with Increasing Amounts
(d) Arbitrary with Decreasing Amounts
(a) Fixed Percentage of Diminishing Value Method
The “Fixed Percentage of Diminishing Value” method estimates the periodic depreciation as a
fixed percentage of the appraised or book value of the asset as at the time of the last appraisal. Thus,
if the asset cost $1,000 and the fixed rate is 10%, the first depreciation estimate is $100 (10% of
$1,000) giving an appraised value of $900; the second depreciation estimate is $90 (10% of $900),
Another proportional method, which in its operation is similar to the straight line method, is
known as the “Composite Life” method. Its feature is the calculation of depreciation on the plant as a
whole, rather than on each individual asset. Under it what is known as the mean life of the plant is
calculated. Depreciation may then be estimated, on the straight line or other basis, for the entire
plant. To determine mean life it is necessary to “weight” the life of each individual asset with its
value and so get a common basis, the dollar-year, for all assets. The process of calculating mean life
will be explained in Chapter XI where also its use and adaptability are discussed. Aside from the
determination of mean life, the method does not differ from others which have been or will be
discussed.
(d) Service Output Method
A fourth type of proportional method is known as the “Service Output” method. Under it, the life
of the asset is reckoned in terms of quantity of output. This is very similar to the working hours
method but differs in the unit of measurement for service life. The life of the asset is measured by its
product. Thus, the life of a water filter may be given in terms of gallons or cubic feet of water run
through it; that of a rock crusher in terms of the cubic feet of rock handled; that of a freight car or
engine in terms of car miles; and so on. If, therefore, record is kept of the performance of such an
asset for the fiscal period, the amount of depreciation to be charged off is readily calculated, being
such a portion of the total depreciation as the units of output for the current period bear to the total
units of life output. It is thus a straight proportional method. Its appraisal schedule and graphical
representation are exactly similar to those of the working hours method. It should be said, however,
that sometimes the service output method is operated on a sinking fund basis instead of on a total
depreciation basis. When the sinking fund basis is used, the total payments into the fund, excluding
all interest accretions, constitute the total amount of depreciation to be distributed over the service
output.
2. Variable Percentage Methods
The second main classification of methods, called for want of a better title, “Variable Percentage”
methods, differs from the proportional methods in that either the base or the percentage rate varies
for each estimate of depreciation. The various proportional methods can all be expressed as
percentages but their base remains fixed and is always the total amount of depreciation to be charged
off. Under the variable percentage methods, if the percentage is fixed, the base varies; and if the base
is fixed, the percentage varies. The subclasses here are:
(a) Fixed Percentage of Diminishing Value Method
(b) “Changing Percentage of Cost Less Scrap” Method (sometimes
known as the “Sum of Expected Life-Periods” Method)
(c) Arbitrary with Increasing Amounts
(d) Arbitrary with Decreasing Amounts
(a) Fixed Percentage of Diminishing Value Method
The “Fixed Percentage of Diminishing Value” method estimates the periodic depreciation as a
fixed percentage of the appraised or book value of the asset as at the time of the last appraisal. Thus,
if the asset cost $1,000 and the fixed rate is 10%, the first depreciation estimate is $100 (10% of
$1,000) giving an appraised value of $900; the second depreciation estimate is $90 (10% of $900),
Page 153
with a new appraised value of $810; the third estimate is $81 (10% of $810), with an appraisal of
$729 for the asset; and so on. It is evident that a final zero valuation can never be reached (although
it may be approximated) as the series becomes an indefinite or indeterminate series. If there is any
scrap value, and there usually is, the series becomes determinate. From the standpoint of calculation
the problem here is the determination of the fixed rate necessary to reduce the asset value to residual
or scrap value in the given life-term. Using the standard notation, we may formulate the following
equations:
V₁ = V(1 - d); V₂ = V₁(1 - d) = V(1 - d)(1 - d);
V₃ = V₂(1 - d) = V(1 - d)(1 - d)(1 - d); whence
Vₙ = V(1 - d)ⁿ, which solved for 1 - d gives
1 - d = ⁿ√Vₙ/V, and, solving for d, we get
(2) d = 1 - ⁿ√Vₙ/V,
While complex, the formula is readily solvable by means of logarithms. For an asset costing $150
with a service life of 5 years and a scrap value of $50, the rate is found by the above formula to be
approximately 19.726%.
d = 1 - ⁵√50/150, = .19726
The appraisal schedule is, therefore, as follows:
Fixed
Age in Periodic Depreciated or Total Accumulated
Depreciation
Periods Depreciation Appraised Value Depreciation
Rate %
0 ..... $ ..... $150.00 $ .....
1 19.726 29.59 120.41 29.59
2 19.726 23.75 96.66 53.34
3 19.726 19.07 77.59 72.41
4 19.726 15.32 62.27 87.73
5 19.726 12.27 50.00 100.00
100.00
The following chart shows graphically the appraised values and the accumulated depreciation:
$729 for the asset; and so on. It is evident that a final zero valuation can never be reached (although
it may be approximated) as the series becomes an indefinite or indeterminate series. If there is any
scrap value, and there usually is, the series becomes determinate. From the standpoint of calculation
the problem here is the determination of the fixed rate necessary to reduce the asset value to residual
or scrap value in the given life-term. Using the standard notation, we may formulate the following
equations:
V₁ = V(1 - d); V₂ = V₁(1 - d) = V(1 - d)(1 - d);
V₃ = V₂(1 - d) = V(1 - d)(1 - d)(1 - d); whence
Vₙ = V(1 - d)ⁿ, which solved for 1 - d gives
1 - d = ⁿ√Vₙ/V, and, solving for d, we get
(2) d = 1 - ⁿ√Vₙ/V,
While complex, the formula is readily solvable by means of logarithms. For an asset costing $150
with a service life of 5 years and a scrap value of $50, the rate is found by the above formula to be
approximately 19.726%.
d = 1 - ⁵√50/150, = .19726
The appraisal schedule is, therefore, as follows:
Fixed
Age in Periodic Depreciated or Total Accumulated
Depreciation
Periods Depreciation Appraised Value Depreciation
Rate %
0 ..... $ ..... $150.00 $ .....
1 19.726 29.59 120.41 29.59
2 19.726 23.75 96.66 53.34
3 19.726 19.07 77.59 72.41
4 19.726 15.32 62.27 87.73
5 19.726 12.27 50.00 100.00
100.00
The following chart shows graphically the appraised values and the accumulated depreciation:
Page 154
Graphic Chart—Fixed Percentage of
Diminishing Value Method
(b) Changing Percentage of Cost Less Scrap Method
Similar in effect to the method just explained is the “Changing Percentage of Cost Less Scrap” or
the “Sum of Expected Life-Periods” method. Here, the base remains fixed, but the periodic
depreciation rates change. Each depreciation rate is a fraction the common denominator of which is
the sum of the expected life-periods as viewed from the beginning of each successive period, and the
numerator of which is the expected life for the period in question. For example, an asset of which the
expected life is 5 periods has at the beginning of each successive period expected life-terms of 4, 3,
2, and 1 periods respectively, making a total of 15 which becomes the common denominator of the
fractions whose numerators are 5, 4, 3, 2, and 1 respectively; i.e., the changing depreciation rates are
⁵/₁₅, ⁴/₁₅, ³/₁₅, ²/₁₅, and ¹/₁₅. For an asset costing $150 with expected life of 5 periods and scrap
value of $50, the appraisal schedule would be as follows:
Changing
Age in Periodic Depreciated or Total Accumulated
Depreciation
Periods Depreciation Appraised Value Depreciation
Rate %
0 ..... $ ..... $150.00 $ .....
1 33⅓ 33.33 116.67 33.33
2 26⅔ 26.67 90.00 60.00
3 20 20.00 70.00 80.00
4 13⅓ 13.33 56.67 93.33
Diminishing Value Method
(b) Changing Percentage of Cost Less Scrap Method
Similar in effect to the method just explained is the “Changing Percentage of Cost Less Scrap” or
the “Sum of Expected Life-Periods” method. Here, the base remains fixed, but the periodic
depreciation rates change. Each depreciation rate is a fraction the common denominator of which is
the sum of the expected life-periods as viewed from the beginning of each successive period, and the
numerator of which is the expected life for the period in question. For example, an asset of which the
expected life is 5 periods has at the beginning of each successive period expected life-terms of 4, 3,
2, and 1 periods respectively, making a total of 15 which becomes the common denominator of the
fractions whose numerators are 5, 4, 3, 2, and 1 respectively; i.e., the changing depreciation rates are
⁵/₁₅, ⁴/₁₅, ³/₁₅, ²/₁₅, and ¹/₁₅. For an asset costing $150 with expected life of 5 periods and scrap
value of $50, the appraisal schedule would be as follows:
Changing
Age in Periodic Depreciated or Total Accumulated
Depreciation
Periods Depreciation Appraised Value Depreciation
Rate %
0 ..... $ ..... $150.00 $ .....
1 33⅓ 33.33 116.67 33.33
2 26⅔ 26.67 90.00 60.00
3 20 20.00 70.00 80.00
4 13⅓ 13.33 56.67 93.33
Page 155
Changing
Age in Periodic Depreciated or Total Accumulated
Depreciation
Periods Depreciation Appraised Value Depreciation
Rate %
5 6⅔ 6.67 50.00 100.00
A comparison of this appraisal schedule with that of the fixed percentage of diminishing value
method shows that this method charges more depreciation during the early life-periods and less
during the later periods. The general effect of this method and its significance are discussed in
Chapter X where the relative merits of the various methods are considered. The graph for the sum of
expected life-periods method is not shown as it differs little from that of the fixed percentage of
diminishing value method on page 158.
(c, d) Arbitrary Methods
The two other arbitrary types of this variable percentage method are hardly to be classed as
methods as they do not rest on any law according to which they may be operated. Under them
arbitrary amounts are charged to depreciation each period, the only controlling principle being that in
the one case these periodic amounts increase from period to period, while in the other case they
decrease. In the one case, therefore, the appraisal schedule would be similar as to its “Periodic
Depreciation” column to those of the two methods just explained, excepting that the column must be
reversed, i.e., read from the bottom upward. In the other case, the appraisal schedule would be
exactly similar to those just shown. Within the restriction that they must be increasing or decreasing
amounts for succeeding periods and that the total depreciation must be charged off within the
estimated life-period of the asset, the periodic depreciation charges are, under these methods, purely
arbitrary, neither based on fact nor logic.
3. Compound Interest Methods
The third general type of methods for making the depreciation estimate may be called the
“Compound Interest” type. This differs radically from any of the others in that it uses the compound
interest principle to determine the amount of periodic depreciation. In the practical application of
some of these methods, not only is depreciation estimated on this basis but an actual fund of cash or
other assets is set aside for accumulation on the compound interest principle so as to provide ready
funds for financing the replacement when the old asset is discarded. The setting aside of the fund is
not an essential part of the method, and its discussion is therefore deferred to Chapter XXV where
the subject of funds and their treatment is fully considered. Under this type there are three methods:
(a) Sinking Fund
(b) Annuity
(c) Unit Cost
(a) Sinking Fund Method
The problem under the “Sinking Fund” method is the calculation of the amount of a sum of
money which placed at compound interest at the end of successive periods will accumulate to the
amount of the total depreciation of the asset during its life-term. At the end of each period, this
amount plus any accumulated interest on the amounts previously set aside becomes the depreciation
Age in Periodic Depreciated or Total Accumulated
Depreciation
Periods Depreciation Appraised Value Depreciation
Rate %
5 6⅔ 6.67 50.00 100.00
A comparison of this appraisal schedule with that of the fixed percentage of diminishing value
method shows that this method charges more depreciation during the early life-periods and less
during the later periods. The general effect of this method and its significance are discussed in
Chapter X where the relative merits of the various methods are considered. The graph for the sum of
expected life-periods method is not shown as it differs little from that of the fixed percentage of
diminishing value method on page 158.
(c, d) Arbitrary Methods
The two other arbitrary types of this variable percentage method are hardly to be classed as
methods as they do not rest on any law according to which they may be operated. Under them
arbitrary amounts are charged to depreciation each period, the only controlling principle being that in
the one case these periodic amounts increase from period to period, while in the other case they
decrease. In the one case, therefore, the appraisal schedule would be similar as to its “Periodic
Depreciation” column to those of the two methods just explained, excepting that the column must be
reversed, i.e., read from the bottom upward. In the other case, the appraisal schedule would be
exactly similar to those just shown. Within the restriction that they must be increasing or decreasing
amounts for succeeding periods and that the total depreciation must be charged off within the
estimated life-period of the asset, the periodic depreciation charges are, under these methods, purely
arbitrary, neither based on fact nor logic.
3. Compound Interest Methods
The third general type of methods for making the depreciation estimate may be called the
“Compound Interest” type. This differs radically from any of the others in that it uses the compound
interest principle to determine the amount of periodic depreciation. In the practical application of
some of these methods, not only is depreciation estimated on this basis but an actual fund of cash or
other assets is set aside for accumulation on the compound interest principle so as to provide ready
funds for financing the replacement when the old asset is discarded. The setting aside of the fund is
not an essential part of the method, and its discussion is therefore deferred to Chapter XXV where
the subject of funds and their treatment is fully considered. Under this type there are three methods:
(a) Sinking Fund
(b) Annuity
(c) Unit Cost
(a) Sinking Fund Method
The problem under the “Sinking Fund” method is the calculation of the amount of a sum of
money which placed at compound interest at the end of successive periods will accumulate to the
amount of the total depreciation of the asset during its life-term. At the end of each period, this
amount plus any accumulated interest on the amounts previously set aside becomes the depreciation
Page 156
estimate for this period. Unless a fund is actually established, there can, of course, be no
accumulation of interest. Under this method the amount of such theoretically accumulated interest is,
nevertheless, made a part of the periodic depreciation charge.
The method thus becomes simply a mathematical device for making the estimate. The calculation
of the fixed periodic amount is in accordance with the following mathematical formula, using the
notation given on page 151. The development of this formula is given in full in Chapter XXV, “The
Sinking Fund”:
(V - Vₙ)r Dr
(3) A= =
Rⁿ - 1 Rⁿ - 1
For the asset used in the other illustrations, i.e., for an asset with a full valuation at the beginning
of its life of $150 and a residual value of $50 after a service life of five years, this periodic amount is
$18.10, if interest is reckoned at 5%. Any other rate of interest within reason would, of course, be
equally appropriate.
The following appraisal schedule may be set up:
Periodic Depreciation Composed of:
Age in Depreciated or Total Accumulated
Periodic
Periods Interest Total Appraised Value Depreciation
Amount
0 $ ..... $ ..... $ ..... $150.00 $ .....
1 18.10 ..... 18.10 131.90 18.10
2 18.10 .90 19.00 112.90 37.10
3 18.10 1.85 19.95 92.95 57.05
4 18.10 2.85 20.95 72.00 78.00
5 18.10 3.90 22.00 50.00 100.00
$100.00
The following chart shows graphically the appraised values, the accumulating depreciation and
the elements which compose it, the curve OD representing the fixed periodic amounts, and EF the
theoretical interest accumulations. The curve OD is a straight line inasmuch as it represents fixed
periodic amounts. The depreciation and interest curves, OC and EF, representing gradually
increasing amounts, are both slightly concave and would become increasingly so the longer the
period covered. The appraisal curve AB is slightly convex and its convexity is accelerated by lapse of
time.
accumulation of interest. Under this method the amount of such theoretically accumulated interest is,
nevertheless, made a part of the periodic depreciation charge.
The method thus becomes simply a mathematical device for making the estimate. The calculation
of the fixed periodic amount is in accordance with the following mathematical formula, using the
notation given on page 151. The development of this formula is given in full in Chapter XXV, “The
Sinking Fund”:
(V - Vₙ)r Dr
(3) A= =
Rⁿ - 1 Rⁿ - 1
For the asset used in the other illustrations, i.e., for an asset with a full valuation at the beginning
of its life of $150 and a residual value of $50 after a service life of five years, this periodic amount is
$18.10, if interest is reckoned at 5%. Any other rate of interest within reason would, of course, be
equally appropriate.
The following appraisal schedule may be set up:
Periodic Depreciation Composed of:
Age in Depreciated or Total Accumulated
Periodic
Periods Interest Total Appraised Value Depreciation
Amount
0 $ ..... $ ..... $ ..... $150.00 $ .....
1 18.10 ..... 18.10 131.90 18.10
2 18.10 .90 19.00 112.90 37.10
3 18.10 1.85 19.95 92.95 57.05
4 18.10 2.85 20.95 72.00 78.00
5 18.10 3.90 22.00 50.00 100.00
$100.00
The following chart shows graphically the appraised values, the accumulating depreciation and
the elements which compose it, the curve OD representing the fixed periodic amounts, and EF the
theoretical interest accumulations. The curve OD is a straight line inasmuch as it represents fixed
periodic amounts. The depreciation and interest curves, OC and EF, representing gradually
increasing amounts, are both slightly concave and would become increasingly so the longer the
period covered. The appraisal curve AB is slightly convex and its convexity is accelerated by lapse of
time.
Page 157
Graphic Chart—Sinking Fund Method
(b) Annuity Method
The “Annuity” method also makes use of the compound interest principle, but in addition to the
method of the sinking fund it adds to the periodic depreciation charge as determined thereunder
interest on the successive appraised values of the asset. The effect of this is to charge to the product,
by way of Profit and Loss, interest on the capital invested in each asset used in manufacture. The
appraised values of the asset are exactly the same as under the sinking fund method, but the expense
charge to depreciation is larger under the annuity method by the interest on the appraised value of the
asset. This charging of interest to the product under the title “depreciation” makes it necessary to
capitalize the interest charge by adding it to the value of the asset. If the amount to be charged off,
i.e., V-Vₙ is the same under both methods, for both to arrive at the same scrap value, Vₙ, the interest
under the annuity method must be added to the value of the asset each time before deducting the
depreciation charge, a part of which is this same interest. The annuity method thus makes a larger
periodic charge than the sinking fund method.
The problem involved in the calculation of the periodic depreciation charge by the annuity
method is sometimes stated as the method of finding a fixed or constantly equal periodic charge
sufficient to charge off not only depreciation as such but also the interest which has been added to the
value of the asset. The mathematical formula may be derived as follows, using the standard notation:
VR = V(1 + r), or the asset with interest added to it
VR - D₁ = V₁, appraised value at end of first period
V₁R - D₁[31] = VR² - D₁R - D₁ = V₂,
(b) Annuity Method
The “Annuity” method also makes use of the compound interest principle, but in addition to the
method of the sinking fund it adds to the periodic depreciation charge as determined thereunder
interest on the successive appraised values of the asset. The effect of this is to charge to the product,
by way of Profit and Loss, interest on the capital invested in each asset used in manufacture. The
appraised values of the asset are exactly the same as under the sinking fund method, but the expense
charge to depreciation is larger under the annuity method by the interest on the appraised value of the
asset. This charging of interest to the product under the title “depreciation” makes it necessary to
capitalize the interest charge by adding it to the value of the asset. If the amount to be charged off,
i.e., V-Vₙ is the same under both methods, for both to arrive at the same scrap value, Vₙ, the interest
under the annuity method must be added to the value of the asset each time before deducting the
depreciation charge, a part of which is this same interest. The annuity method thus makes a larger
periodic charge than the sinking fund method.
The problem involved in the calculation of the periodic depreciation charge by the annuity
method is sometimes stated as the method of finding a fixed or constantly equal periodic charge
sufficient to charge off not only depreciation as such but also the interest which has been added to the
value of the asset. The mathematical formula may be derived as follows, using the standard notation:
VR = V(1 + r), or the asset with interest added to it
VR - D₁ = V₁, appraised value at end of first period
V₁R - D₁[31] = VR² - D₁R - D₁ = V₂,
Page 158
appraised value at end of second period
V₂R - D₁[32] = VR³ - D₁R² - D₁R - D₁ = VR³ - D₁(R² + R + 1)
= V₃, appraised value at end of third period, etc.
Generalizing, we have:
Vₙ₋₁R - D₁ = VRⁿ - D₁(Rⁿ⁻¹ + Rⁿ⁻² ... + R² + R + 1) = Vₙ,
scrap value. Whence
Rⁿ - 1
VRⁿ - Vₙ = D₁
R-1
Solving for D₁; we have:
(VRⁿ - Vₙ)(R - 1) (VRⁿ - Vₙ)r
(4) D₁ = =
Rⁿ - 1 Rⁿ - 1
= periodic depreciation charge
That this is the same as the amount of the periodic depreciation charge by the sinking fund
method plus interest on the investment, is seen by comparing formula (4) with formula (3). Formula
(4) may be written as
(VRⁿ - Vₙ)r + Vr - Vr
Rⁿ - 1
i.e., the quantity Vr-Vr = 0 is put into the numerator. Adding zero (Vr - Vr = 0) cannot change its
value. Performing the multiplication indicated by the parentheses, we have
VRⁿr - Vₙr + Vr - Vr
Rⁿ - 1
Rearranging the terms, we have
(Vr - Vₙr) + (VRⁿr - Vr)
Rⁿ - 1
which factored in each group becomes
(V - Vₙ)r Vr(Rⁿ - 1)
+
Rⁿ - 1 Rⁿ - 1
By reducing the second fraction, this may be written as:
(V - Vₙ)r
(5) + Vr
Rⁿ - 1
V₂R - D₁[32] = VR³ - D₁R² - D₁R - D₁ = VR³ - D₁(R² + R + 1)
= V₃, appraised value at end of third period, etc.
Generalizing, we have:
Vₙ₋₁R - D₁ = VRⁿ - D₁(Rⁿ⁻¹ + Rⁿ⁻² ... + R² + R + 1) = Vₙ,
scrap value. Whence
Rⁿ - 1
VRⁿ - Vₙ = D₁
R-1
Solving for D₁; we have:
(VRⁿ - Vₙ)(R - 1) (VRⁿ - Vₙ)r
(4) D₁ = =
Rⁿ - 1 Rⁿ - 1
= periodic depreciation charge
That this is the same as the amount of the periodic depreciation charge by the sinking fund
method plus interest on the investment, is seen by comparing formula (4) with formula (3). Formula
(4) may be written as
(VRⁿ - Vₙ)r + Vr - Vr
Rⁿ - 1
i.e., the quantity Vr-Vr = 0 is put into the numerator. Adding zero (Vr - Vr = 0) cannot change its
value. Performing the multiplication indicated by the parentheses, we have
VRⁿr - Vₙr + Vr - Vr
Rⁿ - 1
Rearranging the terms, we have
(Vr - Vₙr) + (VRⁿr - Vr)
Rⁿ - 1
which factored in each group becomes
(V - Vₙ)r Vr(Rⁿ - 1)
+
Rⁿ - 1 Rⁿ - 1
By reducing the second fraction, this may be written as:
(V - Vₙ)r
(5) + Vr
Rⁿ - 1
Page 159
which is seen to be identical with formula (3) for the sinking fund except for the addition of Vr,
which represents interest at r% on the investment V. The identity of the annuity formula (4) with the
sinking fund formula (3) plus interest on investment can be established similarly for any of the
periods.
It will be noted that by the annuity method the whole original value of the investment is always
earning interest either in the sinking fund or in the diminishing appraised value. Thus, the portion of
original value deducted each period earns interest in the sinking fund, while what is left as appraised
value earns interest outside the fund. Thus, the annuity method of charging depreciation may be said
to consist of two parts, viz., the fixed periodic amount and interest on the original investment. This
will be seen from the appraisal schedule which follows. The same illustrative data are used as before,
including interest at 5%.
Periodic Depreciation Charge
Composed of:
Age in Interest on Interest
Fixed Total
Periods Fixed on
Amount Charge
Amount Investment
(a) (b) (c) (d)
0 $ ..... $ ..... $ ..... $ .....
1 18.10 ..... 7.50 25.60
2 18.10 .90 6.60 25.60
3 18.10 1.85 5.65 25.60
4 18.10 2.85 4.65 25.60
5 18.10 3.90 3.60 25.60
$90.50 $9.50 $28.00 $128.00
Appraised
Depreciated Accumulated Depreciation
Value
Age in or Appraised Including True
Plus
Periods Value Interest Depreciation
Interest
(e) (f) (g) (h)
0 $ ..... $150.00 $ ..... $ .....
1 157.50 131.90 25.60 18.10
2 138.50 112.90 51.20 37.10
3 118.55 92.95 76.80 57.05
4 97.60 72.00 102.40 78.00
5 75.60 50.00 128.00 100.00
which represents interest at r% on the investment V. The identity of the annuity formula (4) with the
sinking fund formula (3) plus interest on investment can be established similarly for any of the
periods.
It will be noted that by the annuity method the whole original value of the investment is always
earning interest either in the sinking fund or in the diminishing appraised value. Thus, the portion of
original value deducted each period earns interest in the sinking fund, while what is left as appraised
value earns interest outside the fund. Thus, the annuity method of charging depreciation may be said
to consist of two parts, viz., the fixed periodic amount and interest on the original investment. This
will be seen from the appraisal schedule which follows. The same illustrative data are used as before,
including interest at 5%.
Periodic Depreciation Charge
Composed of:
Age in Interest on Interest
Fixed Total
Periods Fixed on
Amount Charge
Amount Investment
(a) (b) (c) (d)
0 $ ..... $ ..... $ ..... $ .....
1 18.10 ..... 7.50 25.60
2 18.10 .90 6.60 25.60
3 18.10 1.85 5.65 25.60
4 18.10 2.85 4.65 25.60
5 18.10 3.90 3.60 25.60
$90.50 $9.50 $28.00 $128.00
Appraised
Depreciated Accumulated Depreciation
Value
Age in or Appraised Including True
Plus
Periods Value Interest Depreciation
Interest
(e) (f) (g) (h)
0 $ ..... $150.00 $ ..... $ .....
1 157.50 131.90 25.60 18.10
2 138.50 112.90 51.20 37.10
3 118.55 92.95 76.80 57.05
4 97.60 72.00 102.40 78.00
5 75.60 50.00 128.00 100.00
Page 160
It will be noted, as stated above, that the sum of the two interest items in columns (b) and (c) is
the same for each period, viz., $7.50, interest on the original investment. The total of column (d),
total charge for periodic depreciation, minus the total of column (c), interest on the diminishing
appraised values, gives $100, the true depreciation as shown by column (h). True depreciation under
the annuity method is the same as under the sinking fund method. The periodic depreciation charge
differs, however.
A graphical illustration of the main items of the appraisal schedule is shown below:
Graphic Chart—Annuity Method
In the above chart the points A¹, A², etc., represent the appraised values plus interest, the
segments, A¹I¹, A²I², etc., representing interest on each period’s investment. It is to write down these
increases in value that the additional $28 of periodic depreciation charges is needed. The curve OC is
a straight line since each period’s depreciation charge is the same. Curves AB and OD are identical
with those of the sinking fund method. Curve OE represents the accumulating interest on investment
as shown by the segments A¹I¹, A²I², etc. Curve OC is the sum or resultant of curves OD and OE.
The annuity method is termed the “Equal Annual Payment” method in a preliminary report of the
Valuation Committee of the American Society of Civil Engineers. As here illustrated it does bring
about an equal periodic charge but only because the assumed rate of interest for the sinking fund
accumulations is taken also as the rate for interest on the investment. If these two rates differ, the
periodic charges will also differ. For example, if the sinking fund rate is taken as 5% and the rate
applicable to the appraised values is 8%, the sum of these two interest amounts will not be constant
because the bases on which they are calculated are changing each period. Because of this fact the
Committee above referred to called this the “Compound Interest” method in its final report. To
distinguish this from the sinking fund method which also uses the compound interest principle, the
title here adopted, i.e., the “Annuity” method seems to accomplish that purpose.
the same for each period, viz., $7.50, interest on the original investment. The total of column (d),
total charge for periodic depreciation, minus the total of column (c), interest on the diminishing
appraised values, gives $100, the true depreciation as shown by column (h). True depreciation under
the annuity method is the same as under the sinking fund method. The periodic depreciation charge
differs, however.
A graphical illustration of the main items of the appraisal schedule is shown below:
Graphic Chart—Annuity Method
In the above chart the points A¹, A², etc., represent the appraised values plus interest, the
segments, A¹I¹, A²I², etc., representing interest on each period’s investment. It is to write down these
increases in value that the additional $28 of periodic depreciation charges is needed. The curve OC is
a straight line since each period’s depreciation charge is the same. Curves AB and OD are identical
with those of the sinking fund method. Curve OE represents the accumulating interest on investment
as shown by the segments A¹I¹, A²I², etc. Curve OC is the sum or resultant of curves OD and OE.
The annuity method is termed the “Equal Annual Payment” method in a preliminary report of the
Valuation Committee of the American Society of Civil Engineers. As here illustrated it does bring
about an equal periodic charge but only because the assumed rate of interest for the sinking fund
accumulations is taken also as the rate for interest on the investment. If these two rates differ, the
periodic charges will also differ. For example, if the sinking fund rate is taken as 5% and the rate
applicable to the appraised values is 8%, the sum of these two interest amounts will not be constant
because the bases on which they are calculated are changing each period. Because of this fact the
Committee above referred to called this the “Compound Interest” method in its final report. To
distinguish this from the sinking fund method which also uses the compound interest principle, the
title here adopted, i.e., the “Annuity” method seems to accomplish that purpose.
Page 161
(c) Unit Cost Method
A third method which uses the compound interest principle is called the “Unit Cost” method.
Because of the involved mathematical processes required for the calculation of the amount of its
periodic charge, and the doubtful practical value of the method, only a description of its main
features will be given here.[33] The aim of this method is to equalize over each unit of product three
costs, viz.: the cost of interest on investment, the cost of operation and repairs, and the true
depreciation cost, all of these to be included in a periodic charge under the title of “depreciation.”
The calculation of the true depreciation cost by the sinking fund principle is the reason for
including this method in the compound interest type. The problem to be solved is the determination
of the price to be paid for an asset at a given time so that the cost of each unit of product turned out
during its remaining service life shall be the same as the cost of each unit of product turned out
during the spent portion of its service life. The difference between the original cost of the asset and
the price determined as above will be the depreciation of the asset for the elapsed period. A symbolic
showing of the problem will make the matter clear. The following notation will be used:
V = original cost of the asset installed ready for use
V₁ = price that could be paid for it at the end of the
period as above explained
O = estimated average operating costs per period,
including repairs, for V
o = estimated average operating costs per period,
including repairs, for V₁
[34]
D = true depreciation rate or multiplier under
the sinking fund method, for V
[35]
d = true depreciation rate or multiplier under
the sinking fund method, for V₁
U = units of output for V during one period
u = units of output for V₁ during one period
r = rate of interest on the investment
Then:
O + DV + Vr
= the cost per unit of output for V,
U
o + dV₁ + V₁r
= the cost per unit of output for V₁.
u
Since, by hypothesis, these two costs are to be equal, we may form the equation
O + DV + Vr o + dV₁ + V₁r
=
U u
A third method which uses the compound interest principle is called the “Unit Cost” method.
Because of the involved mathematical processes required for the calculation of the amount of its
periodic charge, and the doubtful practical value of the method, only a description of its main
features will be given here.[33] The aim of this method is to equalize over each unit of product three
costs, viz.: the cost of interest on investment, the cost of operation and repairs, and the true
depreciation cost, all of these to be included in a periodic charge under the title of “depreciation.”
The calculation of the true depreciation cost by the sinking fund principle is the reason for
including this method in the compound interest type. The problem to be solved is the determination
of the price to be paid for an asset at a given time so that the cost of each unit of product turned out
during its remaining service life shall be the same as the cost of each unit of product turned out
during the spent portion of its service life. The difference between the original cost of the asset and
the price determined as above will be the depreciation of the asset for the elapsed period. A symbolic
showing of the problem will make the matter clear. The following notation will be used:
V = original cost of the asset installed ready for use
V₁ = price that could be paid for it at the end of the
period as above explained
O = estimated average operating costs per period,
including repairs, for V
o = estimated average operating costs per period,
including repairs, for V₁
[34]
D = true depreciation rate or multiplier under
the sinking fund method, for V
[35]
d = true depreciation rate or multiplier under
the sinking fund method, for V₁
U = units of output for V during one period
u = units of output for V₁ during one period
r = rate of interest on the investment
Then:
O + DV + Vr
= the cost per unit of output for V,
U
o + dV₁ + V₁r
= the cost per unit of output for V₁.
u
Since, by hypothesis, these two costs are to be equal, we may form the equation
O + DV + Vr o + dV₁ + V₁r
=
U u
Page 162
which solved for V₁, the price to be paid, gives
u
U
(O + DV + Vr) - o
V₁ =
d+r
Evidently, V-V₁ is the amount of the depreciation charge. The values for D and d, as indicated in the
footnote, may be substituted and the amount of V₁ determined. The process is somewhat complicated
in its practical application and will not be carried further here.
4. Miscellaneous Methods
Other methods of calculating the depreciation charge are used, but they cannot be classified
under any of the three groups discussed so far. They are a miscellaneous, mongrel breed, scarcely to
be dignified in some instances as methods. Among these may be mentioned the following:
(a) Maintenance Method
(b) Replacement Method
(c) Fifty Per Cent Method
(d) Appraisal Method
(e) Insurance Method
(f) Gross Earnings Method
(a) Maintenance Method
In this case a periodic charge for depreciation is made, equal in amount to the cost of
maintenance of the asset for the period. It is thus a definite but variable amount, depending upon the
maintenance policy.
(b) Replacement Method
This is hardly a method of calculating the depreciation charge, but rather of recognizing the fact
of depreciation by charging all renewals and replacements to revenue. It is argued that in a large,
widely extended plant after depreciation has reached the point where renewals are necessary, the
charging of all renewals and replacements as expenses will take care of all accruing depreciation and
secure a fairly uniform charge to product from period to period. Under this plan depreciation as such
does not appear on the books but is taken care of under other titles.
(c) The Fifty Per Cent Method
This is somewhat similar to the replacement method in that it is applicable only after depreciation
has reached the renewals stage. It is claimed for it that, in a property or class of asset consisting of
many similar parts, as railroad ties, for example, after the stage of normal repairs has been reached so
that the parts are in all degrees of repair from 0% to 100%, the normal maintenance and renewals
policy will maintain the property or asset always in about 50% condition. Therefore the total
depreciation for the asset or class is the other 50%, which never reaches a larger amount because of a
constant renewal of parts. This 50% depreciation may or may not be carried on the books but it exists
nevertheless. For the conditions under which it is applicable as above, the law of averages doubtless
applies and makes the estimate a fairly good one.
u
U
(O + DV + Vr) - o
V₁ =
d+r
Evidently, V-V₁ is the amount of the depreciation charge. The values for D and d, as indicated in the
footnote, may be substituted and the amount of V₁ determined. The process is somewhat complicated
in its practical application and will not be carried further here.
4. Miscellaneous Methods
Other methods of calculating the depreciation charge are used, but they cannot be classified
under any of the three groups discussed so far. They are a miscellaneous, mongrel breed, scarcely to
be dignified in some instances as methods. Among these may be mentioned the following:
(a) Maintenance Method
(b) Replacement Method
(c) Fifty Per Cent Method
(d) Appraisal Method
(e) Insurance Method
(f) Gross Earnings Method
(a) Maintenance Method
In this case a periodic charge for depreciation is made, equal in amount to the cost of
maintenance of the asset for the period. It is thus a definite but variable amount, depending upon the
maintenance policy.
(b) Replacement Method
This is hardly a method of calculating the depreciation charge, but rather of recognizing the fact
of depreciation by charging all renewals and replacements to revenue. It is argued that in a large,
widely extended plant after depreciation has reached the point where renewals are necessary, the
charging of all renewals and replacements as expenses will take care of all accruing depreciation and
secure a fairly uniform charge to product from period to period. Under this plan depreciation as such
does not appear on the books but is taken care of under other titles.
(c) The Fifty Per Cent Method
This is somewhat similar to the replacement method in that it is applicable only after depreciation
has reached the renewals stage. It is claimed for it that, in a property or class of asset consisting of
many similar parts, as railroad ties, for example, after the stage of normal repairs has been reached so
that the parts are in all degrees of repair from 0% to 100%, the normal maintenance and renewals
policy will maintain the property or asset always in about 50% condition. Therefore the total
depreciation for the asset or class is the other 50%, which never reaches a larger amount because of a
constant renewal of parts. This 50% depreciation may or may not be carried on the books but it exists
nevertheless. For the conditions under which it is applicable as above, the law of averages doubtless
applies and makes the estimate a fairly good one.
Page 163
(d) Appraisal Method
Here a physical appraisal of the asset or property is taken at the close of every fiscal period. The
difference in value between the two appraisals for successive fiscal periods represents the
depreciation for the period and would be brought on the books as such.
(e) Insurance Method
This is applicable only to large properties with assets widely distributed. Its operation “involves
the actuarial principles of ordinary insurance. This means that the fund accumulated by depreciation
charges should not be reserved as an accumulation until it can be spent for the purpose of replacing
the identical property upon which the fund accumulated when such property is abandoned; and
furthermore, that this fund should be expended, in whole or in part, during the year in which it is
created, in the replacement of equipment.”
(f) Gross Earnings Method
Here the depreciation estimate is based on the gross earnings for the period. This does not
necessarily mean that the depreciation estimate will be large when profits are large, and small or
nothing when profits are small, although it may be made to apply in that way in individual cases. The
policy of making ample reserves for depreciation in good years and scant reserves in poor years is
not to be wholly condemned. Depreciation, however, has no relation to, or dependence upon, profits.
Rather, profits depend on depreciation in the sense that they cannot exist until after charges for
depreciation have been taken care of. Depreciation considered as a fixed per cent of gross earnings is
almost the same in effect as the service output method, and has much to commend it.
Condition Per Cent
Before leaving the topic of method, it may be well to explain a term used in connection with the
depreciation estimate, viz., condition per cent. The condition per cent of an asset is found by
subtracting from 100%, the fraction which represents the ratio of the present accumulated
depreciation to the total estimated depreciation. Thus, if an asset has depreciated in value one-
quarter, its condition per cent is said to be 75 (100%-25%). Hence, condition per cent is easily
calculated if depreciation has been estimated by any of the proportional methods. If, in addition to
the standard notation used, we assume that:
Dₘ = total amount of depreciation for m periods
Vₘ = value of the asset at end of m’th period
then, in general, condition per cent may be expressed by the formula:
Dₘ
100% -
D
Evidently, therefore,
Dₘ
Vₘ = V 100% -
D
Under the proportional methods Dₘ/D = nd. Therefore, condition per cent is 100%-nd.
Here a physical appraisal of the asset or property is taken at the close of every fiscal period. The
difference in value between the two appraisals for successive fiscal periods represents the
depreciation for the period and would be brought on the books as such.
(e) Insurance Method
This is applicable only to large properties with assets widely distributed. Its operation “involves
the actuarial principles of ordinary insurance. This means that the fund accumulated by depreciation
charges should not be reserved as an accumulation until it can be spent for the purpose of replacing
the identical property upon which the fund accumulated when such property is abandoned; and
furthermore, that this fund should be expended, in whole or in part, during the year in which it is
created, in the replacement of equipment.”
(f) Gross Earnings Method
Here the depreciation estimate is based on the gross earnings for the period. This does not
necessarily mean that the depreciation estimate will be large when profits are large, and small or
nothing when profits are small, although it may be made to apply in that way in individual cases. The
policy of making ample reserves for depreciation in good years and scant reserves in poor years is
not to be wholly condemned. Depreciation, however, has no relation to, or dependence upon, profits.
Rather, profits depend on depreciation in the sense that they cannot exist until after charges for
depreciation have been taken care of. Depreciation considered as a fixed per cent of gross earnings is
almost the same in effect as the service output method, and has much to commend it.
Condition Per Cent
Before leaving the topic of method, it may be well to explain a term used in connection with the
depreciation estimate, viz., condition per cent. The condition per cent of an asset is found by
subtracting from 100%, the fraction which represents the ratio of the present accumulated
depreciation to the total estimated depreciation. Thus, if an asset has depreciated in value one-
quarter, its condition per cent is said to be 75 (100%-25%). Hence, condition per cent is easily
calculated if depreciation has been estimated by any of the proportional methods. If, in addition to
the standard notation used, we assume that:
Dₘ = total amount of depreciation for m periods
Vₘ = value of the asset at end of m’th period
then, in general, condition per cent may be expressed by the formula:
Dₘ
100% -
D
Evidently, therefore,
Dₘ
Vₘ = V 100% -
D
Under the proportional methods Dₘ/D = nd. Therefore, condition per cent is 100%-nd.
Page 164
Under the sinking fund method, the calculation is more complex. Dₘ, the total amount of
depreciation accumulated to date, i.e., after m periods, is the amount of the annuity A for m periods.
From formula (3), Chapter XV, page 272, the amount of an annuity A is seen to be
A(Rⁿ - 1)
r
Therefore,
A(Rᵐ - 1)
Therefore, Dₘ =
r
A(Rⁿ - 1)
and, D=
r
from which the ratio
A(Rᵐ - 1)
Dₘ r Rᵐ - 1
= =
D A(Rⁿ - 1) Rⁿ - 1
r
Accordingly, condition per cent under the sinking fund method is:
Rᵐ - 1
100% -
Rⁿ - 1
depreciation accumulated to date, i.e., after m periods, is the amount of the annuity A for m periods.
From formula (3), Chapter XV, page 272, the amount of an annuity A is seen to be
A(Rⁿ - 1)
r
Therefore,
A(Rᵐ - 1)
Therefore, Dₘ =
r
A(Rⁿ - 1)
and, D=
r
from which the ratio
A(Rᵐ - 1)
Dₘ r Rᵐ - 1
= =
D A(Rⁿ - 1) Rⁿ - 1
r
Accordingly, condition per cent under the sinking fund method is:
Rᵐ - 1
100% -
Rⁿ - 1
Page 165
CHAPTER X
DEPRECIATION—APPRAISEMENT
OF THE VARIOUS METHODS
General Considerations
No method of estimating depreciation will ever be devised which will
be applicable under all conditions and to all kinds of property. Such a
panacea for the ills of wasting assets can obviously never be found, for the
very good reason that the same medicine will not suit all patients. What
gives good results in one case may not be applicable or not equally so, in
another case. In discussing the relative merits of the various methods,
therefore, no dogmatic rules for their use can be laid down; furthermore,
without a detailed knowledge of operating conditions, only their main
points of strength and weakness can be pointed out, and this is all that will
be attempted here.
In a critical discussion of methods and their effects, the fact of
depreciation may be considered from either the viewpoint of time or
service. Depreciation when viewed from the aspect of time may be said to
be due to:
1. Decrepitude, which is merely the lapse of time.
2. Inadequacy, which is lack of capacity to do the
work which increasing markets demand (a
condition the essence of which is also time).
3. Obsolescence, which represents the inability to
perform efficiently as compared with the service
secured from more modern equipment, and which
may be a condition brought about by lapse of time
and the developments of an art or science.
When viewed from the aspect of service, depreciation may be due
primarily to wear and tear, which is a condition directly dependent upon the
DEPRECIATION—APPRAISEMENT
OF THE VARIOUS METHODS
General Considerations
No method of estimating depreciation will ever be devised which will
be applicable under all conditions and to all kinds of property. Such a
panacea for the ills of wasting assets can obviously never be found, for the
very good reason that the same medicine will not suit all patients. What
gives good results in one case may not be applicable or not equally so, in
another case. In discussing the relative merits of the various methods,
therefore, no dogmatic rules for their use can be laid down; furthermore,
without a detailed knowledge of operating conditions, only their main
points of strength and weakness can be pointed out, and this is all that will
be attempted here.
In a critical discussion of methods and their effects, the fact of
depreciation may be considered from either the viewpoint of time or
service. Depreciation when viewed from the aspect of time may be said to
be due to:
1. Decrepitude, which is merely the lapse of time.
2. Inadequacy, which is lack of capacity to do the
work which increasing markets demand (a
condition the essence of which is also time).
3. Obsolescence, which represents the inability to
perform efficiently as compared with the service
secured from more modern equipment, and which
may be a condition brought about by lapse of time
and the developments of an art or science.
When viewed from the aspect of service, depreciation may be due
primarily to wear and tear, which is a condition directly dependent upon the
Page 166
service rendered.
It has been pointed out that these elements of depreciation, viz., wear
and tear, inadequacy, obsolescence, etc., are single and isolated in their
action and not cumulative. One of them, therefore, is the controlling
element in any estimate of depreciation. Accordingly, in judging the merits
of a method the kind of depreciation must be taken into account; i.e.,
depreciation must be viewed from a time and service standpoint.
Ideal Basis for Distribution of Depreciation Charge
Regardless of the actual progress of depreciation, the theoretically ideal
method of distributing the charge, from the standpoint of a going concern, is
so that each unit of output shall bear its just proportion of the burden. Any
other attitude is inconsistent. Thus, assuming that actual depreciation does
not progress uniformly, that, as some maintain, the rate of depreciation is
heaviest towards the end of the service life of an asset, it would not be
equitable to charge the product of those years with a much higher burden
than that of the earlier years. Just as it is a misfortune to be born under some
conditions, so here it would be a misfortune to a commodity to be produced
during the latter years of the service life of an asset. The life-period of an
asset must be viewed as a whole and its total depreciation should be
distributed evenly over its output, if equity is to be secured—other
conditions, of course, remaining the same. This principle does not apply
alone to the depreciation charge but equally to all other charges in
connection with the asset, such as repairs, maintenance, etc. The author
does not believe that these other costs should include a charge for an
assumed rate of interest on the money invested in the asset. For a full
consideration of the question of interest on capital as an item of cost of
production, the student is referred to Chapter XXVI. Any method of
distributing the depreciation cost must take cognizance of the other costs as
well.
1. Proportional Methods
(a) Straight Line Method
The straight line method is, first of all, simple in application and can
easily be adapted to any asset under almost any conditions. Partly because
It has been pointed out that these elements of depreciation, viz., wear
and tear, inadequacy, obsolescence, etc., are single and isolated in their
action and not cumulative. One of them, therefore, is the controlling
element in any estimate of depreciation. Accordingly, in judging the merits
of a method the kind of depreciation must be taken into account; i.e.,
depreciation must be viewed from a time and service standpoint.
Ideal Basis for Distribution of Depreciation Charge
Regardless of the actual progress of depreciation, the theoretically ideal
method of distributing the charge, from the standpoint of a going concern, is
so that each unit of output shall bear its just proportion of the burden. Any
other attitude is inconsistent. Thus, assuming that actual depreciation does
not progress uniformly, that, as some maintain, the rate of depreciation is
heaviest towards the end of the service life of an asset, it would not be
equitable to charge the product of those years with a much higher burden
than that of the earlier years. Just as it is a misfortune to be born under some
conditions, so here it would be a misfortune to a commodity to be produced
during the latter years of the service life of an asset. The life-period of an
asset must be viewed as a whole and its total depreciation should be
distributed evenly over its output, if equity is to be secured—other
conditions, of course, remaining the same. This principle does not apply
alone to the depreciation charge but equally to all other charges in
connection with the asset, such as repairs, maintenance, etc. The author
does not believe that these other costs should include a charge for an
assumed rate of interest on the money invested in the asset. For a full
consideration of the question of interest on capital as an item of cost of
production, the student is referred to Chapter XXVI. Any method of
distributing the depreciation cost must take cognizance of the other costs as
well.
1. Proportional Methods
(a) Straight Line Method
The straight line method is, first of all, simple in application and can
easily be adapted to any asset under almost any conditions. Partly because
Page 167
of the ease of calculation and application, it has been designated as an
official method by many regulatory boards. Its basis is a time basis and it
spreads the charge evenly over the periods of the service life of the asset.
Accordingly, where the time elements of depreciation, viz., decrepitude,
inadequacy, or obsolescence, control and where the output does not
fluctuate much from period to period, the straight line method should give
satisfactory results for its intended purpose, i.e., for allocating the real
depreciation charge.
Its effect, however, must be considered also in conjunction with the
distribution of the other costs connected with the asset. Many engineers
maintain that repairs are light during the early life of an asset and heavy
during the later years. If this is true and these costs are charged to the period
in which they are incurred, the combined depreciation and up-keep costs
place an unjustly heavy burden on the output of the later years. Almost
equally good authority maintains that the cost of repairs is in no sense
uniformly graduated as implied above but can be counted upon in practice
to be extremely irregular. If this is true and up-keep costs are charged as
above, then many periods are apt to be underburdened and others loaded too
heavily.
While, however, these considerations must be given weight when a
single asset is under view, in a large plant after operation has continued to
the point where a normal and fairly regular cost of up-keep has become
established, the inequalities of the individual up-keep charges may merge
into fairly equal charges for the up-keep of the plant as a whole. This the
law of averages accomplishes to a greater or less degree. But in a small
plant with few assets subject to depreciation, the equality of the whole
might not result from the individual inequalities. After all, this magic rule of
averages which is invoked to cover up many troublesome and embarrassing
situations is obnoxious to scientific accounting; it is a makeshift which
carries with it a shiftless trust in the happy outcome of things—a trust
which has been so often betrayed as to carry little weight.
If depreciation costs can be predetermined with a satisfactory degree of
accuracy—and an estimate of them is all that can ever be made—with equal
accuracy and satisfaction can up-keep costs be predetermined. The one is no
more difficult than the other and equal reason exists for predetermination in
both cases, viz., the securing of an equitable distribution of costs. With both
official method by many regulatory boards. Its basis is a time basis and it
spreads the charge evenly over the periods of the service life of the asset.
Accordingly, where the time elements of depreciation, viz., decrepitude,
inadequacy, or obsolescence, control and where the output does not
fluctuate much from period to period, the straight line method should give
satisfactory results for its intended purpose, i.e., for allocating the real
depreciation charge.
Its effect, however, must be considered also in conjunction with the
distribution of the other costs connected with the asset. Many engineers
maintain that repairs are light during the early life of an asset and heavy
during the later years. If this is true and these costs are charged to the period
in which they are incurred, the combined depreciation and up-keep costs
place an unjustly heavy burden on the output of the later years. Almost
equally good authority maintains that the cost of repairs is in no sense
uniformly graduated as implied above but can be counted upon in practice
to be extremely irregular. If this is true and up-keep costs are charged as
above, then many periods are apt to be underburdened and others loaded too
heavily.
While, however, these considerations must be given weight when a
single asset is under view, in a large plant after operation has continued to
the point where a normal and fairly regular cost of up-keep has become
established, the inequalities of the individual up-keep charges may merge
into fairly equal charges for the up-keep of the plant as a whole. This the
law of averages accomplishes to a greater or less degree. But in a small
plant with few assets subject to depreciation, the equality of the whole
might not result from the individual inequalities. After all, this magic rule of
averages which is invoked to cover up many troublesome and embarrassing
situations is obnoxious to scientific accounting; it is a makeshift which
carries with it a shiftless trust in the happy outcome of things—a trust
which has been so often betrayed as to carry little weight.
If depreciation costs can be predetermined with a satisfactory degree of
accuracy—and an estimate of them is all that can ever be made—with equal
accuracy and satisfaction can up-keep costs be predetermined. The one is no
more difficult than the other and equal reason exists for predetermination in
both cases, viz., the securing of an equitable distribution of costs. With both
Page 168
estimates made at the beginning of the service life of the asset, all costs in
connection with the asset can thus be prorated over the years of its service
life.
If, as stated above, the output is fairly regular as between periods, fair
and equitable results will be obtained. If the output fluctuates violently,
unsatisfactory costs and an inequitable burdening of product will be the
result. The proper treatment of overtime and “beyond-capacity” work, i.e.,
abnormal operations, requires care. It is expected that such work will have a
higher unit cost than normal output, and it is proper that a sliding scale of
depreciation be applied in such a case.
(b) Working Hours Method
Most of the considerations taken into account for the straight line
method are equally applicable to the working hours method. Here, with the
service life expressed in terms of working hours instead of fiscal periods, a
far step has been made towards securing an equitable distribution of
depreciation costs over product. The rate per working hour can in this way
be applied directly to the product. The machine-hour and sold-hour methods
of costing distribute the depreciation along with all other costs on this basis
of “rate per working hour.”
Where a machine or other asset is limited in its use to a few operations
equally wearing in their effect, this method should give satisfactory results.
Where, however, one asset can be used for many different processes,
involving inequalities in wear and tear, if the service rendered is the
controlling factor, an inequitable distribution will result. Similarly, beyond-
capacity operation, i.e., operation beyond the normal speed at which
depreciation cost has been predetermined, will not be taken care of
automatically by this method. Adjustment is necessary and, though
arbitrarily made, must be attempted. Thus, ten articles might be turned out
in one working hour, whereas an estimated output of six formed the basis
for determining the rate of depreciation per working hour. As with the
straight line method, so here equal care must be exercised in securing an
equitable distribution of up-keep costs.
(c) Composite Life Method
connection with the asset can thus be prorated over the years of its service
life.
If, as stated above, the output is fairly regular as between periods, fair
and equitable results will be obtained. If the output fluctuates violently,
unsatisfactory costs and an inequitable burdening of product will be the
result. The proper treatment of overtime and “beyond-capacity” work, i.e.,
abnormal operations, requires care. It is expected that such work will have a
higher unit cost than normal output, and it is proper that a sliding scale of
depreciation be applied in such a case.
(b) Working Hours Method
Most of the considerations taken into account for the straight line
method are equally applicable to the working hours method. Here, with the
service life expressed in terms of working hours instead of fiscal periods, a
far step has been made towards securing an equitable distribution of
depreciation costs over product. The rate per working hour can in this way
be applied directly to the product. The machine-hour and sold-hour methods
of costing distribute the depreciation along with all other costs on this basis
of “rate per working hour.”
Where a machine or other asset is limited in its use to a few operations
equally wearing in their effect, this method should give satisfactory results.
Where, however, one asset can be used for many different processes,
involving inequalities in wear and tear, if the service rendered is the
controlling factor, an inequitable distribution will result. Similarly, beyond-
capacity operation, i.e., operation beyond the normal speed at which
depreciation cost has been predetermined, will not be taken care of
automatically by this method. Adjustment is necessary and, though
arbitrarily made, must be attempted. Thus, ten articles might be turned out
in one working hour, whereas an estimated output of six formed the basis
for determining the rate of depreciation per working hour. As with the
straight line method, so here equal care must be exercised in securing an
equitable distribution of up-keep costs.
(c) Composite Life Method
Page 169
This is not a working method for estimating individual depreciation
costs, but rather a method of proof or check, which proves very valuable in
some cases. The method is discussed in detail on page 197 where the uses
to which it may be turned are pointed out.
(d) Service Output Method
The service output method bases the depreciation cost not on years of
life nor on life in terms of working hours of service. Here an attempt is
made to predetermine the output of the asset in terms of units of product,
and so burden every unit with its fair share of depreciation. To secure full
equality of charges, up-keep costs must be reckoned on the same basis,
rather than on a time basis of service hours or length of life. If conditions
are uniform and normal, this method, where applicable, secures perhaps the
most satisfactory of all allocations of depreciation costs. To an individual
machine performing several different processes the method would scarcely
be applicable. To a group or battery of machines, turning out a uniform
product in finished form or in the same degree of partly finished condition,
the method could be well applied. The estimated total output of the group
would then be taken as the basis for calculating the service output of each
machine in the group. When calculating service life in whatever units, that
speed of operation which secures the highest efficiency is taken as the
figure of normal operation.
From the foregoing it follows that the service output method of
calculating the depreciation charge per unit of output is well adapted to an
inherently wasting asset, such as a mine, a quarry, and timber lands, and is
almost invariably applied in such cases.
2. Variable Percentage Methods
(a) Fixed Per Cent of Diminishing Value Method
The chief merit of the variable percentage methods, in the eyes of their
advocates, is the way they are automatically adjusted to the up-keep
charges. The reader should study the graphs of these various methods as a
means of comparing results.
costs, but rather a method of proof or check, which proves very valuable in
some cases. The method is discussed in detail on page 197 where the uses
to which it may be turned are pointed out.
(d) Service Output Method
The service output method bases the depreciation cost not on years of
life nor on life in terms of working hours of service. Here an attempt is
made to predetermine the output of the asset in terms of units of product,
and so burden every unit with its fair share of depreciation. To secure full
equality of charges, up-keep costs must be reckoned on the same basis,
rather than on a time basis of service hours or length of life. If conditions
are uniform and normal, this method, where applicable, secures perhaps the
most satisfactory of all allocations of depreciation costs. To an individual
machine performing several different processes the method would scarcely
be applicable. To a group or battery of machines, turning out a uniform
product in finished form or in the same degree of partly finished condition,
the method could be well applied. The estimated total output of the group
would then be taken as the basis for calculating the service output of each
machine in the group. When calculating service life in whatever units, that
speed of operation which secures the highest efficiency is taken as the
figure of normal operation.
From the foregoing it follows that the service output method of
calculating the depreciation charge per unit of output is well adapted to an
inherently wasting asset, such as a mine, a quarry, and timber lands, and is
almost invariably applied in such cases.
2. Variable Percentage Methods
(a) Fixed Per Cent of Diminishing Value Method
The chief merit of the variable percentage methods, in the eyes of their
advocates, is the way they are automatically adjusted to the up-keep
charges. The reader should study the graphs of these various methods as a
means of comparing results.
Page 170
On the graph, page 158, it is shown that under the fixed per cent of
diminishing value method the periodic depreciation charges are heavy in the
beginning and decrease toward the end. It is argued that, inasmuch as up-
keep costs increase as the depreciation charge decreases, this method
automatically equalizes these two costs. This argument was examined in
detail under the previous discussion of the straight line method. What was
there set down applies equally here. The fixed per cent method is also based
on service life by periods—a time basis rather than a service or output
basis. Furthermore, it involves a complex calculation and is perhaps never
applied with any degree of accuracy. Lawrence R. Dicksee prefers this
method for handling depreciation on machinery.
(b) Sum of Expected Life-Periods Method
The objection of complexity of calculation to the method just discussed
is overcome largely in the sum of expected life-periods method. Here the
rate of decrease is more marked, but the method has the same general effect
as the fixed per cent method. If the repair charges are handled, as suggested,
by means, of pre-estimates, the results will not be equitable. If repairs
increase with uniform regularity as the depreciation costs decrease, fair
equality is secured. Otherwise the method has little to commend it.
(c, d) Arbitrary Methods
The two other methods under this main group, viz.: arbitrary with
increasing amounts in the one case and decreasing amounts in the other, are
not based on any orderly scheme of calculation and, having little logic
behind them, are not to be relied upon. Ease of calculation is perhaps their
only merit.
3. Compound Interest Methods
General Considerations
In a discussion of compound interest methods the basic feature, that of
the compound interest principle, requires consideration. The thought of
progression on a compound interest basis is fascinating to many. It is a
powerful instrument of accumulation and its charm seems to lie in the fact
that through its instrumentality small sums can be made to grow into large
diminishing value method the periodic depreciation charges are heavy in the
beginning and decrease toward the end. It is argued that, inasmuch as up-
keep costs increase as the depreciation charge decreases, this method
automatically equalizes these two costs. This argument was examined in
detail under the previous discussion of the straight line method. What was
there set down applies equally here. The fixed per cent method is also based
on service life by periods—a time basis rather than a service or output
basis. Furthermore, it involves a complex calculation and is perhaps never
applied with any degree of accuracy. Lawrence R. Dicksee prefers this
method for handling depreciation on machinery.
(b) Sum of Expected Life-Periods Method
The objection of complexity of calculation to the method just discussed
is overcome largely in the sum of expected life-periods method. Here the
rate of decrease is more marked, but the method has the same general effect
as the fixed per cent method. If the repair charges are handled, as suggested,
by means, of pre-estimates, the results will not be equitable. If repairs
increase with uniform regularity as the depreciation costs decrease, fair
equality is secured. Otherwise the method has little to commend it.
(c, d) Arbitrary Methods
The two other methods under this main group, viz.: arbitrary with
increasing amounts in the one case and decreasing amounts in the other, are
not based on any orderly scheme of calculation and, having little logic
behind them, are not to be relied upon. Ease of calculation is perhaps their
only merit.
3. Compound Interest Methods
General Considerations
In a discussion of compound interest methods the basic feature, that of
the compound interest principle, requires consideration. The thought of
progression on a compound interest basis is fascinating to many. It is a
powerful instrument of accumulation and its charm seems to lie in the fact
that through its instrumentality small sums can be made to grow into large
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sums. Whether the principle is applied to the creation of a fund or simply as
a method of calculating periodic amounts, the remarks of P. D. Leake,[36] an
English authority, are equally appropriate. He says: “May I impress upon
you that these devices are dangerous expedients in any but the most skillful
hands.... It (the sinking fund) is apt to give a sense of false security, because
its whole virtue depends upon its obligations being faithfully carried out
over the whole period, and this condition is not always fulfilled.... It is
probable that in many cases the use of a sinking fund is an altogether
unwarrantable draft upon the future, because there is no reasonable
certainty that the fund, whether it be state, municipal or commercial, will
not be raided before it attains its object.”
Over short periods the difference between the periodic amounts under
this method and the straight line method is slight, as will be apparent from a
comparison of the two charts on pages 153 and 162, giving graphic
illustration of the two methods. There the period is for five years. When the
period is extended to, say, twenty or fifty years, the difference in burden,
due to interest accumulations, between the early years and the later years is
very marked. “Thus, a 10-year unit having no salvage value, loses half its
value in 5 years under the straight line theory, regardless of the rate of
interest, and at 5% under the compound interest theory it loses nearly as
much—about 44% of its value in the same time; ... but a 50-year unit,
losing half its value in 25 years, under the straight line theory, loses only
22.8% of its value, at 5%, under the compound interest theory.”
(a) Sinking Fund Method
The sinking fund method as an orderly scheme for estimating the
periodic depreciation charge will make the estimate, and, if adhered to
faithfully, the entire depreciation will be written off by the end of the
service life of the asset. In this respect it is to be preferred to any arbitrary
or haphazard method. That it secures an equitable distribution of
depreciation costs over the product of the various periods, or that it effects a
correct valuation of the asset at intermediate periods of its life is open to
serious questioning. The periodic charge under the sinking fund method
perhaps bears no relation to the fact of depreciation. The method is, at the
best, simply a mathematical device for an orderly calculation of periodic
amounts. In the valuation work of public service companies or in regulation
a method of calculating periodic amounts, the remarks of P. D. Leake,[36] an
English authority, are equally appropriate. He says: “May I impress upon
you that these devices are dangerous expedients in any but the most skillful
hands.... It (the sinking fund) is apt to give a sense of false security, because
its whole virtue depends upon its obligations being faithfully carried out
over the whole period, and this condition is not always fulfilled.... It is
probable that in many cases the use of a sinking fund is an altogether
unwarrantable draft upon the future, because there is no reasonable
certainty that the fund, whether it be state, municipal or commercial, will
not be raided before it attains its object.”
Over short periods the difference between the periodic amounts under
this method and the straight line method is slight, as will be apparent from a
comparison of the two charts on pages 153 and 162, giving graphic
illustration of the two methods. There the period is for five years. When the
period is extended to, say, twenty or fifty years, the difference in burden,
due to interest accumulations, between the early years and the later years is
very marked. “Thus, a 10-year unit having no salvage value, loses half its
value in 5 years under the straight line theory, regardless of the rate of
interest, and at 5% under the compound interest theory it loses nearly as
much—about 44% of its value in the same time; ... but a 50-year unit,
losing half its value in 25 years, under the straight line theory, loses only
22.8% of its value, at 5%, under the compound interest theory.”
(a) Sinking Fund Method
The sinking fund method as an orderly scheme for estimating the
periodic depreciation charge will make the estimate, and, if adhered to
faithfully, the entire depreciation will be written off by the end of the
service life of the asset. In this respect it is to be preferred to any arbitrary
or haphazard method. That it secures an equitable distribution of
depreciation costs over the product of the various periods, or that it effects a
correct valuation of the asset at intermediate periods of its life is open to
serious questioning. The periodic charge under the sinking fund method
perhaps bears no relation to the fact of depreciation. The method is, at the
best, simply a mathematical device for an orderly calculation of periodic
amounts. In the valuation work of public service companies or in regulation
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work where, as in California, actual funds must be set aside to accumulate
at compound interest, there is no serious objection to the method. Although
it rests on false or doubtful assumptions of fact and results in an inequitable
burden on the product as viewed from the standpoint of individual assets,
these are minor considerations; for the method does by the end of its service
life take care of the loss in value. Judged from the standpoint of its relation
to up-keep costs, the method lays an increasingly heavy burden on the later
years of the life of the asset.
(b) Annuity Method
All that has been said with regard to the sinking fund method applies
with equal point to the annuity method. As previously indicated, in the
explanation of its essential features, this method automatically secures a
charge for interest on the investment as a part of the depreciation charge.
Not only is the charging of interest of doubtful propriety in itself, but
certainly its inclusion under the title of depreciation is misleading and
indefensible. The courage of one’s convictions with regard to interest as a
part of cost should not allow interest to shelter itself under the cloak of
“depreciation.” By referring to the appraisal schedule and chart, it is seen
that the real depreciation charge is exactly the same under the annuity as
under the sinking fund method.
(c) Unit Cost Method
The unit cost method represents an attempt to secure an equal burdening
of each unit of product with interest, depreciation, and operating costs. In
the language of its proponents, “this theory is probably the soundest theory
of depreciation, and when applied with intelligence, probably furnishes the
truest measure of accrued depreciation.” While the end sought by the unit
cost method is commendable, it is a compound interest method and it mixes
interest, up-keep, and depreciation under the one title “depreciation.”
4. Miscellaneous Methods
Criticisms of the miscellaneous theories can be brief.
(a) Maintenance Method
at compound interest, there is no serious objection to the method. Although
it rests on false or doubtful assumptions of fact and results in an inequitable
burden on the product as viewed from the standpoint of individual assets,
these are minor considerations; for the method does by the end of its service
life take care of the loss in value. Judged from the standpoint of its relation
to up-keep costs, the method lays an increasingly heavy burden on the later
years of the life of the asset.
(b) Annuity Method
All that has been said with regard to the sinking fund method applies
with equal point to the annuity method. As previously indicated, in the
explanation of its essential features, this method automatically secures a
charge for interest on the investment as a part of the depreciation charge.
Not only is the charging of interest of doubtful propriety in itself, but
certainly its inclusion under the title of depreciation is misleading and
indefensible. The courage of one’s convictions with regard to interest as a
part of cost should not allow interest to shelter itself under the cloak of
“depreciation.” By referring to the appraisal schedule and chart, it is seen
that the real depreciation charge is exactly the same under the annuity as
under the sinking fund method.
(c) Unit Cost Method
The unit cost method represents an attempt to secure an equal burdening
of each unit of product with interest, depreciation, and operating costs. In
the language of its proponents, “this theory is probably the soundest theory
of depreciation, and when applied with intelligence, probably furnishes the
truest measure of accrued depreciation.” While the end sought by the unit
cost method is commendable, it is a compound interest method and it mixes
interest, up-keep, and depreciation under the one title “depreciation.”
4. Miscellaneous Methods
Criticisms of the miscellaneous theories can be brief.
(a) Maintenance Method
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This method is irregular in its incidence, and under it the depreciation
charge fluctuates violently between periods. Just as maintenance is
subordinated to the requirements and demands of the trade, so also are
depreciation costs made to depend on the same conditions. The charging of
depreciation thus becomes a matter of business convenience instead of an
inexorable fact of production. Just as repairs are postponed to a slack period
during which maintenance charges are in consequence heavy, so does the
depreciation charge increase even though actual wear and tear has
decreased. Presumably the method makes charges light during the early
years and heavy during the later years of the life of the asset. In a large
plant with various kinds of assets, after a normal up-keep charge has been
established, the maintenance method of estimating the periodic charge for
depreciation for the plant as a whole may work out fairly well on the theory
of averages or by accident; for maintenance is not a measure of
depreciation.
(b) Replacement Method
This is not a method of measuring depreciation but rather of financing
it, i.e., of making good the loss. It also is based on the law of averages, and
in a large plant after the point of normal replacements has been reached it
may prove a satisfactory method of accomplishing its purpose. It does not
serve as a means whereby a periodic depreciation charge can be brought on
the books. Furthermore, it disregards the depreciation accrued up to the
point of normal replacements.
(c) Fifty Per Cent Method
This method is also based on the law of averages. Here the law is very
apt to work out satisfactorily. When the point of normal replacement of the
assets, to which the 50% method is applicable, has been reached, the
amount of depreciation is approximately 50% of the original value of the
group of assets. This amount may be booked at that time and will remain
without change thereafter, for the assets are maintained constantly in that
condition. As a means of valuation, the method may serve well; as a
measure of periodic depreciation or as a means of distributing the
depreciation cost over the product, it is inadequate.
(d) Appraisal Method
charge fluctuates violently between periods. Just as maintenance is
subordinated to the requirements and demands of the trade, so also are
depreciation costs made to depend on the same conditions. The charging of
depreciation thus becomes a matter of business convenience instead of an
inexorable fact of production. Just as repairs are postponed to a slack period
during which maintenance charges are in consequence heavy, so does the
depreciation charge increase even though actual wear and tear has
decreased. Presumably the method makes charges light during the early
years and heavy during the later years of the life of the asset. In a large
plant with various kinds of assets, after a normal up-keep charge has been
established, the maintenance method of estimating the periodic charge for
depreciation for the plant as a whole may work out fairly well on the theory
of averages or by accident; for maintenance is not a measure of
depreciation.
(b) Replacement Method
This is not a method of measuring depreciation but rather of financing
it, i.e., of making good the loss. It also is based on the law of averages, and
in a large plant after the point of normal replacements has been reached it
may prove a satisfactory method of accomplishing its purpose. It does not
serve as a means whereby a periodic depreciation charge can be brought on
the books. Furthermore, it disregards the depreciation accrued up to the
point of normal replacements.
(c) Fifty Per Cent Method
This method is also based on the law of averages. Here the law is very
apt to work out satisfactorily. When the point of normal replacement of the
assets, to which the 50% method is applicable, has been reached, the
amount of depreciation is approximately 50% of the original value of the
group of assets. This amount may be booked at that time and will remain
without change thereafter, for the assets are maintained constantly in that
condition. As a means of valuation, the method may serve well; as a
measure of periodic depreciation or as a means of distributing the
depreciation cost over the product, it is inadequate.
(d) Appraisal Method
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This method is also inadequate as a means of measuring the periodic
cost of depreciation. The physical facts of depreciation are not usually
discernible at such short intervals. A judgment of values must, therefore,
almost invariably make use, consciously or unconsciously, of some of the
other methods of estimating the amount of depreciation by periods. After
all, all methods of measuring depreciation are appraisals. Under the
appraisal method confusion between original cost and reproduction cost is
almost certain to occur, for present market values usually control physical
appraisals. A discussion of the relative merits of original cost and
reproduction cost as a proper basis for estimating depreciation will be
presented in Chapter XI.
(e) Insurance Method
This method of carrying the depreciation charge is analogous to the
policy practiced by some concerns of taking care of their fire losses by
carrying their own insurance. If physical conditions are such as to make
such a policy advisable or prudent, it should work out satisfactorily. It
should be noted, however, that the insurance method is a means of
providing funds for financing replacements and renewals rather than a
method of insuring an equitable distribution of the depreciation cost over
the product. The method of providing funds does not need to be the same as
the method of measuring the periodic cost of depreciation. The insurance
method serves the former purpose but is not well adapted to the latter. Much
of the criticism of the sinking fund method is here applicable.
(f) Percentage of Gross Earnings Method
Measuring periodic depreciation as a percentage of the period’s gross
earnings is a convenient and fairly satisfactory method under some
conditions. If the principal element is wear and tear—a service factor rather
than a time factor—output may have a very direct relation to gross earnings.
If the commodity dealt in is a standardized product and its price does not
fluctuate to any extent or, better still, is fixed, gross earnings will be a very
fair measure of output. It is true that the estimate is based on a sales
valuation of output rather than its cost of manufacture, but under some
conditions this is a good measure of relative output as between periods. A
depreciation charge based on gross earnings may thus give an equitable
distribution of the depreciation burden. In the case of public utilities, when
cost of depreciation. The physical facts of depreciation are not usually
discernible at such short intervals. A judgment of values must, therefore,
almost invariably make use, consciously or unconsciously, of some of the
other methods of estimating the amount of depreciation by periods. After
all, all methods of measuring depreciation are appraisals. Under the
appraisal method confusion between original cost and reproduction cost is
almost certain to occur, for present market values usually control physical
appraisals. A discussion of the relative merits of original cost and
reproduction cost as a proper basis for estimating depreciation will be
presented in Chapter XI.
(e) Insurance Method
This method of carrying the depreciation charge is analogous to the
policy practiced by some concerns of taking care of their fire losses by
carrying their own insurance. If physical conditions are such as to make
such a policy advisable or prudent, it should work out satisfactorily. It
should be noted, however, that the insurance method is a means of
providing funds for financing replacements and renewals rather than a
method of insuring an equitable distribution of the depreciation cost over
the product. The method of providing funds does not need to be the same as
the method of measuring the periodic cost of depreciation. The insurance
method serves the former purpose but is not well adapted to the latter. Much
of the criticism of the sinking fund method is here applicable.
(f) Percentage of Gross Earnings Method
Measuring periodic depreciation as a percentage of the period’s gross
earnings is a convenient and fairly satisfactory method under some
conditions. If the principal element is wear and tear—a service factor rather
than a time factor—output may have a very direct relation to gross earnings.
If the commodity dealt in is a standardized product and its price does not
fluctuate to any extent or, better still, is fixed, gross earnings will be a very
fair measure of output. It is true that the estimate is based on a sales
valuation of output rather than its cost of manufacture, but under some
conditions this is a good measure of relative output as between periods. A
depreciation charge based on gross earnings may thus give an equitable
distribution of the depreciation burden. In the case of public utilities, when
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the price of the commodity or service dealt in is fixed, an estimate based on
gross earnings usually gives satisfactory results where used. In applying the
method, the expected earnings during the composite life-period of the plant
are estimated and depreciation costs are then prorated over periods on the
basis of earnings for the period as compared with total earnings for the
composite life-period; or more simply, a fixed percentage based on past
experience can be applied to the earnings of each period. Some objections
to the method, arising in some cases from a misunderstanding of its
operation, were pointed out when an explanation of its working was given.
In some cases gross earnings bear no relation, or only the remotest, to
the quantity of output or the units of service rendered. A depreciation
estimate based on earnings would not in that case be logical and could not
give satisfactory results.
From the above discussion of some of the merits and shortcomings of
the various methods, the cogency of the introductory remarks, to the effect
that no method of measuring depreciation can serve as a panacea, should be
appreciated. Every depreciation problem is more or less an individual
problem; sweeping generalities will not serve.
Effect on Return on Investment
Many interesting studies have been made of the effect of some of the
above methods on stability of income as between periods and their effect on
the return of the investment, using hypothetical data as to the earnings of
the depreciating asset. Except for the purpose of fixing rates in the case of
public service corporations, where the public has an interest because of the
monopoly granted, stability of income should be subordinated to the fact of
depreciation and not serve as a test of the merit or demerit of a method.
gross earnings usually gives satisfactory results where used. In applying the
method, the expected earnings during the composite life-period of the plant
are estimated and depreciation costs are then prorated over periods on the
basis of earnings for the period as compared with total earnings for the
composite life-period; or more simply, a fixed percentage based on past
experience can be applied to the earnings of each period. Some objections
to the method, arising in some cases from a misunderstanding of its
operation, were pointed out when an explanation of its working was given.
In some cases gross earnings bear no relation, or only the remotest, to
the quantity of output or the units of service rendered. A depreciation
estimate based on earnings would not in that case be logical and could not
give satisfactory results.
From the above discussion of some of the merits and shortcomings of
the various methods, the cogency of the introductory remarks, to the effect
that no method of measuring depreciation can serve as a panacea, should be
appreciated. Every depreciation problem is more or less an individual
problem; sweeping generalities will not serve.
Effect on Return on Investment
Many interesting studies have been made of the effect of some of the
above methods on stability of income as between periods and their effect on
the return of the investment, using hypothetical data as to the earnings of
the depreciating asset. Except for the purpose of fixing rates in the case of
public service corporations, where the public has an interest because of the
monopoly granted, stability of income should be subordinated to the fact of
depreciation and not serve as a test of the merit or demerit of a method.
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CHAPTER XI
RECORDING DEPRECIATION ON THE BOOKS
Methods Commonly Employed
Two methods of booking depreciation in the ledger are commonly employed. The
periodic adjusting entry on account of depreciation has as its basic purpose the separation of
the mixed account under asset title into its two elements—the one to show the expense
element, the other to set up the true valuation of the asset. The expense element is set up
under the one title “Depreciation” for all the assets. The deduction from the values as shown
in the unadjusted asset account may be made either by credit entry direct to the asset account
or by entry to a separate “Depreciation Reserve” account, each one of these reserves
distinguished by the name of the asset to which it applies.
The latter method is preferred because thus the asset account at any time shows the
original cost of the property—information of value for many purposes and worth the effort
needed to maintain it distinct from other items. Under this method every wasting asset
account is immediately followed by its particular depreciation reserve account, called its
“valuation” account. The depreciation reserve is as much a part of the record of the asset as is
the asset account itself. The two accounts are complementary, neither giving reliable
information without the other. The reserve account is thus always and only a balance sheet
account.
The above statement indicates the most satisfactory method of handling the various
depreciation reserve accounts on the balance sheet. Although appearing on the credit side of
the ledger, they are in no sense liability accounts, being interpreted always as credits to the
asset account, held in suspense, as it were, in the reserve account, pending full determination
of their accuracy, which governs their ultimate disposition. Thus, on the balance sheet, either
only the net present value of the asset should be shown, or preferably its original cost with its
value extended short, its depreciation reserve deducted, and the present value, thus
determined, full-extended. Further information of some value is given if besides the amount
of the reserve the rate of depreciation is shown, though this is not often done. Occasionally
an entirely incorrect showing, from the viewpoint of strict form, is seen when not only are the
depreciation reserves—usually in one item—shown on the right side of the balance sheet but
are set up in the Net Worth section, seemingly as a part of the surplus or other true profit
reserves. This practice cannot be justified on any ground except that the sheet is kept in
balance—a consideration which is far removed from real essentials.
Renewals and Replacements
First Method. As to the handling of the reserve at the time of renewal of parts and
replacement of the entire asset, here also two methods are met. Under the one, the original
cost of the part (or whole) retired is transferred from the asset account, its salvage value as
defined above being carried to a Salvage account, and the cost less salvage portion being
charged to the reserve account of the asset. This clears the asset account of all capital charges
RECORDING DEPRECIATION ON THE BOOKS
Methods Commonly Employed
Two methods of booking depreciation in the ledger are commonly employed. The
periodic adjusting entry on account of depreciation has as its basic purpose the separation of
the mixed account under asset title into its two elements—the one to show the expense
element, the other to set up the true valuation of the asset. The expense element is set up
under the one title “Depreciation” for all the assets. The deduction from the values as shown
in the unadjusted asset account may be made either by credit entry direct to the asset account
or by entry to a separate “Depreciation Reserve” account, each one of these reserves
distinguished by the name of the asset to which it applies.
The latter method is preferred because thus the asset account at any time shows the
original cost of the property—information of value for many purposes and worth the effort
needed to maintain it distinct from other items. Under this method every wasting asset
account is immediately followed by its particular depreciation reserve account, called its
“valuation” account. The depreciation reserve is as much a part of the record of the asset as is
the asset account itself. The two accounts are complementary, neither giving reliable
information without the other. The reserve account is thus always and only a balance sheet
account.
The above statement indicates the most satisfactory method of handling the various
depreciation reserve accounts on the balance sheet. Although appearing on the credit side of
the ledger, they are in no sense liability accounts, being interpreted always as credits to the
asset account, held in suspense, as it were, in the reserve account, pending full determination
of their accuracy, which governs their ultimate disposition. Thus, on the balance sheet, either
only the net present value of the asset should be shown, or preferably its original cost with its
value extended short, its depreciation reserve deducted, and the present value, thus
determined, full-extended. Further information of some value is given if besides the amount
of the reserve the rate of depreciation is shown, though this is not often done. Occasionally
an entirely incorrect showing, from the viewpoint of strict form, is seen when not only are the
depreciation reserves—usually in one item—shown on the right side of the balance sheet but
are set up in the Net Worth section, seemingly as a part of the surplus or other true profit
reserves. This practice cannot be justified on any ground except that the sheet is kept in
balance—a consideration which is far removed from real essentials.
Renewals and Replacements
First Method. As to the handling of the reserve at the time of renewal of parts and
replacement of the entire asset, here also two methods are met. Under the one, the original
cost of the part (or whole) retired is transferred from the asset account, its salvage value as
defined above being carried to a Salvage account, and the cost less salvage portion being
charged to the reserve account of the asset. This clears the asset account of all capital charges
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on account of the part (or whole) retired. The new part (or whole) replacing it is now charged
to the asset account which then represents true cost of the new asset. If it is a whole which is
replaced, theoretically the charging of it against the reserve should just clear that account of
all values. Practically the preliminary estimate or forecast of the amount and time of
depreciation never coincides exactly with the fact of depreciation. A credit balance in the
reserve indicates an overallowance for depreciation and is an item of true reserved profits,
i.e., surplus; whereas a debit balance indicates an insufficient allowance and is an expense
item chargeable against surplus and not current profits. This matter is treated at greater length
on page 205. When the whole asset is replaced, the depreciation reserve should always be
cleared of any remaining balance, as indicated above, so that the new asset and its
depreciation allowance may be handled and watched unobscured by the record of any
inherited sins or virtues from the past.
Second Method. The other method of handling the reserve at the time of replacement
requires a comparison of the cost of the displaced asset and the cost of the new asset. The old
asset account is allowed to stand untouched, but any betterment, i.e., excess of reproduction
cost over original cost, is charged to it so that the asset account may show cost of the new
asset. This cost, except for its betterment portion, if any, is now charged against the reserve.
Both methods thus accomplish the same purpose, but the first is more direct and simpler of
operation. It may be interesting to note that, in early instructions to railway accounting
officers, the Interstate Commerce Commission prescribed the second method, which
emphasizes the betterment feature. The present regulation is in accord with the first method.
Occasionally one finds a practice which, though based on the second method, differs in
that no determination of betterment values is made, the original asset values remaining
undisturbed and the entire reproduction cost being charged against the reserve account. This
practice, of course, is due to a lack of understanding of the nature and purpose of the
depreciation charge and its offsetting reserve, and is counter to correct principles. There is,
however, seeming judicial support for it in cases of the valuation of utility properties for rate
purposes. The problem is discussed in full on page 202. The entries on the general books thus
present no difficulties.
Subsidiary Records
Subsidiary records should usually be kept to show the detail of the group asset accounts
carried on the general ledger. Not only is this necessary to maintain an adequate check on the
inventory of the group asset and control over it, but without a detailed record of items it is
impossible to keep careful watch over the operation of the forces of decay and depreciation
and, therefore, equally impossible to build up reliable experience data concerning each group
of assets. The amount of detail necessary in the record of the plant assets is dependent upon
the information desired and capable of being obtained within a limit of cost low enough to
make it worth the cost. This is a matter of policy which the management must determine. It
may be desirable to carry the records in much greater detail for a period than would be
justifiable as a permanent policy. It may be worth while to make more or less frequent studies
of particular groups of assets in order to check up the effect of the depreciation rates.
As is pointed out elsewhere, while the preliminary estimate of expected life, and
determination therefrom of the depreciation rate, are of great importance and the utmost skill
to the asset account which then represents true cost of the new asset. If it is a whole which is
replaced, theoretically the charging of it against the reserve should just clear that account of
all values. Practically the preliminary estimate or forecast of the amount and time of
depreciation never coincides exactly with the fact of depreciation. A credit balance in the
reserve indicates an overallowance for depreciation and is an item of true reserved profits,
i.e., surplus; whereas a debit balance indicates an insufficient allowance and is an expense
item chargeable against surplus and not current profits. This matter is treated at greater length
on page 205. When the whole asset is replaced, the depreciation reserve should always be
cleared of any remaining balance, as indicated above, so that the new asset and its
depreciation allowance may be handled and watched unobscured by the record of any
inherited sins or virtues from the past.
Second Method. The other method of handling the reserve at the time of replacement
requires a comparison of the cost of the displaced asset and the cost of the new asset. The old
asset account is allowed to stand untouched, but any betterment, i.e., excess of reproduction
cost over original cost, is charged to it so that the asset account may show cost of the new
asset. This cost, except for its betterment portion, if any, is now charged against the reserve.
Both methods thus accomplish the same purpose, but the first is more direct and simpler of
operation. It may be interesting to note that, in early instructions to railway accounting
officers, the Interstate Commerce Commission prescribed the second method, which
emphasizes the betterment feature. The present regulation is in accord with the first method.
Occasionally one finds a practice which, though based on the second method, differs in
that no determination of betterment values is made, the original asset values remaining
undisturbed and the entire reproduction cost being charged against the reserve account. This
practice, of course, is due to a lack of understanding of the nature and purpose of the
depreciation charge and its offsetting reserve, and is counter to correct principles. There is,
however, seeming judicial support for it in cases of the valuation of utility properties for rate
purposes. The problem is discussed in full on page 202. The entries on the general books thus
present no difficulties.
Subsidiary Records
Subsidiary records should usually be kept to show the detail of the group asset accounts
carried on the general ledger. Not only is this necessary to maintain an adequate check on the
inventory of the group asset and control over it, but without a detailed record of items it is
impossible to keep careful watch over the operation of the forces of decay and depreciation
and, therefore, equally impossible to build up reliable experience data concerning each group
of assets. The amount of detail necessary in the record of the plant assets is dependent upon
the information desired and capable of being obtained within a limit of cost low enough to
make it worth the cost. This is a matter of policy which the management must determine. It
may be desirable to carry the records in much greater detail for a period than would be
justifiable as a permanent policy. It may be worth while to make more or less frequent studies
of particular groups of assets in order to check up the effect of the depreciation rates.
As is pointed out elsewhere, while the preliminary estimate of expected life, and
determination therefrom of the depreciation rate, are of great importance and the utmost skill
Page 178
and judgment possible should be employed, only a policy of everlasting vigilance and
readjustment, in the light of new data available with the increasing age of the asset, will bring
satisfactory results. To predetermine a rate and then to expect it without supervision to work
out to a successful conclusion is, to say the least, foolish. Only by means of a complete
record of life histories can a mass of reliable data be built up which can be made to serve as a
guide for the future. The depreciation problem is an individual problem and must, from the
nature of things, remain so to a marked degree. Until conditions under which the lives of
assets are to be lived become more or less standardized, or so long as each concern must
carry its own depreciation insurance, standard rates of depreciation will not have a
controlling significance.
Grouping and Classification of Plant Assets
From what has been said it is evident that the assets of a plant must be divided into
groups for the sake of simplicity and convenience in keeping record of them. The basis of
grouping should be physical similarity, process, or product. Thus, all tram cars might be
carried in a group, as also all machines doing the same work or process. Groups of machines
performing different processes on the same product could well be treated as a depreciation
unit, and likewise all buildings used for the same purpose, if of a similar type of construction.
If the latter are of different types it might be desirable to keep separate records. As stated
above, the information desired must govern the groups under which record of behavior and
performance are kept.
A numerical or an alphabetic numeric system of classification and identification is
advantageous. Each machine, piece of equipment, or other asset should be marked or tagged
when installed so that any particular piece of equipment can be identified at any time. The tag
should carry date of installation and the name of the maker or vendor, as well as its own
identification number. By the use of a combined alphabetical and decimal numerical system,
almost any possible grouping can be made according to main and auxiliary groups, processes,
or products.
Form of Plant Ledger
The form of the plant register or ledger need not be elaborate. Its main subdivisions
should correspond with the subdivisions of plant and equipment carried on the general ledger.
Thus, if we find therein accounts with buildings (factory, store, office, etc.), machinery,
furniture and fixtures for factory, store, and office, delivery equipment, etc., subsidiary
records should show corresponding subdivisions. It should be a matter of fixed policy to
require a periodic proof of these subsidiary records against their respective controlling
accounts on the general ledger. Only thus can the inclusion of all items in both records be
made certain. The control established must cover both the items of the assets record—the
original cost as shown by the asset account—and the accumulated depreciation as shown by
the reserve account.
Asset Record
Aside from the title and classification and identification number, the plant register should
provide a record of the asset under the heads of:
readjustment, in the light of new data available with the increasing age of the asset, will bring
satisfactory results. To predetermine a rate and then to expect it without supervision to work
out to a successful conclusion is, to say the least, foolish. Only by means of a complete
record of life histories can a mass of reliable data be built up which can be made to serve as a
guide for the future. The depreciation problem is an individual problem and must, from the
nature of things, remain so to a marked degree. Until conditions under which the lives of
assets are to be lived become more or less standardized, or so long as each concern must
carry its own depreciation insurance, standard rates of depreciation will not have a
controlling significance.
Grouping and Classification of Plant Assets
From what has been said it is evident that the assets of a plant must be divided into
groups for the sake of simplicity and convenience in keeping record of them. The basis of
grouping should be physical similarity, process, or product. Thus, all tram cars might be
carried in a group, as also all machines doing the same work or process. Groups of machines
performing different processes on the same product could well be treated as a depreciation
unit, and likewise all buildings used for the same purpose, if of a similar type of construction.
If the latter are of different types it might be desirable to keep separate records. As stated
above, the information desired must govern the groups under which record of behavior and
performance are kept.
A numerical or an alphabetic numeric system of classification and identification is
advantageous. Each machine, piece of equipment, or other asset should be marked or tagged
when installed so that any particular piece of equipment can be identified at any time. The tag
should carry date of installation and the name of the maker or vendor, as well as its own
identification number. By the use of a combined alphabetical and decimal numerical system,
almost any possible grouping can be made according to main and auxiliary groups, processes,
or products.
Form of Plant Ledger
The form of the plant register or ledger need not be elaborate. Its main subdivisions
should correspond with the subdivisions of plant and equipment carried on the general ledger.
Thus, if we find therein accounts with buildings (factory, store, office, etc.), machinery,
furniture and fixtures for factory, store, and office, delivery equipment, etc., subsidiary
records should show corresponding subdivisions. It should be a matter of fixed policy to
require a periodic proof of these subsidiary records against their respective controlling
accounts on the general ledger. Only thus can the inclusion of all items in both records be
made certain. The control established must cover both the items of the assets record—the
original cost as shown by the asset account—and the accumulated depreciation as shown by
the reserve account.
Asset Record
Aside from the title and classification and identification number, the plant register should
provide a record of the asset under the heads of:
Page 179
1. Date of installation or adjustment.
2. Estimate of life in periods, working hours, service output, etc.
3. Original value, including installation costs.
4. Periodic depreciation burden.
5. Periodic appraisal value.
On the form shown below, provision is made for adjustment of the original estimate of
depreciation. Where there is a realizable scrap value, additional columns to show scrap value
and total depreciation to be written off should be provided. The form shown would have to be
adapted to the method of depreciation decided upon as applicable to a particular asset. Thus,
if working hours or service output are the basis, provision should be made to show the basis
of calculation of each period’s depreciation burden. The following form is well adapted to
make record of the asset under the straight line method of depreciation.
From “Principles of Depreciation” by Earl A. Saliers.
Plant Ledger (showing adjustment of value)
Periodic Revision of Rates
In Chapter VIII where the problems in connection with depreciation rates were discussed,
a periodic testing of the effects of the particular rate employed was laid down as an essential
for the application of any rate. The determination of the rate in the first place is a problem
requiring expert knowledge and the most careful consideration of many factors. Hardly less
important, however, for the successful operation of any depreciation scheme is the attention
given to the manner of its operation and a modification and readjustment of rates to bring the
theoretical expectation of the wasting of the asset into accord with its actual wasting to date.
2. Estimate of life in periods, working hours, service output, etc.
3. Original value, including installation costs.
4. Periodic depreciation burden.
5. Periodic appraisal value.
On the form shown below, provision is made for adjustment of the original estimate of
depreciation. Where there is a realizable scrap value, additional columns to show scrap value
and total depreciation to be written off should be provided. The form shown would have to be
adapted to the method of depreciation decided upon as applicable to a particular asset. Thus,
if working hours or service output are the basis, provision should be made to show the basis
of calculation of each period’s depreciation burden. The following form is well adapted to
make record of the asset under the straight line method of depreciation.
From “Principles of Depreciation” by Earl A. Saliers.
Plant Ledger (showing adjustment of value)
Periodic Revision of Rates
In Chapter VIII where the problems in connection with depreciation rates were discussed,
a periodic testing of the effects of the particular rate employed was laid down as an essential
for the application of any rate. The determination of the rate in the first place is a problem
requiring expert knowledge and the most careful consideration of many factors. Hardly less
important, however, for the successful operation of any depreciation scheme is the attention
given to the manner of its operation and a modification and readjustment of rates to bring the
theoretical expectation of the wasting of the asset into accord with its actual wasting to date.
Page 180
At the beginning, when the asset is first installed the depreciation rate must be based, so
far as this particular asset is concerned, entirely on contingencies. None of its life has been
lived; none of its actions and behavior have yet become a matter of record. What it is apt to
do can be forecast only by a study of its ancestors—heredity as modified by a reasonable
expectation of change due to different environment. However, at the end of five years, say,
there is available a record of service and behavior in the light of which not only can the
accuracy of the forecast be judged, but also a more reliable forecast for the remainder of its
service life can be made.
Frequency of Revision of Rates
Because of the conditions stated above, a periodic testing of rates should be made. How
frequently this should be done depends largely on local conditions. Certainly sufficient time
should be allowed to pass to secure a really worthwhile test. What constitutes a sufficient
time depends largely on the expected length of life. Long-lived assets obviously need not be
tested so frequently as short-lived assets; and the periods should be shortened when the asset
has been serving under supernormal conditions; the intensity of its life would be a controlling
factor. It is usually stated that this testing of rates and conditions should be made at least
every five years in the form of an appraisal. In the physical appraisal care should be used not
to allow present market prices to enter into it, else the element of fluctuation may easily be
brought in to nullify or exaggerate the real results of depreciation.
Test of Condition Per Cent
At the time of reappraisal the estimated condition per cent or the expectancy as to
remaining service life are the points most to be considered. C. E. Grunsky has made an
interesting contribution to the study of expectancy—theoretical, it is true, in the sense that it
is based on assumed hypotheses, but nevertheless of value as calling attention to a phase of
the subject that presents large possibilities. He takes 10,000 similar articles, all of probable
life-terms of 10 years, and all simultaneously installed. Assuming that of these 10,000, 100
will fail or go out of service at the end of the first year, 200 at the end of the second year, that
the largest numbers will fail in the years just before and just after the expected life-term of 10
years, and from then on, that there will be a gradual decrease in the number of failures until
the 20th year, beyond which time (double the estimated life-period) none will remain in
service—the following table is shown, which gives in the last column at the right the life
expectancy of all remaining articles as at the beginning of a given year.
It will thus be seen that an article which has survived its 5th year, has at the beginning of
its 6th an expectancy, not of 5 years but of 6.12 years; an article which has lived its allotted
10 years has an expectancy of 3.67 years; and so on. Certainly Mr. Grunsky’s study, if it
serves no other purpose, at least draws attention to possible lines of development and, read in
connection with facts as to the known length of life of many assets which have outlived their
expected terms, it draws strong attention to the need of very careful use of any so-called
mortality tables. These life history tables for assets are similar to the mortality tables used by
life insurance companies.
far as this particular asset is concerned, entirely on contingencies. None of its life has been
lived; none of its actions and behavior have yet become a matter of record. What it is apt to
do can be forecast only by a study of its ancestors—heredity as modified by a reasonable
expectation of change due to different environment. However, at the end of five years, say,
there is available a record of service and behavior in the light of which not only can the
accuracy of the forecast be judged, but also a more reliable forecast for the remainder of its
service life can be made.
Frequency of Revision of Rates
Because of the conditions stated above, a periodic testing of rates should be made. How
frequently this should be done depends largely on local conditions. Certainly sufficient time
should be allowed to pass to secure a really worthwhile test. What constitutes a sufficient
time depends largely on the expected length of life. Long-lived assets obviously need not be
tested so frequently as short-lived assets; and the periods should be shortened when the asset
has been serving under supernormal conditions; the intensity of its life would be a controlling
factor. It is usually stated that this testing of rates and conditions should be made at least
every five years in the form of an appraisal. In the physical appraisal care should be used not
to allow present market prices to enter into it, else the element of fluctuation may easily be
brought in to nullify or exaggerate the real results of depreciation.
Test of Condition Per Cent
At the time of reappraisal the estimated condition per cent or the expectancy as to
remaining service life are the points most to be considered. C. E. Grunsky has made an
interesting contribution to the study of expectancy—theoretical, it is true, in the sense that it
is based on assumed hypotheses, but nevertheless of value as calling attention to a phase of
the subject that presents large possibilities. He takes 10,000 similar articles, all of probable
life-terms of 10 years, and all simultaneously installed. Assuming that of these 10,000, 100
will fail or go out of service at the end of the first year, 200 at the end of the second year, that
the largest numbers will fail in the years just before and just after the expected life-term of 10
years, and from then on, that there will be a gradual decrease in the number of failures until
the 20th year, beyond which time (double the estimated life-period) none will remain in
service—the following table is shown, which gives in the last column at the right the life
expectancy of all remaining articles as at the beginning of a given year.
It will thus be seen that an article which has survived its 5th year, has at the beginning of
its 6th an expectancy, not of 5 years but of 6.12 years; an article which has lived its allotted
10 years has an expectancy of 3.67 years; and so on. Certainly Mr. Grunsky’s study, if it
serves no other purpose, at least draws attention to possible lines of development and, read in
connection with facts as to the known length of life of many assets which have outlived their
expected terms, it draws strong attention to the need of very careful use of any so-called
mortality tables. These life history tables for assets are similar to the mortality tables used by
life insurance companies.
Page 181
Table of Expectancy[37]
The probable life of each article is 10 years or periods. For terms other
than 10 years, each year in the table may be regarded as a period equal to
one-tenth of the probable life-term.
(Based on the special hypothesis of failures as explained in the text)
For 10,000 Articles Single Article
Remaining
Remaining
Year or Number Number of Expectancy at
Service at
Period of Articles at Beginning of
Beginning
Failures Beginning Year or Period
of Year
of Year
1 100 10,000 100,000 10.00
2 200 9,900 90,000 9.00
3 300 9,700 80,100 8.27
4 400 9,400 70,400 7.46
5 500 9,000 61,000 6.77
6 600 8,500 52,000 6.12
7 700 7,900 43,500 5.51
8 800 7,200 35,600 4.95
9 900 6,400 28,400 4.44
10 1,000 5,500 22,000 4.00
11 900 4,500 16,500 3.67
12 800 3,600 12,000 3.33
13 700 2,800 8,400 3.00
14 600 2,100 5,600 2.67
15 500 1,500 3,500 2.33
16 400 1,000 2,000 2.00
17 300 600 1,000 1.67
18 200 300 400 1.33
19 100 100 100 1.00
20 0 0 0 0
Composite and Group Rates
The probable life of each article is 10 years or periods. For terms other
than 10 years, each year in the table may be regarded as a period equal to
one-tenth of the probable life-term.
(Based on the special hypothesis of failures as explained in the text)
For 10,000 Articles Single Article
Remaining
Remaining
Year or Number Number of Expectancy at
Service at
Period of Articles at Beginning of
Beginning
Failures Beginning Year or Period
of Year
of Year
1 100 10,000 100,000 10.00
2 200 9,900 90,000 9.00
3 300 9,700 80,100 8.27
4 400 9,400 70,400 7.46
5 500 9,000 61,000 6.77
6 600 8,500 52,000 6.12
7 700 7,900 43,500 5.51
8 800 7,200 35,600 4.95
9 900 6,400 28,400 4.44
10 1,000 5,500 22,000 4.00
11 900 4,500 16,500 3.67
12 800 3,600 12,000 3.33
13 700 2,800 8,400 3.00
14 600 2,100 5,600 2.67
15 500 1,500 3,500 2.33
16 400 1,000 2,000 2.00
17 300 600 1,000 1.67
18 200 300 400 1.33
19 100 100 100 1.00
20 0 0 0 0
Composite and Group Rates
Page 182
In the practical application of the depreciation rate in a large plant, every separate piece
of property is not, of course, considered by itself. The plant is divided into groups of similar
assets, determined roughly on the basis of life expectancy, conditions of service, etc. Using
these groups it is possible to find the rate of composite depreciation—a figure which serves
as a check over the group depreciation. This is also sometimes called the “mean life” of the
plant. It is determined by two methods—one called the direct, the other the dollar-year
method. Assuming groups of assets of varying life lengths and costs, the following examples
show the manner of estimating the amount of depreciation for the whole plant and also
composite life; that is, the mean average life of the individual assets when viewed not as units
but as a composite whole:
Mean Life
Direct Method
Value Amount of
Life in to be Rate of
Group Periodic
Periods [38] Depreciation
Depreciated Depreciation
A 5 $100,000 20 $20,000
B 10 75,000 10 7,500
C 15 60,000 6⅔ 4,000
D 20 120,000 5 6,000
$355,000 $37,500
Mean life is $355,000 ÷ $37,500, or 9⁷/₁₅ periods.
Under the dollar-year method, the invested values are weighted by the length of their
investment term and thus all investments are reduced to the common basis of one dollar for
one year:
Mean Life
Dollar-Year (or Weighted Ratio) Method
Value Turnover Rate Total Investment
Dollar-
Group Life to be in Longest During Longest
Years
Depreciated Life-Period Life-Period
(a) (b) (c) (d)[39] (e) (f)[40]
A 5 $100,000 4 $400,000 $2,000,000
B 10 75,000 2 150,000 1,500,000
of property is not, of course, considered by itself. The plant is divided into groups of similar
assets, determined roughly on the basis of life expectancy, conditions of service, etc. Using
these groups it is possible to find the rate of composite depreciation—a figure which serves
as a check over the group depreciation. This is also sometimes called the “mean life” of the
plant. It is determined by two methods—one called the direct, the other the dollar-year
method. Assuming groups of assets of varying life lengths and costs, the following examples
show the manner of estimating the amount of depreciation for the whole plant and also
composite life; that is, the mean average life of the individual assets when viewed not as units
but as a composite whole:
Mean Life
Direct Method
Value Amount of
Life in to be Rate of
Group Periodic
Periods [38] Depreciation
Depreciated Depreciation
A 5 $100,000 20 $20,000
B 10 75,000 10 7,500
C 15 60,000 6⅔ 4,000
D 20 120,000 5 6,000
$355,000 $37,500
Mean life is $355,000 ÷ $37,500, or 9⁷/₁₅ periods.
Under the dollar-year method, the invested values are weighted by the length of their
investment term and thus all investments are reduced to the common basis of one dollar for
one year:
Mean Life
Dollar-Year (or Weighted Ratio) Method
Value Turnover Rate Total Investment
Dollar-
Group Life to be in Longest During Longest
Years
Depreciated Life-Period Life-Period
(a) (b) (c) (d)[39] (e) (f)[40]
A 5 $100,000 4 $400,000 $2,000,000
B 10 75,000 2 150,000 1,500,000
Page 183
Value Turnover Rate Total Investment
Dollar-
Group Life to be in Longest During Longest
Years
Depreciated Life-Period Life-Period
C 15 60,000 1⅓ 80,000 1,200,000
D 20 120,000 1 120,000 2,400,000
$355,000 $750,000 $7,100,000
Column (f) ÷ column (e), (7,100,000 ÷ 750,000 = 9⁷/₁₅) gives the mean life.
Column (e) ÷ the longest life-period, 20 years, (750,000 ÷ 20 = 37,500) gives
an annual charge for the whole plant.
What is known as “mean” age or plant expectancy as to remaining life may be found
similarly. Assume a physical appraisal made after 12 years’ life of the above assets:
Mean Age (Life Expectancy)
Direct Method
Unexpired or Condition Values to be Values Already
Group Life
Remainder Life % Depreciated Depreciated
(a) (b) (c) (d)[41] (e) (f)
A 5 3 60 $100,000 $40,000
B 10 8 80 75,000 15,000
C 15 3 20 60,000 48,000
D 20 8 40 120,000 72,000
$355,000 $175,000
Group A assets, having been twice renewed, would be in 60% condition; Group
B, 80%; Group C, 20%; and Group D, 40%.
Column (f) ÷ column (e), (175,000 ÷ 355,000 = 49²¹/₇₁%) gives the per cent of
composite depreciation already taken effect.
The mean life, as determined above, multiplied by per cent of composite
depreciation gives the mean age or portion of the mean life already lived (9⁷/₁₅ ×
49²¹/₇₁% = 4⅔).
Dollar-
Group Life to be in Longest During Longest
Years
Depreciated Life-Period Life-Period
C 15 60,000 1⅓ 80,000 1,200,000
D 20 120,000 1 120,000 2,400,000
$355,000 $750,000 $7,100,000
Column (f) ÷ column (e), (7,100,000 ÷ 750,000 = 9⁷/₁₅) gives the mean life.
Column (e) ÷ the longest life-period, 20 years, (750,000 ÷ 20 = 37,500) gives
an annual charge for the whole plant.
What is known as “mean” age or plant expectancy as to remaining life may be found
similarly. Assume a physical appraisal made after 12 years’ life of the above assets:
Mean Age (Life Expectancy)
Direct Method
Unexpired or Condition Values to be Values Already
Group Life
Remainder Life % Depreciated Depreciated
(a) (b) (c) (d)[41] (e) (f)
A 5 3 60 $100,000 $40,000
B 10 8 80 75,000 15,000
C 15 3 20 60,000 48,000
D 20 8 40 120,000 72,000
$355,000 $175,000
Group A assets, having been twice renewed, would be in 60% condition; Group
B, 80%; Group C, 20%; and Group D, 40%.
Column (f) ÷ column (e), (175,000 ÷ 355,000 = 49²¹/₇₁%) gives the per cent of
composite depreciation already taken effect.
The mean life, as determined above, multiplied by per cent of composite
depreciation gives the mean age or portion of the mean life already lived (9⁷/₁₅ ×
49²¹/₇₁% = 4⅔).
Page 184
The figure of mean or composite life may serve two purposes. First, it forms the basis for
comparison with other similar plants and is about the only fair basis for comparison. Second,
it gives the basis for estimating the amount of annual depreciation of the plant as a whole.
This statement does not mean that individual depreciation reserves are not to be carried for
each group of assets and those charged with the value of the asset as soon as it is discarded
and renewed. But the use of the estimated mean or composite life figure does give a control
over the amounts which should always be found in the individual group reserve accounts,
i.e., at any given time the sum of the individual reserve account balances should be
approximately equal to the amount as shown by the reserve when calculated on the mean life
basis.
The Reserve as an Index of Financial Condition
The statement is often made that a balance sheet showing depreciation reserves points to
a conservative policy in the treatment of plant properties. Usually such a balance sheet
affords little or no basis for expressing a judgment as to conservatism or the lack of it. All
that it does show is that recognition is made of the fact of depreciation. As to its adequacy or
inadequacy, a knowledge of other factors is necessary.
Fluctuating Reserve. According to successive balance sheets a reserve may vary little
from year to year, or it may show considerable increase or decrease, and any of these
conditions may be entirely normal and express adequacy of reserve requirements. In the first
case, stability of the reserve may result because the asset is short-lived and hence is more or
less frequently replaced; or different units of the property may have been installed at
somewhat regular intervals so that retirements from service are also somewhat regular. Under
either supposition, the charges against the reserve for the units displaced would just about
keep pace with the regular credits to reserve for replacement purposes. In other words, that
condition of the reserve for that class of asset is the normal condition—except perhaps in the
case of a rapidly expanding plant, or other conditions not counted as normal when the reserve
requirements were put into operation—and any other condition should lead to inquiry and
investigation.
Increasing Reserve. In the second case where the reserve is showing a considerable
increase from year to year, that also may be a normal condition. Long-lived assets are seldom
replaced with any degree of regularity in the annual charge against the reserve, except in the
case of very large plants where the number of such assets is correspondingly large in
proportion to their size. Here more or less regular installations may take place as a result of
an expanding business, covering a period of approximately the same length as that of the life
of the asset. So here, too, any other than a regularly increasing reserve must incite inquiry.
Decreasing Reserve. As to the third case, that of a somewhat regularly decreasing reserve,
the condition is not usually normal but may occasionally be met in a plant where one type of
equipment is being retired and not replaced, due perhaps to a changing line of activity; as
when, for instance, a stock furniture manufacturer works gradually into the exclusive
manufacture of automobile and carriage bodies. Some types of equipment will thus be
gradually retired and their reserves will constantly diminish, their place being taken by other
reserves covering the new type of equipment. However, this condition of decreasing reserves,
while entirely normal under certain circumstances, being unusual, should always receive
comparison with other similar plants and is about the only fair basis for comparison. Second,
it gives the basis for estimating the amount of annual depreciation of the plant as a whole.
This statement does not mean that individual depreciation reserves are not to be carried for
each group of assets and those charged with the value of the asset as soon as it is discarded
and renewed. But the use of the estimated mean or composite life figure does give a control
over the amounts which should always be found in the individual group reserve accounts,
i.e., at any given time the sum of the individual reserve account balances should be
approximately equal to the amount as shown by the reserve when calculated on the mean life
basis.
The Reserve as an Index of Financial Condition
The statement is often made that a balance sheet showing depreciation reserves points to
a conservative policy in the treatment of plant properties. Usually such a balance sheet
affords little or no basis for expressing a judgment as to conservatism or the lack of it. All
that it does show is that recognition is made of the fact of depreciation. As to its adequacy or
inadequacy, a knowledge of other factors is necessary.
Fluctuating Reserve. According to successive balance sheets a reserve may vary little
from year to year, or it may show considerable increase or decrease, and any of these
conditions may be entirely normal and express adequacy of reserve requirements. In the first
case, stability of the reserve may result because the asset is short-lived and hence is more or
less frequently replaced; or different units of the property may have been installed at
somewhat regular intervals so that retirements from service are also somewhat regular. Under
either supposition, the charges against the reserve for the units displaced would just about
keep pace with the regular credits to reserve for replacement purposes. In other words, that
condition of the reserve for that class of asset is the normal condition—except perhaps in the
case of a rapidly expanding plant, or other conditions not counted as normal when the reserve
requirements were put into operation—and any other condition should lead to inquiry and
investigation.
Increasing Reserve. In the second case where the reserve is showing a considerable
increase from year to year, that also may be a normal condition. Long-lived assets are seldom
replaced with any degree of regularity in the annual charge against the reserve, except in the
case of very large plants where the number of such assets is correspondingly large in
proportion to their size. Here more or less regular installations may take place as a result of
an expanding business, covering a period of approximately the same length as that of the life
of the asset. So here, too, any other than a regularly increasing reserve must incite inquiry.
Decreasing Reserve. As to the third case, that of a somewhat regularly decreasing reserve,
the condition is not usually normal but may occasionally be met in a plant where one type of
equipment is being retired and not replaced, due perhaps to a changing line of activity; as
when, for instance, a stock furniture manufacturer works gradually into the exclusive
manufacture of automobile and carriage bodies. Some types of equipment will thus be
gradually retired and their reserves will constantly diminish, their place being taken by other
reserves covering the new type of equipment. However, this condition of decreasing reserves,
while entirely normal under certain circumstances, being unusual, should always receive
Page 185
careful investigation. It is here that mean life and mean age or composite plant depreciation
are of assistance in forming a judgment as to the general adequacy of reserves.
The Reserve in Relation to Expanding Plant
In the case of a plant the development of which is stationary, the problem of judging the
adequacy of the reserves is simple in comparison with a plant which is expanding, resulting
not only in the installation of more of the same kind of equipment but also of equipment of
other kinds. A disturbing element is thus introduced and careful oversight of the depreciation
policy must be exercised. In all cases, intelligent reading of the reserve and its sufficiency are
internal problems based on intimate knowledge of conditions. Lacking this knowledge no
true judgment can be made. The character of the asset, number of units in use, dates of
installation, a comparison of the assumed conditions at date of installation with the actual
conditions of the present—all are factors to be taken into account.
Reserve as Related to Efficiency
The general relation of efficiency to depreciation has already been discussed. As to
whether the condition of the reserve is any index of the efficiency of the service rendered by
the plant unit, attention is briefly directed to a misinterpretation of individual reserves.
Experts state that many types of equipment cannot deteriorate actually more than a fixed per
cent of their cost and continue to give efficient service. If, say, 30% is the limit in the case of
one type, this does not, of course, indicate that, as soon as the depreciation reserve shows an
amount equal to 30% of the cost, the approach of inefficient operation and the time of discard
are at hand. It must be borne in mind that the reserve is a device based on financial
considerations and, if properly calculated and handled, no asset should be ready for
retirement until its reserve approaches in amount the value at which the asset is carried in its
account. Nor is the point of approaching inefficiency shown until that condition of the
reserve is found.
Reserve not Based on Cost of Replacement
The question is sometimes raised as to whether reserve requirements should be based on
original cost or cost of replacement new. The question usually reveals a lack of understanding
both of the purpose of the depreciation charge and the means of financing depreciation. It is
usually said that the reserves carried on the books are for the purpose of providing the means
of financing the replacement. It is not the purpose here to go into the question of original cost
versus cost of reproduction new, either as a basis for valuation of public utility properties or
from the viewpoint as to where the incidence of the burden of replacement properly should
rest—whether on the users of the service given by the asset to be replaced or on those using
the new asset. In the private enterprise where the rights of the public are not so apparent,
under present-day tenets of political and economic philosophy, only internal policies and
purposes to be accomplished need be considered.
As stated above, the basic purpose of the creation of the reserve is to burden the product
with depreciation charge as a real part of the cost of production. If we are concerned with real
and actual costs of production, by no stretch of the imagination can replacement cost—what
it might cost to replace the asset at some more or less distant time—enter into the question. It
might, with equal obscurity of logic, be said that, because the labor cost is bound to be higher
are of assistance in forming a judgment as to the general adequacy of reserves.
The Reserve in Relation to Expanding Plant
In the case of a plant the development of which is stationary, the problem of judging the
adequacy of the reserves is simple in comparison with a plant which is expanding, resulting
not only in the installation of more of the same kind of equipment but also of equipment of
other kinds. A disturbing element is thus introduced and careful oversight of the depreciation
policy must be exercised. In all cases, intelligent reading of the reserve and its sufficiency are
internal problems based on intimate knowledge of conditions. Lacking this knowledge no
true judgment can be made. The character of the asset, number of units in use, dates of
installation, a comparison of the assumed conditions at date of installation with the actual
conditions of the present—all are factors to be taken into account.
Reserve as Related to Efficiency
The general relation of efficiency to depreciation has already been discussed. As to
whether the condition of the reserve is any index of the efficiency of the service rendered by
the plant unit, attention is briefly directed to a misinterpretation of individual reserves.
Experts state that many types of equipment cannot deteriorate actually more than a fixed per
cent of their cost and continue to give efficient service. If, say, 30% is the limit in the case of
one type, this does not, of course, indicate that, as soon as the depreciation reserve shows an
amount equal to 30% of the cost, the approach of inefficient operation and the time of discard
are at hand. It must be borne in mind that the reserve is a device based on financial
considerations and, if properly calculated and handled, no asset should be ready for
retirement until its reserve approaches in amount the value at which the asset is carried in its
account. Nor is the point of approaching inefficiency shown until that condition of the
reserve is found.
Reserve not Based on Cost of Replacement
The question is sometimes raised as to whether reserve requirements should be based on
original cost or cost of replacement new. The question usually reveals a lack of understanding
both of the purpose of the depreciation charge and the means of financing depreciation. It is
usually said that the reserves carried on the books are for the purpose of providing the means
of financing the replacement. It is not the purpose here to go into the question of original cost
versus cost of reproduction new, either as a basis for valuation of public utility properties or
from the viewpoint as to where the incidence of the burden of replacement properly should
rest—whether on the users of the service given by the asset to be replaced or on those using
the new asset. In the private enterprise where the rights of the public are not so apparent,
under present-day tenets of political and economic philosophy, only internal policies and
purposes to be accomplished need be considered.
As stated above, the basic purpose of the creation of the reserve is to burden the product
with depreciation charge as a real part of the cost of production. If we are concerned with real
and actual costs of production, by no stretch of the imagination can replacement cost—what
it might cost to replace the asset at some more or less distant time—enter into the question. It
might, with equal obscurity of logic, be said that, because the labor cost is bound to be higher
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10 years from now than at present, in order to get the true present cost of the product the
estimated future labor cost should be taken in place of the actual present cost.
The Financing of Replacements
If one purpose of the depreciation reserve is that of financing depreciation, this can mean
only that the reserve must insure provision being made so that the capital invested will not be
lessened or encroached upon by the wasting of the assets in which it is invested. It is no
necessary or proper purpose of the reserve to provide for increasing the invested capital.
Financing the replacement of the retired asset is a separate financial problem and only
concerns accountancy, so far as the records may reflect that policy. The reserve, in itself, does
not furnish the means of financing any part of replacement, as was fully shown above. If the
new asset is expected to cost more than the old, certainly business prudence would dictate
provision for the added cost as well as ready funds of an amount equal to the original cost.
The actual capital provided originally need be sufficient only for the time being; to provide
more than that, if remaining idle, would be folly. If there is evidence of expansion, or if it is
recognized that more will be needed—due to change in markets—for replacement purposes
than was originally needed at the inception of the enterprise, provision must be made
therefor.
Methods of Financing Replacements. In the financing of replacements, three courses are
open:
1. Capital stock may be increased.
2. Funds may be borrowed.
3. Profits of the past may be reserved in the business and the actual
value of the holdings of the owners thus be enhanced.
In the third case present dividends may be sacrificed for the sake of the future. Such
reserve profits must be kept and used for the intended purpose, the purpose dictating their
form as liquid or fixed. It cannot be too strongly emphasized that these are reserves of profits
—not valuation or offset accounts under the title of reserves. Depreciation reserves, except
they become secret reserves in the sense referred to below, have no right to serve any other
purpose than that intended, viz., to provide insurance that none of the originally invested
capital shall be dissipated and that the current product shall be burdened with its just share of
all the materials and costs of production.
Secret Reserve
A great deal has been said about inaccuracies in the depreciation charge; the need of
periodic readjustments has been emphasized. Now it is purposed to look into the effects of
inaccurate charges remaining unadjusted on the books. In a desire to be on the safe side,
some concerns, notably financial institutions, make very liberal provision for depreciation.
Such a policy is not entirely to be condemned and is decidedly refreshing in comparison with
the parsimonious allowances, begrudgingly made in some quarters. The effect of such a
policy, if operated without check, is to create what is known as a “secret reserve.” The value
of the asset is charged more rapidly against operation than the asset actually wastes. Hence
the books show a reserve sufficient to cover the cost of asset while there are still values
estimated future labor cost should be taken in place of the actual present cost.
The Financing of Replacements
If one purpose of the depreciation reserve is that of financing depreciation, this can mean
only that the reserve must insure provision being made so that the capital invested will not be
lessened or encroached upon by the wasting of the assets in which it is invested. It is no
necessary or proper purpose of the reserve to provide for increasing the invested capital.
Financing the replacement of the retired asset is a separate financial problem and only
concerns accountancy, so far as the records may reflect that policy. The reserve, in itself, does
not furnish the means of financing any part of replacement, as was fully shown above. If the
new asset is expected to cost more than the old, certainly business prudence would dictate
provision for the added cost as well as ready funds of an amount equal to the original cost.
The actual capital provided originally need be sufficient only for the time being; to provide
more than that, if remaining idle, would be folly. If there is evidence of expansion, or if it is
recognized that more will be needed—due to change in markets—for replacement purposes
than was originally needed at the inception of the enterprise, provision must be made
therefor.
Methods of Financing Replacements. In the financing of replacements, three courses are
open:
1. Capital stock may be increased.
2. Funds may be borrowed.
3. Profits of the past may be reserved in the business and the actual
value of the holdings of the owners thus be enhanced.
In the third case present dividends may be sacrificed for the sake of the future. Such
reserve profits must be kept and used for the intended purpose, the purpose dictating their
form as liquid or fixed. It cannot be too strongly emphasized that these are reserves of profits
—not valuation or offset accounts under the title of reserves. Depreciation reserves, except
they become secret reserves in the sense referred to below, have no right to serve any other
purpose than that intended, viz., to provide insurance that none of the originally invested
capital shall be dissipated and that the current product shall be burdened with its just share of
all the materials and costs of production.
Secret Reserve
A great deal has been said about inaccuracies in the depreciation charge; the need of
periodic readjustments has been emphasized. Now it is purposed to look into the effects of
inaccurate charges remaining unadjusted on the books. In a desire to be on the safe side,
some concerns, notably financial institutions, make very liberal provision for depreciation.
Such a policy is not entirely to be condemned and is decidedly refreshing in comparison with
the parsimonious allowances, begrudgingly made in some quarters. The effect of such a
policy, if operated without check, is to create what is known as a “secret reserve.” The value
of the asset is charged more rapidly against operation than the asset actually wastes. Hence
the books show a reserve sufficient to cover the cost of asset while there are still values
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remaining in the asset. In other words, the business possesses an asset of value which is
carried on the books as of no value. Were the real present value of the asset brought on the
books, the contra credit would appear in some surplus or profits reserved account. Such
would constitute a true record of the item, openly stated. So long as the asset remains
concealed, i.e., without record on the books, its contra credit is also latent and constitutes a
secret reserve of profits.
A too liberal depreciation policy, if recognized and adjusted at the time of a reappraisal,
will require a separation from the depreciation reserve of the portion brought about by the
overallowance, and its showing as a part of the surplus. When so handled, an overcharge for
depreciation has no permanently bad effect except as it may show, for purposes of
comparison, too high costs of production for the period overburdened. However it may be
and sometimes is, used for purposes of fraud and therefore, as a fixed policy, the practice of
the secret reserve is to be condemned.
Insufficient Charge
On the other side is the parsimonious policy of too low a charge or none at all. This
results, whether consciously or not, in a charge against capital instead of revenue. At the
close of the fiscal period the books are supposed to be brought into accord with the facts of
true condition as then existing. Therefore, if the full portion of the accrued expenses is not
separated from the wasting asset accounts, but is allowed to stand on the books under the title
of assets, then these true expense items will still be carried hidden under the cloak of asset
titles. The depreciation is thus carried as a charge against capital. The depreciation of a going
concern should never be so treated; it is an operating charge, and no flight of fancy or
shuffling of figures can make anything else of it.
In the case of a property, showing inflated values because of too low depreciation charges
in the past, which is taken over and rehabilitated, the sums spent on the property previous to
operation to put it in condition are properly capital charges. This is allowed on the theory—
unfortunately, not always a fact—that the difference between the book value of the property
and what was paid for it represents the estimated expenditures necessary to bring the property
up to its book value. If such is not the case and full book value was given for the property, the
charge is still allowed, being looked upon as in the nature of an organization expense,
representing in an instance of this sort the measure of the bad bargain made. This will, of
course, result in a penalty in the form of an added depreciation burden on all product from
the property taken over and rehabilitated.
Appreciation as an Offset to Depreciation
If depreciation is so inevitable and the necessity of its charge so absolute, can anything be
said in support of the proposal to offset depreciation against appreciation? By appreciation is
meant an increase in value due to the passing of time. Judicial authority can be found in
support of it in cases of valuation for rate purposes.[42] There is no question but that a
realized increment in land or any other asset offsets a depreciation or any other expense
charge in just the same way that any other item of income offsets an expense. There is,
however, this marked difference between depreciation and appreciation: the former is an
carried on the books as of no value. Were the real present value of the asset brought on the
books, the contra credit would appear in some surplus or profits reserved account. Such
would constitute a true record of the item, openly stated. So long as the asset remains
concealed, i.e., without record on the books, its contra credit is also latent and constitutes a
secret reserve of profits.
A too liberal depreciation policy, if recognized and adjusted at the time of a reappraisal,
will require a separation from the depreciation reserve of the portion brought about by the
overallowance, and its showing as a part of the surplus. When so handled, an overcharge for
depreciation has no permanently bad effect except as it may show, for purposes of
comparison, too high costs of production for the period overburdened. However it may be
and sometimes is, used for purposes of fraud and therefore, as a fixed policy, the practice of
the secret reserve is to be condemned.
Insufficient Charge
On the other side is the parsimonious policy of too low a charge or none at all. This
results, whether consciously or not, in a charge against capital instead of revenue. At the
close of the fiscal period the books are supposed to be brought into accord with the facts of
true condition as then existing. Therefore, if the full portion of the accrued expenses is not
separated from the wasting asset accounts, but is allowed to stand on the books under the title
of assets, then these true expense items will still be carried hidden under the cloak of asset
titles. The depreciation is thus carried as a charge against capital. The depreciation of a going
concern should never be so treated; it is an operating charge, and no flight of fancy or
shuffling of figures can make anything else of it.
In the case of a property, showing inflated values because of too low depreciation charges
in the past, which is taken over and rehabilitated, the sums spent on the property previous to
operation to put it in condition are properly capital charges. This is allowed on the theory—
unfortunately, not always a fact—that the difference between the book value of the property
and what was paid for it represents the estimated expenditures necessary to bring the property
up to its book value. If such is not the case and full book value was given for the property, the
charge is still allowed, being looked upon as in the nature of an organization expense,
representing in an instance of this sort the measure of the bad bargain made. This will, of
course, result in a penalty in the form of an added depreciation burden on all product from
the property taken over and rehabilitated.
Appreciation as an Offset to Depreciation
If depreciation is so inevitable and the necessity of its charge so absolute, can anything be
said in support of the proposal to offset depreciation against appreciation? By appreciation is
meant an increase in value due to the passing of time. Judicial authority can be found in
support of it in cases of valuation for rate purposes.[42] There is no question but that a
realized increment in land or any other asset offsets a depreciation or any other expense
charge in just the same way that any other item of income offsets an expense. There is,
however, this marked difference between depreciation and appreciation: the former is an
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inexorable reality advancing day by day entirely independent of market fluctuations, whereas
the latter is dependent on the market and usually cannot be realized until the asset is sold.
When, however, as is too often the case, the proposal to offset depreciation by
appreciation is meant to justify a policy which takes no cognizance of depreciation on the
books because it is offset by appreciation, no support can be found for that view. In itself it
reveals an entire lack of knowledge of the purpose of the depreciation charge or a disregard
of the fundamental and obvious requirements of prudence. Depreciation is one of the costs of
production and without it true cost cannot be shown. Failure to show depreciation on the
books would justify also the omission of a cash income item because the cash was to be spent
immediately in payment of salaries—a cancellation outside the business records of income
against expense which can under no circumstances be justified.
Appreciation Due to Physical Changes
There is a kind of appreciation which is not dependent on fluctuations of the market and
which as surely accrues, up to a certain point, day by day as does depreciation. Properties the
value of which has been enhanced by earth construction work done on them are susceptible
of this kind of appreciation. “Appreciation is generally restricted to physical items, and
measures their gain in value due to age, use, and properly directed labor.... It results from
work not specifically charged to capital account ... and covers items not represented ... in
connection with a valuation.”[43] It is found in connection with such items as roadbeds,
solidification and grassing of slopes, drainage, dams, embankments, etc.
Its two forms are called solidification and seasoning, and adaptation. By the first is meant
a settling and compacting of loose earth and its protection from wasting and washing away,
as by the grassing of slopes, and the planting of trees and shrubs to hold the snows. When a
roadbed is turned over to the operating division, it frequently is far from complete in the
sense of being in a high state of efficiency, and the cost of its maintenance and up-keep
during the early years of its life is much higher than during later years. This appreciation due
to seasoning is difficult of valuation, but perhaps the difference in up-keep between early and
later years is the best measure of it.
Appreciation Due to Adaptation to Use
“Adaptation” is a term used to cover that class of expenditures needed for the better
adaptation of the property to its use. In the early stages of the development of a property
many things cannot be foreseen nor can a proper basis be settled upon for a determination of
the charges as between capital and revenue. The proper handling of such expenditures as
those incurred for drainage requirements, better adaptation of the roadway to the surrounding
topography of the country, etc., are difficult. If these costs have not originally been charged
against capital, the properties may truly be said to have appreciated in value by reason of
them. Items of this kind require a wise discrimination between costs of operation and capital
charges. The effect of such changes is almost always lost sight of so far as physical
appearance shows, and the appreciation due to them is difficult of valuation at a later time. In
the case of railroads, perhaps the difference in maintenance cost as between the early and
later years of the roadbed is the best index.
the latter is dependent on the market and usually cannot be realized until the asset is sold.
When, however, as is too often the case, the proposal to offset depreciation by
appreciation is meant to justify a policy which takes no cognizance of depreciation on the
books because it is offset by appreciation, no support can be found for that view. In itself it
reveals an entire lack of knowledge of the purpose of the depreciation charge or a disregard
of the fundamental and obvious requirements of prudence. Depreciation is one of the costs of
production and without it true cost cannot be shown. Failure to show depreciation on the
books would justify also the omission of a cash income item because the cash was to be spent
immediately in payment of salaries—a cancellation outside the business records of income
against expense which can under no circumstances be justified.
Appreciation Due to Physical Changes
There is a kind of appreciation which is not dependent on fluctuations of the market and
which as surely accrues, up to a certain point, day by day as does depreciation. Properties the
value of which has been enhanced by earth construction work done on them are susceptible
of this kind of appreciation. “Appreciation is generally restricted to physical items, and
measures their gain in value due to age, use, and properly directed labor.... It results from
work not specifically charged to capital account ... and covers items not represented ... in
connection with a valuation.”[43] It is found in connection with such items as roadbeds,
solidification and grassing of slopes, drainage, dams, embankments, etc.
Its two forms are called solidification and seasoning, and adaptation. By the first is meant
a settling and compacting of loose earth and its protection from wasting and washing away,
as by the grassing of slopes, and the planting of trees and shrubs to hold the snows. When a
roadbed is turned over to the operating division, it frequently is far from complete in the
sense of being in a high state of efficiency, and the cost of its maintenance and up-keep
during the early years of its life is much higher than during later years. This appreciation due
to seasoning is difficult of valuation, but perhaps the difference in up-keep between early and
later years is the best measure of it.
Appreciation Due to Adaptation to Use
“Adaptation” is a term used to cover that class of expenditures needed for the better
adaptation of the property to its use. In the early stages of the development of a property
many things cannot be foreseen nor can a proper basis be settled upon for a determination of
the charges as between capital and revenue. The proper handling of such expenditures as
those incurred for drainage requirements, better adaptation of the roadway to the surrounding
topography of the country, etc., are difficult. If these costs have not originally been charged
against capital, the properties may truly be said to have appreciated in value by reason of
them. Items of this kind require a wise discrimination between costs of operation and capital
charges. The effect of such changes is almost always lost sight of so far as physical
appearance shows, and the appreciation due to them is difficult of valuation at a later time. In
the case of railroads, perhaps the difference in maintenance cost as between the early and
later years of the roadbed is the best index.
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In the case of industrial concerns, the cost of a rearrangement of machinery and working
facilities for the better and more economical handling of the product frequently results in an
appreciation in value due to adaptation to use. This has already been discussed in Chapter V.
As stated above, appreciation has judicial sanction and its valuation, although fraught
with many difficulties and uncertainties, has been made and the results accepted. The
generally haphazard method of roughly estimating the value of an appreciation when its
determination becomes necessary suggests that it were better, by far, to attempt the proper
segregation of the charge between capital and revenue at the time of its incurrence, rather
than to take cognizance of an appreciation in value at a later time. There are undoubtedly
circumstances in which appreciation in value can be properly recognized and should be taken
into the accounts not only of public utility properties but also of industrial concerns.
Unearned Increment
Appreciation in value due to so-called unearned increment is entirely a matter of market
value. By this is not meant that the monetary value of this kind of appreciation fluctuates
with the market; it accrues from day to day and is just as real as depreciation. Although very
real, it does not become realized until the property is disposed of, a thing which is determined
by business policy and does not rest on any principles of accountancy. It is not good practice
to bring such unrealized values on the books. For a fuller consideration of this phase of the
subject, see Chapter XVII where the problem is treated in connection with land and real
estate.
Depreciation Policy and Stockholders
A final consideration concerns the relation of the depreciation policy to the stockholder.
As stated above, a too liberal depreciation policy results in the creation of secret reserves
which may be used to the prejudice of the stockholder by an unscrupulous managing clique
desirous of buying minority holdings at a depreciated value or of manipulating the stock for
speculative purposes. An insufficient depreciation allowance results in a false optimism, a
payment of dividends out of capital, and perhaps finally in a wrecking of the property. Except
for the transient, speculative shareholder, a fixed depreciation policy based on a
conservatively accurate allowance is always for the best interest of the property and its
owners.
facilities for the better and more economical handling of the product frequently results in an
appreciation in value due to adaptation to use. This has already been discussed in Chapter V.
As stated above, appreciation has judicial sanction and its valuation, although fraught
with many difficulties and uncertainties, has been made and the results accepted. The
generally haphazard method of roughly estimating the value of an appreciation when its
determination becomes necessary suggests that it were better, by far, to attempt the proper
segregation of the charge between capital and revenue at the time of its incurrence, rather
than to take cognizance of an appreciation in value at a later time. There are undoubtedly
circumstances in which appreciation in value can be properly recognized and should be taken
into the accounts not only of public utility properties but also of industrial concerns.
Unearned Increment
Appreciation in value due to so-called unearned increment is entirely a matter of market
value. By this is not meant that the monetary value of this kind of appreciation fluctuates
with the market; it accrues from day to day and is just as real as depreciation. Although very
real, it does not become realized until the property is disposed of, a thing which is determined
by business policy and does not rest on any principles of accountancy. It is not good practice
to bring such unrealized values on the books. For a fuller consideration of this phase of the
subject, see Chapter XVII where the problem is treated in connection with land and real
estate.
Depreciation Policy and Stockholders
A final consideration concerns the relation of the depreciation policy to the stockholder.
As stated above, a too liberal depreciation policy results in the creation of secret reserves
which may be used to the prejudice of the stockholder by an unscrupulous managing clique
desirous of buying minority holdings at a depreciated value or of manipulating the stock for
speculative purposes. An insufficient depreciation allowance results in a false optimism, a
payment of dividends out of capital, and perhaps finally in a wrecking of the property. Except
for the transient, speculative shareholder, a fixed depreciation policy based on a
conservatively accurate allowance is always for the best interest of the property and its
owners.
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CHAPTER XII
CASH AND MERCANTILE CREDITS
Introduction
In Chapter V an effort was made to establish the general principles of
valuation as applicable to the main classes of assets found on the average
balance sheet. In doing so, the fundamental distinctions between capital and
revenue charges were set forth. In the six chapters on depreciation the
general principles of depreciation and their application to problems in
accounting have been developed, with particular emphasis on the problems
of valuation and true costs. It is purposed now to consider in detail the
various problems met in the valuation of the individual items found on the
commercial balance sheet. It will be necessary also to consider the method
of showing these items so as to indicate the basis of valuation and
something of the financial policy employed. The various assets will be
considered in the order of their appearance on the balance sheet, the
arrangement being based on degree of liquidity, beginning with the most
liquid.
What Cash Includes
There is little to be said about the valuation of an asset of such evident
and definite value as cash. The problem here is rather one of showing the
nature of the asset, although certain principles of valuation under given
conditions need also to be considered.
The term cash as an item in the balance sheet usually includes all money
and whatever serves as money. Thus, all legal tender of the realm, bank
notes, checks, bankers’ drafts, postal and express money orders, and
occasionally postage stamps and even “IOU’s” are classed as cash. Not all
items, however, that may be carried on the books as cash should appear
under this caption on the balance sheet. There only the current asset cash
should be listed in the group of current assets. All other cash, including that
held for specific purposes under deed of trust or otherwise, should, unless it
CASH AND MERCANTILE CREDITS
Introduction
In Chapter V an effort was made to establish the general principles of
valuation as applicable to the main classes of assets found on the average
balance sheet. In doing so, the fundamental distinctions between capital and
revenue charges were set forth. In the six chapters on depreciation the
general principles of depreciation and their application to problems in
accounting have been developed, with particular emphasis on the problems
of valuation and true costs. It is purposed now to consider in detail the
various problems met in the valuation of the individual items found on the
commercial balance sheet. It will be necessary also to consider the method
of showing these items so as to indicate the basis of valuation and
something of the financial policy employed. The various assets will be
considered in the order of their appearance on the balance sheet, the
arrangement being based on degree of liquidity, beginning with the most
liquid.
What Cash Includes
There is little to be said about the valuation of an asset of such evident
and definite value as cash. The problem here is rather one of showing the
nature of the asset, although certain principles of valuation under given
conditions need also to be considered.
The term cash as an item in the balance sheet usually includes all money
and whatever serves as money. Thus, all legal tender of the realm, bank
notes, checks, bankers’ drafts, postal and express money orders, and
occasionally postage stamps and even “IOU’s” are classed as cash. Not all
items, however, that may be carried on the books as cash should appear
under this caption on the balance sheet. There only the current asset cash
should be listed in the group of current assets. All other cash, including that
held for specific purposes under deed of trust or otherwise, should, unless it
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is readily applicable for the cancellation of current liabilities, be shown in
some other group.
Where the petty cash or working funds of all sorts are operated on the
imprest system, the funds should be replenished before the books are closed
and should thus be truly valued at their ledger figures. The bank account
should be reconciled with the cash book, and the figure should represent the
amount at which the item is to be taken into the balance sheet. This means,
of course, that all properly authorized claims against cash in bank are to be
treated as cash disbursed if they have been regularly issued, whether
presented for redemption at the bank or not. Checks written but not yet
mailed are not usually treated as cash disbursed because they are still under
control. Similarly, items left at the bank for collection and deposit may be
counted as cash on hand. If, however, as might happen in exceptional cases,
a comparatively large amount represented dishonored items and a second
attempt was being made to collect these dishonored items, the better
procedure would be to omit them from the cash total and include them with
the receivable items. In this connection attention should be called to the
practice occasionally met with of holding the cash open for a few days after
the closing date for the purpose of making a better showing as to balance on
hand by means of new collections. This, of course, is a practice which
cannot be countenanced under any circumstances as it is simply an effort to
mislead, even though the effect may not always be bad. A balance sheet is a
statement of financial condition purporting to be true as on a certain named
date. The values shown therein are therefore to be those applicable to, and
true on, that date and no other.
Stamps Remitted as Cash
Some concerns dealing in commodities of small value sold through the
mails allow, and even encourage, payment by means of postage stamps,
these in turn being used for their own correspondence and parcels post
expense. The proper place to record the value of this item at the close of the
fiscal period is in the inventory of office supplies or other similar heading
instead of treating it as a part of the cash. This necessitates a transfer from
cash to office supplies. The transfer can be accomplished in either of two
ways without interfering with the usual handling of the cash whereby it is
checked against the bank’s record of deposits and checks as explained in
some other group.
Where the petty cash or working funds of all sorts are operated on the
imprest system, the funds should be replenished before the books are closed
and should thus be truly valued at their ledger figures. The bank account
should be reconciled with the cash book, and the figure should represent the
amount at which the item is to be taken into the balance sheet. This means,
of course, that all properly authorized claims against cash in bank are to be
treated as cash disbursed if they have been regularly issued, whether
presented for redemption at the bank or not. Checks written but not yet
mailed are not usually treated as cash disbursed because they are still under
control. Similarly, items left at the bank for collection and deposit may be
counted as cash on hand. If, however, as might happen in exceptional cases,
a comparatively large amount represented dishonored items and a second
attempt was being made to collect these dishonored items, the better
procedure would be to omit them from the cash total and include them with
the receivable items. In this connection attention should be called to the
practice occasionally met with of holding the cash open for a few days after
the closing date for the purpose of making a better showing as to balance on
hand by means of new collections. This, of course, is a practice which
cannot be countenanced under any circumstances as it is simply an effort to
mislead, even though the effect may not always be bad. A balance sheet is a
statement of financial condition purporting to be true as on a certain named
date. The values shown therein are therefore to be those applicable to, and
true on, that date and no other.
Stamps Remitted as Cash
Some concerns dealing in commodities of small value sold through the
mails allow, and even encourage, payment by means of postage stamps,
these in turn being used for their own correspondence and parcels post
expense. The proper place to record the value of this item at the close of the
fiscal period is in the inventory of office supplies or other similar heading
instead of treating it as a part of the cash. This necessitates a transfer from
cash to office supplies. The transfer can be accomplished in either of two
ways without interfering with the usual handling of the cash whereby it is
checked against the bank’s record of deposits and checks as explained in
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Volume I, Chapter XXXV. The customary method is to use the cash book as
the place of record for the receipt of stamps and then transfer them to the
stamp drawer for office use. All other “cash” being deposited in the bank,
the record of cash receipts as shown by the cash book does not thus check
against the record of deposits as shown by the bank. To secure this
agreement, a check may be made out payable to “Cash,” “Ourselves,” or
“Postage,” and passed through the bank periodically as a deposit and so
secure the proper agreement between the bank’s record and the concern’s.
The record of the check among the cash disbursements thus secures the
proper charge to Postage or Office Supplies and also effects the proper
agreement between the bank’s record and the concern’s. The use of a
“postage” journal, operated on the same lines as the cash book and
recording all receipts and disbursements of postage, would accomplish the
same purpose and in some circumstances would be advisable.
Temporary Cash Disbursements
The practice of allowing proprietor, cashier, or others to take cash from
the cash drawer and leave a memo of some sort to show responsibility or
purpose is to be deprecated. Only where the principle is strictly adhered to
of depositing all cash and disbursing only by check and by means of a petty
cash fund handled under the imprest method, can adequate control over
cash even be approximated. Where, however, such is not the practice, the
problem is not that of the valuation of cash, for the memos are not cash, but
of the valuation of claims receivable—a subject to be treated later in this
chapter.
Disposition of Cash Funds
In the showing of cash for purposes of management, it is essential to
indicate the present disposition made of the various cash funds or to show
the immediacy of the control over them. Thus cash should be listed as:
1. Safe or drawer
2. Various working funds
3. Petty cash fund
4. Bank
the place of record for the receipt of stamps and then transfer them to the
stamp drawer for office use. All other “cash” being deposited in the bank,
the record of cash receipts as shown by the cash book does not thus check
against the record of deposits as shown by the bank. To secure this
agreement, a check may be made out payable to “Cash,” “Ourselves,” or
“Postage,” and passed through the bank periodically as a deposit and so
secure the proper agreement between the bank’s record and the concern’s.
The record of the check among the cash disbursements thus secures the
proper charge to Postage or Office Supplies and also effects the proper
agreement between the bank’s record and the concern’s. The use of a
“postage” journal, operated on the same lines as the cash book and
recording all receipts and disbursements of postage, would accomplish the
same purpose and in some circumstances would be advisable.
Temporary Cash Disbursements
The practice of allowing proprietor, cashier, or others to take cash from
the cash drawer and leave a memo of some sort to show responsibility or
purpose is to be deprecated. Only where the principle is strictly adhered to
of depositing all cash and disbursing only by check and by means of a petty
cash fund handled under the imprest method, can adequate control over
cash even be approximated. Where, however, such is not the practice, the
problem is not that of the valuation of cash, for the memos are not cash, but
of the valuation of claims receivable—a subject to be treated later in this
chapter.
Disposition of Cash Funds
In the showing of cash for purposes of management, it is essential to
indicate the present disposition made of the various cash funds or to show
the immediacy of the control over them. Thus cash should be listed as:
1. Safe or drawer
2. Various working funds
3. Petty cash fund
4. Bank
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Under “Bank” should be indicated how much is held on “current”
account and how much is restricted to special purposes. Of the current
balance it is desirable to show the portion subject to check for immediate
needs and the portion representing surplus funds not immediately needed
and therefore held to earn interest. These amounts subject to interest are
almost always available on short notice, but usually only with the sacrifice
of interest earnings to date.
Cash from the sale of capital stock or bond issues, or from the sale of
old plant or any portion of it, under authorization from the stockholders that
it be held for purchase or construction of new plant, or for other capital
purposes, comprises that held for specific purposes. Sometimes even cash
in the sinking funds might be included in the list. As it is usually of
importance to keep the management informed as to the amounts of cash
available for the various purposes stated above, an effort should be made to
give this information, without too much detail, in the balance sheet if it is
drawn up for internal use.
Cash Held Abroad
There remains to consider moneys held in a foreign branch and thus
subject to fluctuations of exchange. In Chapter XXXI, where the subject of
the foreign branch is treated, a full discussion of the problem of exchange in
its relation to the accounting records will be given. Here it is sufficient to
say that as between countries where exchange rates vary little, the general
practice is to use an arbitrary conversion figure for incorporating the results
of the foreign branch with those of the head office. This conversion figure
applies to cash as well as to all other items. The use of such an arbitrary
basis will give substantially correct results under the conditions named.
The assets of the foreign branch are the properties, usually and for the
most part, of proprietors and stockholders residing in the country of the
home office, who are concerned merely with the distribution of the earnings
of the foreign branch. Profits are made in one currency to be distributed as
dividends in another currency. Hence, the rate of exchange prevailing at the
time of closing the books would usually give the most accurate results and
should, of course, be used when exchange is not fairly stable between the
two countries. It may even be conservative and advisable to set up a reserve
for fluctuations in exchange, with the object of absorbing what might
account and how much is restricted to special purposes. Of the current
balance it is desirable to show the portion subject to check for immediate
needs and the portion representing surplus funds not immediately needed
and therefore held to earn interest. These amounts subject to interest are
almost always available on short notice, but usually only with the sacrifice
of interest earnings to date.
Cash from the sale of capital stock or bond issues, or from the sale of
old plant or any portion of it, under authorization from the stockholders that
it be held for purchase or construction of new plant, or for other capital
purposes, comprises that held for specific purposes. Sometimes even cash
in the sinking funds might be included in the list. As it is usually of
importance to keep the management informed as to the amounts of cash
available for the various purposes stated above, an effort should be made to
give this information, without too much detail, in the balance sheet if it is
drawn up for internal use.
Cash Held Abroad
There remains to consider moneys held in a foreign branch and thus
subject to fluctuations of exchange. In Chapter XXXI, where the subject of
the foreign branch is treated, a full discussion of the problem of exchange in
its relation to the accounting records will be given. Here it is sufficient to
say that as between countries where exchange rates vary little, the general
practice is to use an arbitrary conversion figure for incorporating the results
of the foreign branch with those of the head office. This conversion figure
applies to cash as well as to all other items. The use of such an arbitrary
basis will give substantially correct results under the conditions named.
The assets of the foreign branch are the properties, usually and for the
most part, of proprietors and stockholders residing in the country of the
home office, who are concerned merely with the distribution of the earnings
of the foreign branch. Profits are made in one currency to be distributed as
dividends in another currency. Hence, the rate of exchange prevailing at the
time of closing the books would usually give the most accurate results and
should, of course, be used when exchange is not fairly stable between the
two countries. It may even be conservative and advisable to set up a reserve
for fluctuations in exchange, with the object of absorbing what might
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otherwise be too great a charge or credit to the current period’s profit and
loss if a particularly unfavorable or favorable rate were prevailing on the
date of conversion.
Accounts and Notes Receivable
In the valuation of accounts and notes receivable the problem is largely
one of appraising the uncollectible items. The book account and note are
intermediate stages in the conversion of merchandise into cash. Were they
always worth their face value there would usually be no problem in their
valuation except for the element of theoretical interest which is not
commonly taken into account by commercial enterprises. In considering
this problem of valuation, the question of the correct use of terms arises.
For the sake of clearness, when showing the items on the balance sheet,
attention will be first directed to this latter phase of the subject.
Objection to the Title, Accounts Receivable
The governing principle here is that only current items can be included
in this group of assets when shown on the balance sheet. In accounting, as
in economics, there is no distinctive scientific terminology. The economist
makes use, for the most part, of every-day words and phrases. These are
often open to misunderstanding and are sometimes capable of being used
even for wilful misrepresentation. Recognition of this fact has made
necessary a more careful definition of some terms. In the language of the
street, almost any claim against outsiders may be spoken of as an “account
receivable.” The term is thus so broad as not only to include current claims
against customers in regular course of trade, and accrued income, such as
rents, commissions, interest, dividends, etc., earned but not yet received, but
also to serve as a cloak covering many other kinds of claims and deposits.
Among these may be enumerated:
1. Cash deposited to cover breakage or damage to
equipment in use, to guarantee the payment of
prospective expense, or to guarantee good faith in
the performance of a contract.
2. Moneys advanced to subsidiaries, salesmen, and
other employees on account of expenses and
salaries.
loss if a particularly unfavorable or favorable rate were prevailing on the
date of conversion.
Accounts and Notes Receivable
In the valuation of accounts and notes receivable the problem is largely
one of appraising the uncollectible items. The book account and note are
intermediate stages in the conversion of merchandise into cash. Were they
always worth their face value there would usually be no problem in their
valuation except for the element of theoretical interest which is not
commonly taken into account by commercial enterprises. In considering
this problem of valuation, the question of the correct use of terms arises.
For the sake of clearness, when showing the items on the balance sheet,
attention will be first directed to this latter phase of the subject.
Objection to the Title, Accounts Receivable
The governing principle here is that only current items can be included
in this group of assets when shown on the balance sheet. In accounting, as
in economics, there is no distinctive scientific terminology. The economist
makes use, for the most part, of every-day words and phrases. These are
often open to misunderstanding and are sometimes capable of being used
even for wilful misrepresentation. Recognition of this fact has made
necessary a more careful definition of some terms. In the language of the
street, almost any claim against outsiders may be spoken of as an “account
receivable.” The term is thus so broad as not only to include current claims
against customers in regular course of trade, and accrued income, such as
rents, commissions, interest, dividends, etc., earned but not yet received, but
also to serve as a cloak covering many other kinds of claims and deposits.
Among these may be enumerated:
1. Cash deposited to cover breakage or damage to
equipment in use, to guarantee the payment of
prospective expense, or to guarantee good faith in
the performance of a contract.
2. Moneys advanced to subsidiaries, salesmen, and
other employees on account of expenses and
salaries.
Page 195
3. Claims against creditors for returned or damaged
goods, against railroads for lost or damaged goods,
and against governments for rebates, drawbacks,
and the like.
4. Prepayments on purchase or expense contracts, as
payments made to bind a bargain or before
delivery of goods; and expenses paid in advance,
such as royalties, rents, interest, etc.
5. Unpaid calls or instalments on stock subscription
contracts.
6. Claims against absconding officers for property
appropriated or trusts violated.
It is necessary, therefore, to employ a term of more definite meaning
which cannot be misused. The word “Customer” is sometimes used and is
not objectionable. However, the term “Trade Debtors” is more generally
employed and will be so used here as denoting all claims against customers,
clients, etc., in regular course of business. Its appearance in a balance sheet
is usually evidence of a careful discrimination among the various classes of
claims and is not therefore a misleading term.
Risk from Credit Losses
As stated above, the chief problem in valuing accounts and notes
receivable is that of estimating bad debts. It is a matter of general
experience that some of those to whom credit is extended do not pay their
bills. Hence, at the close of the fiscal period it is necessary, so as not to
overstate the asset, to estimate the amount which probably cannot be
collected. The necessity for this is recognized in a decision of the United
States Supreme Court in Providence Rubber Co. v. Goodyear, 9 Wall. 788,
and has the sanction of conservative business policy.
The effect of such an estimate is that the period in which the sale is
effected is made to stand the loss, and not the one in which failure to secure
collection is experienced. There is a close relationship between the actual
loss from bad debts and the credit policy of a concern. Where the sales
force is allowed to grant credit, the loss from bad debts is almost invariably
large. Where the extension of credit is controlled by a credit department, the
goods, against railroads for lost or damaged goods,
and against governments for rebates, drawbacks,
and the like.
4. Prepayments on purchase or expense contracts, as
payments made to bind a bargain or before
delivery of goods; and expenses paid in advance,
such as royalties, rents, interest, etc.
5. Unpaid calls or instalments on stock subscription
contracts.
6. Claims against absconding officers for property
appropriated or trusts violated.
It is necessary, therefore, to employ a term of more definite meaning
which cannot be misused. The word “Customer” is sometimes used and is
not objectionable. However, the term “Trade Debtors” is more generally
employed and will be so used here as denoting all claims against customers,
clients, etc., in regular course of business. Its appearance in a balance sheet
is usually evidence of a careful discrimination among the various classes of
claims and is not therefore a misleading term.
Risk from Credit Losses
As stated above, the chief problem in valuing accounts and notes
receivable is that of estimating bad debts. It is a matter of general
experience that some of those to whom credit is extended do not pay their
bills. Hence, at the close of the fiscal period it is necessary, so as not to
overstate the asset, to estimate the amount which probably cannot be
collected. The necessity for this is recognized in a decision of the United
States Supreme Court in Providence Rubber Co. v. Goodyear, 9 Wall. 788,
and has the sanction of conservative business policy.
The effect of such an estimate is that the period in which the sale is
effected is made to stand the loss, and not the one in which failure to secure
collection is experienced. There is a close relationship between the actual
loss from bad debts and the credit policy of a concern. Where the sales
force is allowed to grant credit, the loss from bad debts is almost invariably
large. Where the extension of credit is controlled by a credit department, the
Page 196
loss is less than in the other case but depends on thoroughness of
information and investigation of the risk. However much care may be
exercised, there will be nevertheless some loss, but a live credit supervision
should keep the loss at a minimum.
Risk and Length of Credit Period
The amount of loss, or rather the percentage of loss, is not the same for
different lines of business nor even for different concerns in the same line.
The normal credit period for a particular business has some relation to the
loss. Thus if credit supervision and collection effort are the same for two
concerns, the one with the shorter credit period will usually have the
smaller loss. In a business, for example, where the credit term is 60 days,
we would expect fewer uncollectible accounts than in one whose credit
period extends for a year or more. As between two concerns in the same
line of business, where conditions are fairly uniform, however, there should
be little variation in the loss from bad debts. As pointed out in Volume I,
Chapter XXXVI, the sales discount policy is for the most part a device for
overcoming the element of risk in the extension of credit.
Analysis of Customers’ Accounts as the Basis for Estimate of
Bad Debts
In estimating the amount of bad debts, experience within the particular
business is the only safe guide. Oftentimes, however, the manager or
proprietor is not the most competent person for the task. The auditor, in
consultation with the manager, may often arrive at a better estimate than
could someone closely connected with the business. In making the estimate,
it is an aid to analyze the accounts according to the length of time they are
past due. Thus, there would be, after analysis, the amount of those overdue
not more than 30 days, the amount of those overdue not more than 60 days,
the amount of the 60 to 90 days overdue items, those 90 days to six months,
those six months to a year, and all those more than a year overdue. The total
amount outstanding minus the sum of these overdue classes represents the
portion not yet due. Some part of the not-yet-due portion is, of course, still
subject to discount if paid within the discount term. With the claims against
customers thus analyzed, a much better basis is afforded for testing the
adequacy of the provision for bad debts. The various methods of estimating
this provision are discussed on page 219.
information and investigation of the risk. However much care may be
exercised, there will be nevertheless some loss, but a live credit supervision
should keep the loss at a minimum.
Risk and Length of Credit Period
The amount of loss, or rather the percentage of loss, is not the same for
different lines of business nor even for different concerns in the same line.
The normal credit period for a particular business has some relation to the
loss. Thus if credit supervision and collection effort are the same for two
concerns, the one with the shorter credit period will usually have the
smaller loss. In a business, for example, where the credit term is 60 days,
we would expect fewer uncollectible accounts than in one whose credit
period extends for a year or more. As between two concerns in the same
line of business, where conditions are fairly uniform, however, there should
be little variation in the loss from bad debts. As pointed out in Volume I,
Chapter XXXVI, the sales discount policy is for the most part a device for
overcoming the element of risk in the extension of credit.
Analysis of Customers’ Accounts as the Basis for Estimate of
Bad Debts
In estimating the amount of bad debts, experience within the particular
business is the only safe guide. Oftentimes, however, the manager or
proprietor is not the most competent person for the task. The auditor, in
consultation with the manager, may often arrive at a better estimate than
could someone closely connected with the business. In making the estimate,
it is an aid to analyze the accounts according to the length of time they are
past due. Thus, there would be, after analysis, the amount of those overdue
not more than 30 days, the amount of those overdue not more than 60 days,
the amount of the 60 to 90 days overdue items, those 90 days to six months,
those six months to a year, and all those more than a year overdue. The total
amount outstanding minus the sum of these overdue classes represents the
portion not yet due. Some part of the not-yet-due portion is, of course, still
subject to discount if paid within the discount term. With the claims against
customers thus analyzed, a much better basis is afforded for testing the
adequacy of the provision for bad debts. The various methods of estimating
this provision are discussed on page 219.
Page 197
It may here be noted that when making up the estimate of bad debts it is
by no means always necessary to analyze the outstanding items as
suggested above. Such an analysis is of value in three cases:
1. In the case of a new concern where there is no past
experience on which to base the estimate.
2. In the case of an outsider—a professional auditor or
other party—being called upon to make the
estimate.
3. Periodically, in any business, as a check on the
work of the collection department.
The value of the analysis in cases (1) and (2) is based on the principle
that the longer an item is overdue, the greater is its likelihood of proving
uncollectible. The need of an increasing rate for the different classes as
analyzed above is apparent. In case (3) its value lies in the fact that it
reveals the general effect of the collection policy and incidentally points out
any change in policy. Any additional factors which may have wrought a
change in the general financial situation must, of course, be taken into
account.
Basis of Estimate of Bad Debts
Three methods of making an estimate of bad debts are found, in all of
which a percentage of some given base is used. The various bases are
respectively:
1. The amount of outstanding trade debt at the time of
the balance sheet.
2. The amount of sales on credit made during the
present fiscal period.
3. The total sales, both cash and credit, for the present
period.
Trade Debtors as the Basis. The use of trade debtors as a base is
obvious because it represents the uncollected charges from which alone can
any loss from bad debts arise. The use of such a base seems correct in
principle. This is so in cases where a balance sheet is made up only once a
by no means always necessary to analyze the outstanding items as
suggested above. Such an analysis is of value in three cases:
1. In the case of a new concern where there is no past
experience on which to base the estimate.
2. In the case of an outsider—a professional auditor or
other party—being called upon to make the
estimate.
3. Periodically, in any business, as a check on the
work of the collection department.
The value of the analysis in cases (1) and (2) is based on the principle
that the longer an item is overdue, the greater is its likelihood of proving
uncollectible. The need of an increasing rate for the different classes as
analyzed above is apparent. In case (3) its value lies in the fact that it
reveals the general effect of the collection policy and incidentally points out
any change in policy. Any additional factors which may have wrought a
change in the general financial situation must, of course, be taken into
account.
Basis of Estimate of Bad Debts
Three methods of making an estimate of bad debts are found, in all of
which a percentage of some given base is used. The various bases are
respectively:
1. The amount of outstanding trade debt at the time of
the balance sheet.
2. The amount of sales on credit made during the
present fiscal period.
3. The total sales, both cash and credit, for the present
period.
Trade Debtors as the Basis. The use of trade debtors as a base is
obvious because it represents the uncollected charges from which alone can
any loss from bad debts arise. The use of such a base seems correct in
principle. This is so in cases where a balance sheet is made up only once a
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year, so that conditions as to the periodicity of the sales are practically the
same from year to year. The amount of loss from uncollectible items is then
somewhat nearly proportional to the amount of claims outstanding at the
close of the fiscal year. But where it is necessary to make the estimate
monthly, or oftener than once a year, it is very probable that at some of the
intermediate periods the amount of outstanding claims will bear no logical
relation to the loss from bad debts. Thus, in the garment industry the sales
for practically the whole year are made within a few months, and during the
other months the processes of manufacture and collection are carried on.
For these reasons the amount of bad debts is not proportional to the
outstanding claims at the end of each month, nor does such a base properly
allocate the losses to the periods in which the sales are made. Accordingly
one of the two other methods previously mentioned is used.
Sales as the Basis. Inasmuch as there cannot be any loss from bad debts
in the cash sales, theoretically the credit sales provide the proper base for
making the estimate. Practically, total sales, either gross or net, furnish the
base most frequently employed because the total is always available
without the necessity for analysis. So long as the ratio of the two kinds of
sales remains fairly constant, the loss from bad debts does bear a direct
relation to total sales.
Summary. It may be said with respect to the use of trade debtors as a
base, that it gives satisfactory results where conditions are uniform from
period to period. In its use, however, cognizance must be taken of any
change in the credit policy of the business whereby the term of credit is
shortened or lengthened as that in itself would tend to change the ratio of
the base to the estimated loss from uncollectible items. As between credit
and total sales, theory favors the former but practical considerations the
latter. If for any reason the ratio of cash to credit sales should change, the
change would have to be taken into consideration when making a
comparison between periods of the loss from bad debts. No justification can
be found for a fourth method sometimes met with, which makes the
provision for bad debts bear some relation to the net profits—large if profits
are large, and small or none if profits are small.
In handling the estimate of bad debts on the books, the same
considerations are to be observed as in booking depreciation. Care must be
exercised not to allow the reserve to grow beyond liberally estimated
same from year to year. The amount of loss from uncollectible items is then
somewhat nearly proportional to the amount of claims outstanding at the
close of the fiscal year. But where it is necessary to make the estimate
monthly, or oftener than once a year, it is very probable that at some of the
intermediate periods the amount of outstanding claims will bear no logical
relation to the loss from bad debts. Thus, in the garment industry the sales
for practically the whole year are made within a few months, and during the
other months the processes of manufacture and collection are carried on.
For these reasons the amount of bad debts is not proportional to the
outstanding claims at the end of each month, nor does such a base properly
allocate the losses to the periods in which the sales are made. Accordingly
one of the two other methods previously mentioned is used.
Sales as the Basis. Inasmuch as there cannot be any loss from bad debts
in the cash sales, theoretically the credit sales provide the proper base for
making the estimate. Practically, total sales, either gross or net, furnish the
base most frequently employed because the total is always available
without the necessity for analysis. So long as the ratio of the two kinds of
sales remains fairly constant, the loss from bad debts does bear a direct
relation to total sales.
Summary. It may be said with respect to the use of trade debtors as a
base, that it gives satisfactory results where conditions are uniform from
period to period. In its use, however, cognizance must be taken of any
change in the credit policy of the business whereby the term of credit is
shortened or lengthened as that in itself would tend to change the ratio of
the base to the estimated loss from uncollectible items. As between credit
and total sales, theory favors the former but practical considerations the
latter. If for any reason the ratio of cash to credit sales should change, the
change would have to be taken into consideration when making a
comparison between periods of the loss from bad debts. No justification can
be found for a fourth method sometimes met with, which makes the
provision for bad debts bear some relation to the net profits—large if profits
are large, and small or none if profits are small.
In handling the estimate of bad debts on the books, the same
considerations are to be observed as in booking depreciation. Care must be
exercised not to allow the reserve to grow beyond liberally estimated
Page 199
requirements and so create a secret reserve, nor to fall below such
requirements. This must be watched closely and, if need be, the rate
changed to accomplish the desired result.
Discounts and Collection Costs
In connection with the valuation of trade debtors, the problem of
collection costs and cash discounts must be considered. Some authorities
connect these costs directly with sales and make provision for them in the
valuation of the current trade debtors; i.e., an estimate of the cost of
collecting the outstanding claims and of the probable amount of loss from
discounts on the amounts outstanding is deducted by means of reserves
from trade debtors and so shown on the balance sheet. Where such a
practice is followed, strict consistency would require that a similar credit
provision be made for discounts on purchases—a practice not often
advocated. The weight of opinion is in favor of taking all such costs and
credits into account only when they are actually met. This accords with the
treatment of these items as financial management items (explained in
Volume I, Chapter XXXVI) and as therefore bearing no direct relation to
sales. If, however, unusual costs of this or any other kind are anticipated,
prudence demands that provision, by means of reserves, be made for them.
Usually the costs average up pretty well from period to period.
Valuation of Other Receivable Items on Open Account
The problem of valuing the other classes of receivable items previously
mentioned on page 215, does not differ in the main from that of trade
debtors just discussed. If they are worth their face value they should be so
shown. If worth less, the necessary valuation reserves should be set up.
With these items the chief problem, however, is their proper showing on the
balance sheet; i.e., their correct classification and a suitable nomenclature.
Most of the items are not strictly current, but even their inclusion under this
head is not misleading if they are carefully earmarked to show their true
nature. Some of them are decidedly fixed, some are in no sense assets. In
some cases even trade debtor balances as carried on the books are not
strictly current. In concerns where sales are made on an instalment basis,
usually the payments extend over several months and oftentimes years. The
customer is charged with the whole amount and credited with the regular
instalment payments as made. The portion of the outstanding balance
requirements. This must be watched closely and, if need be, the rate
changed to accomplish the desired result.
Discounts and Collection Costs
In connection with the valuation of trade debtors, the problem of
collection costs and cash discounts must be considered. Some authorities
connect these costs directly with sales and make provision for them in the
valuation of the current trade debtors; i.e., an estimate of the cost of
collecting the outstanding claims and of the probable amount of loss from
discounts on the amounts outstanding is deducted by means of reserves
from trade debtors and so shown on the balance sheet. Where such a
practice is followed, strict consistency would require that a similar credit
provision be made for discounts on purchases—a practice not often
advocated. The weight of opinion is in favor of taking all such costs and
credits into account only when they are actually met. This accords with the
treatment of these items as financial management items (explained in
Volume I, Chapter XXXVI) and as therefore bearing no direct relation to
sales. If, however, unusual costs of this or any other kind are anticipated,
prudence demands that provision, by means of reserves, be made for them.
Usually the costs average up pretty well from period to period.
Valuation of Other Receivable Items on Open Account
The problem of valuing the other classes of receivable items previously
mentioned on page 215, does not differ in the main from that of trade
debtors just discussed. If they are worth their face value they should be so
shown. If worth less, the necessary valuation reserves should be set up.
With these items the chief problem, however, is their proper showing on the
balance sheet; i.e., their correct classification and a suitable nomenclature.
Most of the items are not strictly current, but even their inclusion under this
head is not misleading if they are carefully earmarked to show their true
nature. Some of them are decidedly fixed, some are in no sense assets. In
some cases even trade debtor balances as carried on the books are not
strictly current. In concerns where sales are made on an instalment basis,
usually the payments extend over several months and oftentimes years. The
customer is charged with the whole amount and credited with the regular
instalment payments as made. The portion of the outstanding balance
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covered by the more remote payments is thus not current. In concerns
where both regular and instalment sales take place, a separation of the
customers’ balances on the basis of the sales contract gives the necessary
information for balance sheet purposes. The accounts of instalment trade
debtors normally require a much more liberal valuation reserve than those
of regular credit customers.
Loss on Notes Receivable
In some cases the expected loss because of uncollectible notes may be
less than that from open accounts, due to the greater formality of the note as
an instrument of credit and the probably greater loss of credit to the maker
in case of dishonor. However, in making provision for bad debts, the
practice is almost universal to class the two receivable items together. Such
practice is undoubtedly sound. In the case of notes, the request for payment
is more forceable because of the definitely stated due date and the loss of
standing if unpaid after such date. In some cases the payment of notes is not
pressed, nor is any extraordinary provision made for past-due items—as in
industries allied with farming when an unusually bad season makes
impossible the payment of notes given by farmers. Again, the practice is
sometimes made of taking notes for a long overdue, open account. These
have usually no better value than the accounts and must be treated
accordingly.
The usual method of handling overdue notes receivable is given in
Volume I, Chapter XXXVIII. As there stated, where payment is allowed to
lapse, it is generally advisable to insist on the giving of new notes in place
of the old. There may be circumstances in which this is not advisable, but
the proper method will usually be apparent in each case.
Interest on Notes Receivable
The valuation of notes receivable—using the term to include all written
promises to pay, i.e., promissory notes, accepted drafts, and the like,
requires a consideration of interest. By far the larger number of notes given
in trade are non-interest bearing and are not therefore worth their face value
until they become due. The interest problem in the valuation of notes is thus
whether the notes should be shown at their face value or present, i.e.,
discounted, value. Notes which are interest bearing from their date of issue
where both regular and instalment sales take place, a separation of the
customers’ balances on the basis of the sales contract gives the necessary
information for balance sheet purposes. The accounts of instalment trade
debtors normally require a much more liberal valuation reserve than those
of regular credit customers.
Loss on Notes Receivable
In some cases the expected loss because of uncollectible notes may be
less than that from open accounts, due to the greater formality of the note as
an instrument of credit and the probably greater loss of credit to the maker
in case of dishonor. However, in making provision for bad debts, the
practice is almost universal to class the two receivable items together. Such
practice is undoubtedly sound. In the case of notes, the request for payment
is more forceable because of the definitely stated due date and the loss of
standing if unpaid after such date. In some cases the payment of notes is not
pressed, nor is any extraordinary provision made for past-due items—as in
industries allied with farming when an unusually bad season makes
impossible the payment of notes given by farmers. Again, the practice is
sometimes made of taking notes for a long overdue, open account. These
have usually no better value than the accounts and must be treated
accordingly.
The usual method of handling overdue notes receivable is given in
Volume I, Chapter XXXVIII. As there stated, where payment is allowed to
lapse, it is generally advisable to insist on the giving of new notes in place
of the old. There may be circumstances in which this is not advisable, but
the proper method will usually be apparent in each case.
Interest on Notes Receivable
The valuation of notes receivable—using the term to include all written
promises to pay, i.e., promissory notes, accepted drafts, and the like,
requires a consideration of interest. By far the larger number of notes given
in trade are non-interest bearing and are not therefore worth their face value
until they become due. The interest problem in the valuation of notes is thus
whether the notes should be shown at their face value or present, i.e.,
discounted, value. Notes which are interest bearing from their date of issue
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are, of course, worth their face, on the assumption that the interest takes
care of the discount. Where non-interest bearing notes form a very
considerable item it is well to value them on a discounted basis; if their
amount is small, theoretical principles of valuation give place to practical
considerations and they may be valued at their face. Where notes bearing
interest are valued on a discounted basis, care must be exercised not to
include the interest accrued both in their face valuation and also under the
head of accrued income.
Balance Sheet Titles for Notes Receivable
The problem of terminology is also met in handling notes receivable.
Under the balance sheet caption “Notes Receivable” should usually be
included only notes received from trade debtors, and certainly it should
never represent any but current asset items. Notes received from officers
and employees, of indefinite term and the payment of which will not be
pressed, should be recorded under some such title as “Notes Receivable
Special.” Long-term notes and those representing loans or advances of any
sort should be properly earmarked, as should also loans carried on open
account, salary overdrafts, and the like. The latter should be shown under
Deferred Charges. These nicer points of valuation cannot be presented on a
condensed balance sheet, but care should at all times be taken to make such
a showing as will not be misleading and will serve the purpose for which
the statement is to be used.
care of the discount. Where non-interest bearing notes form a very
considerable item it is well to value them on a discounted basis; if their
amount is small, theoretical principles of valuation give place to practical
considerations and they may be valued at their face. Where notes bearing
interest are valued on a discounted basis, care must be exercised not to
include the interest accrued both in their face valuation and also under the
head of accrued income.
Balance Sheet Titles for Notes Receivable
The problem of terminology is also met in handling notes receivable.
Under the balance sheet caption “Notes Receivable” should usually be
included only notes received from trade debtors, and certainly it should
never represent any but current asset items. Notes received from officers
and employees, of indefinite term and the payment of which will not be
pressed, should be recorded under some such title as “Notes Receivable
Special.” Long-term notes and those representing loans or advances of any
sort should be properly earmarked, as should also loans carried on open
account, salary overdrafts, and the like. The latter should be shown under
Deferred Charges. These nicer points of valuation cannot be presented on a
condensed balance sheet, but care should at all times be taken to make such
a showing as will not be misleading and will serve the purpose for which
the statement is to be used.
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CHAPTER XIII
MERCHANDISE STOCK-IN-TRADE
Definition and Scope of Term
Stock-in-trade, as the term is usually understood, comprises all
commodities purchased for resale. Thus, assets, which in one concern
belong to the fixed asset group, may be the stock-in-trade of other concerns.
In stating the principles of valuation for these assets, it is definitely to be
understood that they apply only to such as are used as stock-in-trade, and
not to the same items when used as fixed assets. Oftentimes the process of
manufacture intervenes between the purchase of a commodity and its sale.
In such a case the commodity, at the time of valuation, may be in different
stages of completion. It is then usually so listed on the balance sheet under
suitable titles, such as Raw Material, Goods in Process, and Finished
Goods, all of which are treated as current assets. Included in the problem of
valuation of stock-in-trade is the treatment of goods out on consignment,
goods of others held for sale on a commission basis, and scrap material.
Finally, some points to be observed in taking the physical inventory will be
considered.
Valuation at Market or Cost Price
Inasmuch as stock-in-trade is purchased solely for resale or ultimate
conversion into cash, it is desirable for the balance sheet to reflect the
proper value of what remains on hand unsold. Such goods may have a
realizable value higher or lower than cost value, from the standpoint of the
market in which they were purchased, and will usually have a higher value
in the market where they are to be sold. The value of all current assets to be
shown on balance sheet is usually stated at the present realizable value. As
applied to stock-in-trade, that must not be understood to mean sale or retail
value. To value the stock-in-trade on such a basis would result in taking into
the current period the profits on sales not effected until the next period;
furthermore, these profits would not even be offset by the costs of making
the sale. It may be laid down as a principle of business practice based on
MERCHANDISE STOCK-IN-TRADE
Definition and Scope of Term
Stock-in-trade, as the term is usually understood, comprises all
commodities purchased for resale. Thus, assets, which in one concern
belong to the fixed asset group, may be the stock-in-trade of other concerns.
In stating the principles of valuation for these assets, it is definitely to be
understood that they apply only to such as are used as stock-in-trade, and
not to the same items when used as fixed assets. Oftentimes the process of
manufacture intervenes between the purchase of a commodity and its sale.
In such a case the commodity, at the time of valuation, may be in different
stages of completion. It is then usually so listed on the balance sheet under
suitable titles, such as Raw Material, Goods in Process, and Finished
Goods, all of which are treated as current assets. Included in the problem of
valuation of stock-in-trade is the treatment of goods out on consignment,
goods of others held for sale on a commission basis, and scrap material.
Finally, some points to be observed in taking the physical inventory will be
considered.
Valuation at Market or Cost Price
Inasmuch as stock-in-trade is purchased solely for resale or ultimate
conversion into cash, it is desirable for the balance sheet to reflect the
proper value of what remains on hand unsold. Such goods may have a
realizable value higher or lower than cost value, from the standpoint of the
market in which they were purchased, and will usually have a higher value
in the market where they are to be sold. The value of all current assets to be
shown on balance sheet is usually stated at the present realizable value. As
applied to stock-in-trade, that must not be understood to mean sale or retail
value. To value the stock-in-trade on such a basis would result in taking into
the current period the profits on sales not effected until the next period;
furthermore, these profits would not even be offset by the costs of making
the sale. It may be laid down as a principle of business practice based on
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sound reason, that the period in which the sale is made should be given
credit for it. Stock-in-trade must therefore be valued on the basis of its
purchase or wholesale market price and according to well-established
practice, either at cost or market, whichever is the lower. This principle has
the support of conservative practice throughout the world.
Objections to Valuation at Less than Cost
The effect of valuing the stock-in-trade at a lower market than cost is to
bring into the period’s results a loss which may never be realized, either
because the change in the purchase market may not be reflected in the sale
market, or because, if so reflected, the market may swing back before actual
sale of the stock is made. If valuation is to be at the market when that is
lower than cost, consistency would seem to demand that, when the market
is higher than cost at the time of preparing the balance sheet, market value
should be used and the profit occasioned thereby be credited to the current
period. The answer to this argument is that operation would thus be placed
on a speculative basis.
Again, it is sometimes argued that good buying is just as essential to
profit-making as good selling. Accordingly, the purchasing department,
with the foresight to buy in a favorable market, should receive the credit for
it; if conditions are reversed, it should bear the blame, i.e., the loss. In other
words, the period in which the purchase effort is expended should be
credited or charged with the gain or the loss brought about by a favorable or
unfavorable condition of the current market as compared with its condition
at the time the purchase was made.
Anticipation of Profits or Losses Undesirable
In answer to these various contentions, it may be stated that though
good buying is an essential factor in profit-making, no refinement of logic
can obscure the obvious fact that goods are bought to be sold and that no
profit arises until the sale takes place. All effort before the sale, whether
directed towards good buying, careful storing and display, the placing of
advertising, or the selection of a sales force, will come to naught unless
sales are made. It would seem, therefore, that potential profit or loss on any
or all effort preliminary to the actual sale has no place in the current record.
From the standpoint of the profit and loss statement, this conclusion as to
credit for it. Stock-in-trade must therefore be valued on the basis of its
purchase or wholesale market price and according to well-established
practice, either at cost or market, whichever is the lower. This principle has
the support of conservative practice throughout the world.
Objections to Valuation at Less than Cost
The effect of valuing the stock-in-trade at a lower market than cost is to
bring into the period’s results a loss which may never be realized, either
because the change in the purchase market may not be reflected in the sale
market, or because, if so reflected, the market may swing back before actual
sale of the stock is made. If valuation is to be at the market when that is
lower than cost, consistency would seem to demand that, when the market
is higher than cost at the time of preparing the balance sheet, market value
should be used and the profit occasioned thereby be credited to the current
period. The answer to this argument is that operation would thus be placed
on a speculative basis.
Again, it is sometimes argued that good buying is just as essential to
profit-making as good selling. Accordingly, the purchasing department,
with the foresight to buy in a favorable market, should receive the credit for
it; if conditions are reversed, it should bear the blame, i.e., the loss. In other
words, the period in which the purchase effort is expended should be
credited or charged with the gain or the loss brought about by a favorable or
unfavorable condition of the current market as compared with its condition
at the time the purchase was made.
Anticipation of Profits or Losses Undesirable
In answer to these various contentions, it may be stated that though
good buying is an essential factor in profit-making, no refinement of logic
can obscure the obvious fact that goods are bought to be sold and that no
profit arises until the sale takes place. All effort before the sale, whether
directed towards good buying, careful storing and display, the placing of
advertising, or the selection of a sales force, will come to naught unless
sales are made. It would seem, therefore, that potential profit or loss on any
or all effort preliminary to the actual sale has no place in the current record.
From the standpoint of the profit and loss statement, this conclusion as to
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the policy of valuation of stock-in-trade at cost can be stated without fear of
contradiction. In support of this is a direction of the Treasury Department in
connection with the federal income tax returns. This reads, as revised in
October, 1916: “In case the annual gain or loss is determined by inventory,
merchandise must be inventoried at the cost price, as any loss in salable
value will ultimately be reflected in the sales during the year when the
goods are disposed of.”
From the viewpoint of the balance sheet, objection is sometimes raised
—and supported by conservative practice and legal requirement as
indicated above—that a balance sheet showing stock-in-trade at cost may
thus very obviously under-or over-value the item, a situation not at all
desirable. In this discussion, the whole problem of valuation is being treated
from the point of view always of a going concern and not of one facing
dissolution and the forced sale of its properties. Under these circumstances,
such a balance sheet must frequently be used as the basis for asking credit,
and credit extended on inflated values of current assets is not properly
extended.
Method of Treatment and Summary
To meet this situation, particularly in the case of large fluctuations in the
market, the true status of affairs is disclosed by appending to the balance
sheet a footnote in which is stated the present market value of the inventory.
Without this information, oftentimes, when the market is showing steadily
rising values, as much harm and financial ruin may result through the
extension of insufficient credit, as under other conditions might arise from
an ill-advised inflation of credit. Sometimes the present market value is
indicated by setting up a reserve out of profits, called “Reserve for Market
Fluctuations in Merchandise”—or other similar title—when the market is
lower than cost. This method retains the inventory on the books at cost
value and so does not burden the current profit and loss, although it does
lessen the amount of profits available for dividend distribution. Without
doubt the policy is good in cases of extreme and somewhat permanent
changes in the market.
To sum up, therefore, the valuation formula of cost or market,
whichever is the lower, while based on conservatism may unnecessarily and
improperly burden the current income account. Valuation at cost, on the
contradiction. In support of this is a direction of the Treasury Department in
connection with the federal income tax returns. This reads, as revised in
October, 1916: “In case the annual gain or loss is determined by inventory,
merchandise must be inventoried at the cost price, as any loss in salable
value will ultimately be reflected in the sales during the year when the
goods are disposed of.”
From the viewpoint of the balance sheet, objection is sometimes raised
—and supported by conservative practice and legal requirement as
indicated above—that a balance sheet showing stock-in-trade at cost may
thus very obviously under-or over-value the item, a situation not at all
desirable. In this discussion, the whole problem of valuation is being treated
from the point of view always of a going concern and not of one facing
dissolution and the forced sale of its properties. Under these circumstances,
such a balance sheet must frequently be used as the basis for asking credit,
and credit extended on inflated values of current assets is not properly
extended.
Method of Treatment and Summary
To meet this situation, particularly in the case of large fluctuations in the
market, the true status of affairs is disclosed by appending to the balance
sheet a footnote in which is stated the present market value of the inventory.
Without this information, oftentimes, when the market is showing steadily
rising values, as much harm and financial ruin may result through the
extension of insufficient credit, as under other conditions might arise from
an ill-advised inflation of credit. Sometimes the present market value is
indicated by setting up a reserve out of profits, called “Reserve for Market
Fluctuations in Merchandise”—or other similar title—when the market is
lower than cost. This method retains the inventory on the books at cost
value and so does not burden the current profit and loss, although it does
lessen the amount of profits available for dividend distribution. Without
doubt the policy is good in cases of extreme and somewhat permanent
changes in the market.
To sum up, therefore, the valuation formula of cost or market,
whichever is the lower, while based on conservatism may unnecessarily and
improperly burden the current income account. Valuation at cost, on the
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other hand, while placing the profit or the loss in the period when realized
may cause the balance sheet to present an entirely inadequate and even
misleading story as the basis for credit. To remedy this, three courses are
open, viz.:
1. Carry the market valuation, whether more or less
than cost, in a footnote to the balance sheet.
2. In case market value is less than cost, set up a
reserve out of profits equal in amount to the
difference.
3. Carry in an inner column in the body of the balance
sheet the present market value.
It would seem, therefore, that valuation at cost with the present market
value shown on the face of the balance sheet, is the most desirable practice
from every viewpoint.
Depreciation of Stock-in-Trade
Quite apart from this discussion of the proper basis for valuation, which
concerns itself with marketable merchandise, is the problem of the method
of handling deterioration or depreciation of stock-in-trade as distinguished
from fluctuations in value. Such deterioration may result from shelf wear,
use of goods for display purposes, changes in style and shape, overstocking
which causes an accumulation of goods which soon are out of date or of
sizes and qualities seldom used, broken lots where such will injure the sale
value, and so on. Many devices, such as the “spiff” or the offer of a
premium to salesmen, are employed by up-to-date merchants to keep their
stocks free from these items of deterioration; but in spite of all that can be
done, it usually proves impossible to keep the stock live in every particular.
A valuation at cost under these circumstances would be an obvious inflation
of values. If the concern had purchased that quality of goods originally with
the expectation of resale, valuation at cost, under the limitations suggested
above, would be the correct basis for showing. Since, however, such is not
usually the case, the proper basis of valuation is now the market price—the
present price at which goods of similar kinds and qualities can be bought.
It may be objected that the effect here also is unduly to burden the
current period with unrealized losses, but this is not the case. The
may cause the balance sheet to present an entirely inadequate and even
misleading story as the basis for credit. To remedy this, three courses are
open, viz.:
1. Carry the market valuation, whether more or less
than cost, in a footnote to the balance sheet.
2. In case market value is less than cost, set up a
reserve out of profits equal in amount to the
difference.
3. Carry in an inner column in the body of the balance
sheet the present market value.
It would seem, therefore, that valuation at cost with the present market
value shown on the face of the balance sheet, is the most desirable practice
from every viewpoint.
Depreciation of Stock-in-Trade
Quite apart from this discussion of the proper basis for valuation, which
concerns itself with marketable merchandise, is the problem of the method
of handling deterioration or depreciation of stock-in-trade as distinguished
from fluctuations in value. Such deterioration may result from shelf wear,
use of goods for display purposes, changes in style and shape, overstocking
which causes an accumulation of goods which soon are out of date or of
sizes and qualities seldom used, broken lots where such will injure the sale
value, and so on. Many devices, such as the “spiff” or the offer of a
premium to salesmen, are employed by up-to-date merchants to keep their
stocks free from these items of deterioration; but in spite of all that can be
done, it usually proves impossible to keep the stock live in every particular.
A valuation at cost under these circumstances would be an obvious inflation
of values. If the concern had purchased that quality of goods originally with
the expectation of resale, valuation at cost, under the limitations suggested
above, would be the correct basis for showing. Since, however, such is not
usually the case, the proper basis of valuation is now the market price—the
present price at which goods of similar kinds and qualities can be bought.
It may be objected that the effect here also is unduly to burden the
current period with unrealized losses, but this is not the case. The
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deterioration in value is a very real loss which is entirely independent of
any fluctuations in the market. If goods are shelf-and window-worn from
display usage, the deterioration is just as much an expense incurred for
advertising as a display advertisement in a daily paper. The deterioration
due to overstocking is a penalty which the current period should bear
because of its poor buying effort or its inadequate sales efficiency. Thus,
valuation of the inventory of any stock of goods must have regard to the
effect of its present condition on its marketability. Any deterioration which
renders the stock less salable is an expense to be borne by the present
period and not the period in which the sale is made.
Full Costs of Stock-in-Trade
Cost having been established as the basis for valuing a stock of
marketable merchandise, there must next be considered the elements of cost
and their application to different classes of goods. By cost of goods is meant
full cost, i.e., not only invoice price but all additional costs, needed to place
them ready for sale. All costs, therefore, up to the point where goods are
ready to create income are proper charges against the stock-in-trade.
Customary costs of this kind are freight, drayage, insurance during transit
and storage, duty, seasoning or aging costs, warehouse charges, and all
similar items. The information as to these costs is usually recorded
separately, but at a summary period they are loaded on the invoice cost of
stock-in-trade.
In connection with this question of the proper composition of cost,
attention is called to two other items sometimes requiring consideration.
The first deals with the handling of cash discounts. The point at issue is as
to whether the invoice figure should be recorded at the price quoted on a
cash basis or on a credit basis. This point is discussed at length in Chapter
XXXVI of the first volume where the conclusion reached is that the credit
policy of each concern must govern the manner of making the record. If the
concern has a fixed policy of buying at a cash price, that price should be the
price of record; whereas if all financial and other related policies are based
on a 30-or 60-day credit term, the credit price for that term should be the
price of record. Particularly is this true when viewed from the sales
standpoint where the fixing of the selling price is a part of the financial
policy. The second point requiring consideration in connection with cost is
any fluctuations in the market. If goods are shelf-and window-worn from
display usage, the deterioration is just as much an expense incurred for
advertising as a display advertisement in a daily paper. The deterioration
due to overstocking is a penalty which the current period should bear
because of its poor buying effort or its inadequate sales efficiency. Thus,
valuation of the inventory of any stock of goods must have regard to the
effect of its present condition on its marketability. Any deterioration which
renders the stock less salable is an expense to be borne by the present
period and not the period in which the sale is made.
Full Costs of Stock-in-Trade
Cost having been established as the basis for valuing a stock of
marketable merchandise, there must next be considered the elements of cost
and their application to different classes of goods. By cost of goods is meant
full cost, i.e., not only invoice price but all additional costs, needed to place
them ready for sale. All costs, therefore, up to the point where goods are
ready to create income are proper charges against the stock-in-trade.
Customary costs of this kind are freight, drayage, insurance during transit
and storage, duty, seasoning or aging costs, warehouse charges, and all
similar items. The information as to these costs is usually recorded
separately, but at a summary period they are loaded on the invoice cost of
stock-in-trade.
In connection with this question of the proper composition of cost,
attention is called to two other items sometimes requiring consideration.
The first deals with the handling of cash discounts. The point at issue is as
to whether the invoice figure should be recorded at the price quoted on a
cash basis or on a credit basis. This point is discussed at length in Chapter
XXXVI of the first volume where the conclusion reached is that the credit
policy of each concern must govern the manner of making the record. If the
concern has a fixed policy of buying at a cash price, that price should be the
price of record; whereas if all financial and other related policies are based
on a 30-or 60-day credit term, the credit price for that term should be the
price of record. Particularly is this true when viewed from the sales
standpoint where the fixing of the selling price is a part of the financial
policy. The second point requiring consideration in connection with cost is
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the item of interest on the money invested in stock. At the close of the fiscal
period should the stock sold and that left on hand be burdened with interest
on the average amount of capital tied up in it during the period? The student
is referred to Chapter XXVI of this book, where a full presentation of the
case for and against the inclusion of interest is made.
The Distribution of Costs Over Stock-in-Trade
It should be said that, due to the particular method of handling
purchasing, delivery, and storage, it frequently is not practicable to take
cognizance of all items which theoretically are constituents of cost. Each
concern must establish a policy relative thereto and hold to it. Having done
this, it is faced at inventory time with the problem of determining the cost
figure applicable to each unit of the stock remaining unsold. Certain of the
costs, such as freight and cartage, have probably been incurred by different
lots of miscellaneous merchandise, and to distribute the proper charges to
each unit comprising the lot is difficult. Usually a certain percentage
sufficient to cover that particular item of cost is spread evenly over all units
remaining on hand. Occasionally, especially where the stock is
homogeneous and only a few varieties are dealt in, an effort is made to
prorate these costs on a more accurate basis. In loading on the freight cost,
for example, a combined weight and value record might bemused or, where
possible, the official freight tariff might govern. Such minute accuracy is
not often needed or desirable, the flat percentage rate on value giving in
most cases sufficiently correct results.
The Pricing of the Inventory
A rule-of-thumb method of valuation requires that the purchase price as
carried on the last invoice of the article shall be used for pricing the
inventory. This usually proves a good working rule, but often raises
perplexing problems and is subject to abuse and misuse. If several
purchases have been made during the period at different prices, should the
last price paid govern the valuation of the portion unsold? The argument for
so doing is that the portions unsold probably belong to the last lot
purchased, good merchandising requiring that the old stock be sold out
before the new is brought forward. That, of course, is not always the case. If
it is made an inflexible rule that the price of the last lot bought shall be the
price of the inventory, a dangerous tool is placed in the hands of the
period should the stock sold and that left on hand be burdened with interest
on the average amount of capital tied up in it during the period? The student
is referred to Chapter XXVI of this book, where a full presentation of the
case for and against the inclusion of interest is made.
The Distribution of Costs Over Stock-in-Trade
It should be said that, due to the particular method of handling
purchasing, delivery, and storage, it frequently is not practicable to take
cognizance of all items which theoretically are constituents of cost. Each
concern must establish a policy relative thereto and hold to it. Having done
this, it is faced at inventory time with the problem of determining the cost
figure applicable to each unit of the stock remaining unsold. Certain of the
costs, such as freight and cartage, have probably been incurred by different
lots of miscellaneous merchandise, and to distribute the proper charges to
each unit comprising the lot is difficult. Usually a certain percentage
sufficient to cover that particular item of cost is spread evenly over all units
remaining on hand. Occasionally, especially where the stock is
homogeneous and only a few varieties are dealt in, an effort is made to
prorate these costs on a more accurate basis. In loading on the freight cost,
for example, a combined weight and value record might bemused or, where
possible, the official freight tariff might govern. Such minute accuracy is
not often needed or desirable, the flat percentage rate on value giving in
most cases sufficiently correct results.
The Pricing of the Inventory
A rule-of-thumb method of valuation requires that the purchase price as
carried on the last invoice of the article shall be used for pricing the
inventory. This usually proves a good working rule, but often raises
perplexing problems and is subject to abuse and misuse. If several
purchases have been made during the period at different prices, should the
last price paid govern the valuation of the portion unsold? The argument for
so doing is that the portions unsold probably belong to the last lot
purchased, good merchandising requiring that the old stock be sold out
before the new is brought forward. That, of course, is not always the case. If
it is made an inflexible rule that the price of the last lot bought shall be the
price of the inventory, a dangerous tool is placed in the hands of the
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unscrupulous. A manager needing or desiring to make a better showing of
profits might in this way make an insignificant purchase at a high price near
the end of the fiscal period and so secure a much higher valuation than the
cost for the whole inventory. Where the inventory is likely to contain
remnants of the various lots purchased during the period, or where the
condition as to an insignificant final purchase may exist, the policy of using
an average price for the inventory will be more accurate in its results. The
weighted average, whereby each purchase price is weighted with the
volume or quantities purchased, is fairer, though more complicated than the
straight average. Thus 10 units bought at $100 per unit, 15 at $90, and 3 at
$110, would give a straight average of $100 but a weighted average of
$95.71, (1,000 + 1,350 + 330) ÷ (10 + 15 + 3). In manufacturing
establishments where the fiscal period is short, say one month, and it is
desirable to keep the raw material cost as nearly uniform as possible, the
method of the weighted average is to be recommended.
As mentioned above, each concern must fix its own policy as to what
items shall be included in the cost of goods purchased. Whatever that policy
may be, care must be exercised to make sure that the same items and no
others form part of the value of the inventory. In the case of any doubtful
items, instead of trusting to memory, a house classification of accounts or
an accounting guide book should be drawn up so as to secure from period to
period a similar handling of all items.
Valuation of Manufacturing Inventory
The whole of the foregoing discussion concerns the valuation of goods
bought for resale, i.e., the inventory of a trading business. Some points in
the application of the same principles to a manufacturing concern will now
be considered.
Finished Goods. So far as finished goods are concerned, the principle of
valuation at cost applies. What constitutes the cost of manufacture was
discussed in Chapter III, from which it is evident that many other elements
in addition to those which must be considered in a trading concern must be
taken into account. The manufacturing cost formula comprises the three
items of: (1) raw material consumed, (2) direct labor applied, and (3)
factory expenses incurred, this latter item sometimes called overhead
expenses. When a concern operates a detailed cost system, the valuation of
profits might in this way make an insignificant purchase at a high price near
the end of the fiscal period and so secure a much higher valuation than the
cost for the whole inventory. Where the inventory is likely to contain
remnants of the various lots purchased during the period, or where the
condition as to an insignificant final purchase may exist, the policy of using
an average price for the inventory will be more accurate in its results. The
weighted average, whereby each purchase price is weighted with the
volume or quantities purchased, is fairer, though more complicated than the
straight average. Thus 10 units bought at $100 per unit, 15 at $90, and 3 at
$110, would give a straight average of $100 but a weighted average of
$95.71, (1,000 + 1,350 + 330) ÷ (10 + 15 + 3). In manufacturing
establishments where the fiscal period is short, say one month, and it is
desirable to keep the raw material cost as nearly uniform as possible, the
method of the weighted average is to be recommended.
As mentioned above, each concern must fix its own policy as to what
items shall be included in the cost of goods purchased. Whatever that policy
may be, care must be exercised to make sure that the same items and no
others form part of the value of the inventory. In the case of any doubtful
items, instead of trusting to memory, a house classification of accounts or
an accounting guide book should be drawn up so as to secure from period to
period a similar handling of all items.
Valuation of Manufacturing Inventory
The whole of the foregoing discussion concerns the valuation of goods
bought for resale, i.e., the inventory of a trading business. Some points in
the application of the same principles to a manufacturing concern will now
be considered.
Finished Goods. So far as finished goods are concerned, the principle of
valuation at cost applies. What constitutes the cost of manufacture was
discussed in Chapter III, from which it is evident that many other elements
in addition to those which must be considered in a trading concern must be
taken into account. The manufacturing cost formula comprises the three
items of: (1) raw material consumed, (2) direct labor applied, and (3)
factory expenses incurred, this latter item sometimes called overhead
expenses. When a concern operates a detailed cost system, the valuation of
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the finished product is not difficult, being the goal towards which the
system works. Where no cost system is used, great care must be exercised
to make sure that every item of cost is calculated as accurately as possible
and that a proportionate share of such costs is applied to the finished
product still on hand unsold. It is sometimes urged that instead of this cost-
to-manufacture price, the price at which the article could be bought on the
open market should govern; or, alternatively, that the article should be
valued at least sufficiently above cost to give a theoretical profit to the
factory. Just as in the case of the discussion of “cost or market price” for the
trading concern, the same conclusion is reached here, viz., that cost should
govern, because while good manufacturing is an element in profit-making,
yet no profit is made until the sale is effected. It is true that if cost to
manufacture is lower than cost to buy in the open market, a real saving has
been made by the policy of manufacturing rather than of buying, but a
saving is quite another thing from a profit. This differentiation between a
saving and a profit will be fully discussed presently. Correct accounting,
therefore, requires a valuation of finished goods at cost to manufacture.
Raw Material. The valuation of the inventory or raw material is on the
same basis as that of a stock of goods bought for resale, i.e., raw material is
to be valued at full cost up to the point of its consumption.
Goods in Process. The valuation of partially completed goods, i.e.,
“goods in process,” is a much more difficult problem. To simplify the
discussion these will be divided into two groups, first, goods manufactured
for stock, and secondly, those made on a specific contract or for special
order. To the first group the principle of cost applies without any
qualification. The problem involved is that of determining what has
constituted cost up to that particular stage of completion. Where a detailed
cost system is in use and a production schedule forms part of the system, it
is possible at almost any moment to ascertain exactly the values
accumulated on any article at each stage or process of manufacture. Where
definite costs are not possible, a careful estimate based on full knowledge of
conditions is the best that can be done. Where parts are first manufactured
for assembly into a completed whole, they should be treated as finished
goods and valued at full cost up to that point.
Contracts. The second group of goods in process, viz., those
manufactured to fill specific orders, or, in large construction work, contracts
system works. Where no cost system is used, great care must be exercised
to make sure that every item of cost is calculated as accurately as possible
and that a proportionate share of such costs is applied to the finished
product still on hand unsold. It is sometimes urged that instead of this cost-
to-manufacture price, the price at which the article could be bought on the
open market should govern; or, alternatively, that the article should be
valued at least sufficiently above cost to give a theoretical profit to the
factory. Just as in the case of the discussion of “cost or market price” for the
trading concern, the same conclusion is reached here, viz., that cost should
govern, because while good manufacturing is an element in profit-making,
yet no profit is made until the sale is effected. It is true that if cost to
manufacture is lower than cost to buy in the open market, a real saving has
been made by the policy of manufacturing rather than of buying, but a
saving is quite another thing from a profit. This differentiation between a
saving and a profit will be fully discussed presently. Correct accounting,
therefore, requires a valuation of finished goods at cost to manufacture.
Raw Material. The valuation of the inventory or raw material is on the
same basis as that of a stock of goods bought for resale, i.e., raw material is
to be valued at full cost up to the point of its consumption.
Goods in Process. The valuation of partially completed goods, i.e.,
“goods in process,” is a much more difficult problem. To simplify the
discussion these will be divided into two groups, first, goods manufactured
for stock, and secondly, those made on a specific contract or for special
order. To the first group the principle of cost applies without any
qualification. The problem involved is that of determining what has
constituted cost up to that particular stage of completion. Where a detailed
cost system is in use and a production schedule forms part of the system, it
is possible at almost any moment to ascertain exactly the values
accumulated on any article at each stage or process of manufacture. Where
definite costs are not possible, a careful estimate based on full knowledge of
conditions is the best that can be done. Where parts are first manufactured
for assembly into a completed whole, they should be treated as finished
goods and valued at full cost up to that point.
Contracts. The second group of goods in process, viz., those
manufactured to fill specific orders, or, in large construction work, contracts
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taken but not completed, may be valued on a somewhat different basis from
that applicable to the first group. Here a sale has actually taken place and
only the intervention of the closing of the books raises the question of
valuation. In a case of this sort it is customary to make a careful estimate of
the costs of the work or contract, up to its present state, due weight being
given to remaining costs necessary to complete it and to any provision for
possible contingencies. When handled in this way, the estimated profit on
the work already done is said to be applicable to the current period and is
therefore taken into account. In other words, the portion completed is
treated as sold, after making the provisions indicated above, and is charged
off the books against a corresponding part of the sale price. Hence, the
valuation involved here does not concern the inventory, but the cost of
goods sold.
It may be objected that, in the case of large contracts, perhaps running
over a period of years, many unforeseen things may happen to wipe out any
seeming profits on the completed portion, and that conservatism would
demand that no profits be taken until the contract is completed or in a
sufficiently advanced stage as to be reasonably sure of results. In such a
case it frequently happens, however, that not only are stockholders
impatient of delay, but very serious injustice may result to any who might
be forced to give up their holdings before the completion of the contract.
Moreover, a fair method of making payment on the contract is usually in
force, the sale price often being on the basis of units of work accomplished,
so that the contingencies giving rise to the objection mentioned are greatly
minimized. Thus, some contracts may be on a fixed price per cubic yard of
earth removed, per unit of goods manufactured, or other similar basis for
periodic payment, a certain per cent being retained as a guarantee for the
satisfactory completion of the whole. Again, where the price is for a lump
sum, engineers representing the contracting parties may agree on the
amount completed and periodical payment may be made on that basis.
This topic of uncompleted contracts will come up again for treatment
when considering the profit and loss summary for the year. It is sufficient to
note here that some share of the profit on the completed portion of a
contract may be taken as indicated above, in which case the inventory
problem may be disposed of either by adding the amount of estimated profit
that applicable to the first group. Here a sale has actually taken place and
only the intervention of the closing of the books raises the question of
valuation. In a case of this sort it is customary to make a careful estimate of
the costs of the work or contract, up to its present state, due weight being
given to remaining costs necessary to complete it and to any provision for
possible contingencies. When handled in this way, the estimated profit on
the work already done is said to be applicable to the current period and is
therefore taken into account. In other words, the portion completed is
treated as sold, after making the provisions indicated above, and is charged
off the books against a corresponding part of the sale price. Hence, the
valuation involved here does not concern the inventory, but the cost of
goods sold.
It may be objected that, in the case of large contracts, perhaps running
over a period of years, many unforeseen things may happen to wipe out any
seeming profits on the completed portion, and that conservatism would
demand that no profits be taken until the contract is completed or in a
sufficiently advanced stage as to be reasonably sure of results. In such a
case it frequently happens, however, that not only are stockholders
impatient of delay, but very serious injustice may result to any who might
be forced to give up their holdings before the completion of the contract.
Moreover, a fair method of making payment on the contract is usually in
force, the sale price often being on the basis of units of work accomplished,
so that the contingencies giving rise to the objection mentioned are greatly
minimized. Thus, some contracts may be on a fixed price per cubic yard of
earth removed, per unit of goods manufactured, or other similar basis for
periodic payment, a certain per cent being retained as a guarantee for the
satisfactory completion of the whole. Again, where the price is for a lump
sum, engineers representing the contracting parties may agree on the
amount completed and periodical payment may be made on that basis.
This topic of uncompleted contracts will come up again for treatment
when considering the profit and loss summary for the year. It is sufficient to
note here that some share of the profit on the completed portion of a
contract may be taken as indicated above, in which case the inventory
problem may be disposed of either by adding the amount of estimated profit
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to the cost value of the uncompleted contract, or by treating the payments
made as sales.
Contracts and Length of Cost Period
In some lines of business, orders are booked several months ahead of
delivery date, the factory operations depending somewhat closely on the
contracts entered into. During the period of manufacture there may be few
deliveries of the product, and therefore no actual profit. Obviously, the
easiest method of handling such a situation is to make the fiscal period long
enough to include the greater part of the deliveries, and so leave the
inventory comparatively free of goods in process. Where this method is
adopted, there is no serious objection to valuing the goods still in process at
the close of the period so as to take a fair portion of the profit, although
conservative practice usually values them at cost. The difference in the
amount of profit under the two methods is insignificant under the condition
named. Under other conditions valuation at cost is the rule.
Valuation of Scrap
Raw materials are never completely used up in manufacture; portions
too small for the main product, corners, odd-shaped pieces, defective
pieces, etc., are usually thrown into scrap. This scrap is frequently utilized
in the manufacture of side lines if a market can be developed; otherwise it
may be valueless. The problem of the valuation not only of the scrap but of
any product that may be made from it presents some interesting features. If
the entire cost of the raw material is charged to the main product, the scrap
material used in the side line costs nothing, and to charge anything for it,
either on the basis of cost or some arbitrary estimate, would result in
inflation. Furthermore, the cost figures of a side line which is not charged
for material might at some time be made the basis for a bid on a contract
too large to be filled entirely out of scrap material, and so result in a loss.
On the other hand, if the main product is charged only for the material
actually consumed, and the side line is compelled to bear the cost value of
the material it consumes, the cost of the side line may so increase that it
cannot be marketed at a profit. The lowered cost of the main product might
lead, in the face of keen competition, to the cutting of its price below real
cost, unless, of course, all the scrap is being utilized in the side line which is
also being sold at a profit. If such is the case, the valuation of the main
made as sales.
Contracts and Length of Cost Period
In some lines of business, orders are booked several months ahead of
delivery date, the factory operations depending somewhat closely on the
contracts entered into. During the period of manufacture there may be few
deliveries of the product, and therefore no actual profit. Obviously, the
easiest method of handling such a situation is to make the fiscal period long
enough to include the greater part of the deliveries, and so leave the
inventory comparatively free of goods in process. Where this method is
adopted, there is no serious objection to valuing the goods still in process at
the close of the period so as to take a fair portion of the profit, although
conservative practice usually values them at cost. The difference in the
amount of profit under the two methods is insignificant under the condition
named. Under other conditions valuation at cost is the rule.
Valuation of Scrap
Raw materials are never completely used up in manufacture; portions
too small for the main product, corners, odd-shaped pieces, defective
pieces, etc., are usually thrown into scrap. This scrap is frequently utilized
in the manufacture of side lines if a market can be developed; otherwise it
may be valueless. The problem of the valuation not only of the scrap but of
any product that may be made from it presents some interesting features. If
the entire cost of the raw material is charged to the main product, the scrap
material used in the side line costs nothing, and to charge anything for it,
either on the basis of cost or some arbitrary estimate, would result in
inflation. Furthermore, the cost figures of a side line which is not charged
for material might at some time be made the basis for a bid on a contract
too large to be filled entirely out of scrap material, and so result in a loss.
On the other hand, if the main product is charged only for the material
actually consumed, and the side line is compelled to bear the cost value of
the material it consumes, the cost of the side line may so increase that it
cannot be marketed at a profit. The lowered cost of the main product might
lead, in the face of keen competition, to the cutting of its price below real
cost, unless, of course, all the scrap is being utilized in the side line which is
also being sold at a profit. If such is the case, the valuation of the main
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product, the side line, and the scrap should be on a cost basis. This is not
usually the case, however. No basis for valuation can be found which will
prove entirely satisfactory under all circumstances.
In the light of the conditions involved, particularly as to whether there is
a constant market for the utilization of all the scrap material in the
manufacture of the side line, each concern must adopt whatever policy best
suits its peculiar needs. At all times the application of materials costs to the
product should provide an intelligent basis for entering into future contracts.
A blind use of cost figures frequently invites disaster. In cases where scrap
is not utilized in a side line, it has only scrap value. The thing to guard
against is the double charge for the same material, i.e., a charge to the main
product and also to the side line, resulting in an inflation of values.
Inventory-Taking
There remains, as a corollary to the problem of valuation, a
consideration of the method of taking the inventory, for if the count is
wrong the most careful valuation per unit will not give true total value. In
connection with the count of the inventory, two fundamental rules must be
observed. These are: (1) make sure that everything, i.e., all stock-in-trade,
belonging to the business is included; and (2) be careful that there is no
duplication of count nor inclusion of any stock belonging to others.
In accordance with the first fundamental rule, care should be exercised
to include all goods out for sale in other markets—these to be valued at full
cost in those markets—and all goods not yet received into stock but
belonging to the business. These latter include goods invoiced but not
received, and goods received but not unloaded prior to the close of the
period.
In accordance with the second fundamental rule, any goods of others
held for sale on a commission basis must be carefully excluded from the
count, as should also goods received before the close of the period but with
invoices dated some time in the future. Furthermore, all goods inventoried
from their invoices, i.e., all goods not taken into stock, must be earmarked
so as not to be charged into the next period’s purchases. This is best
accomplished by stamping the invoices as “Included in the 19.... Inventory.”
usually the case, however. No basis for valuation can be found which will
prove entirely satisfactory under all circumstances.
In the light of the conditions involved, particularly as to whether there is
a constant market for the utilization of all the scrap material in the
manufacture of the side line, each concern must adopt whatever policy best
suits its peculiar needs. At all times the application of materials costs to the
product should provide an intelligent basis for entering into future contracts.
A blind use of cost figures frequently invites disaster. In cases where scrap
is not utilized in a side line, it has only scrap value. The thing to guard
against is the double charge for the same material, i.e., a charge to the main
product and also to the side line, resulting in an inflation of values.
Inventory-Taking
There remains, as a corollary to the problem of valuation, a
consideration of the method of taking the inventory, for if the count is
wrong the most careful valuation per unit will not give true total value. In
connection with the count of the inventory, two fundamental rules must be
observed. These are: (1) make sure that everything, i.e., all stock-in-trade,
belonging to the business is included; and (2) be careful that there is no
duplication of count nor inclusion of any stock belonging to others.
In accordance with the first fundamental rule, care should be exercised
to include all goods out for sale in other markets—these to be valued at full
cost in those markets—and all goods not yet received into stock but
belonging to the business. These latter include goods invoiced but not
received, and goods received but not unloaded prior to the close of the
period.
In accordance with the second fundamental rule, any goods of others
held for sale on a commission basis must be carefully excluded from the
count, as should also goods received before the close of the period but with
invoices dated some time in the future. Furthermore, all goods inventoried
from their invoices, i.e., all goods not taken into stock, must be earmarked
so as not to be charged into the next period’s purchases. This is best
accomplished by stamping the invoices as “Included in the 19.... Inventory.”
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Inventory Methods. The careful organization of the physical stock to be
inventoried, sorting any misplaced items, and separating them into classes,
and an equally careful organization of the clerical force, acting under
explicit directions based on a well-thought-out plan, are fundamentally
essential to accuracy and to the prevention of any duplication of count. In
some cases the use of duplicate or coupon tags proves very valuable. On
these tags provision is made for recording in duplicate the number of units
and condition as to salability, and they are ruled with two money columns.
The tags are numbered on both parts consecutively and are charged out to
the various departments, as many being issued as there are classes or
compartments of goods. As the count is made of a certain class of goods, a
tag is attached to the compartment or other storage place as evidence that
the count has been made, after which the lower portion is torn off and sent
to the office. Any missing numbers indicate omissions in the count. If the
card has been lost, the duplicate still attached to its compartment will
indicate the count. After all cards are accounted for, the duplicates are
detached and the goods covered by them are then released for sale or other
use. In taking the inventory it is especially important that where goods are
below normal as to salability, their estimated per cent of normal condition
be noted on the tag. This gives a basis for valuing and should show the
amount of deterioration and its cause.
Perpetual Inventory
The use of a perpetual inventory system is quite general in some lines.
Its operation requires almost as careful a record of stock as is made of cash,
i.e., not only must all receipts be recorded but all disbursements as well. In
a trading concern this record usually takes the form of a stock book of some
sort, to which entry is made, as to quantities only, from the purchase and
sales invoices, the balance shown at any time being the stock remaining on
hand. The application of the unit value gives the value of the entire stock
and so makes possible monthly statements of approximate condition. In a
factory, a separate stores ledger may be operated, carrying an account with
every kind of material used. This ledger is controlled by the Raw Material
or Stores account on the general ledger. Entry to the stores ledger accounts
is made from the purchase invoices for receipts, and from formal
requisitions drawn on the stores-keeper for disbursements, i.e., for the
issuance of material. The stores ledger may record not only quantities but
inventoried, sorting any misplaced items, and separating them into classes,
and an equally careful organization of the clerical force, acting under
explicit directions based on a well-thought-out plan, are fundamentally
essential to accuracy and to the prevention of any duplication of count. In
some cases the use of duplicate or coupon tags proves very valuable. On
these tags provision is made for recording in duplicate the number of units
and condition as to salability, and they are ruled with two money columns.
The tags are numbered on both parts consecutively and are charged out to
the various departments, as many being issued as there are classes or
compartments of goods. As the count is made of a certain class of goods, a
tag is attached to the compartment or other storage place as evidence that
the count has been made, after which the lower portion is torn off and sent
to the office. Any missing numbers indicate omissions in the count. If the
card has been lost, the duplicate still attached to its compartment will
indicate the count. After all cards are accounted for, the duplicates are
detached and the goods covered by them are then released for sale or other
use. In taking the inventory it is especially important that where goods are
below normal as to salability, their estimated per cent of normal condition
be noted on the tag. This gives a basis for valuing and should show the
amount of deterioration and its cause.
Perpetual Inventory
The use of a perpetual inventory system is quite general in some lines.
Its operation requires almost as careful a record of stock as is made of cash,
i.e., not only must all receipts be recorded but all disbursements as well. In
a trading concern this record usually takes the form of a stock book of some
sort, to which entry is made, as to quantities only, from the purchase and
sales invoices, the balance shown at any time being the stock remaining on
hand. The application of the unit value gives the value of the entire stock
and so makes possible monthly statements of approximate condition. In a
factory, a separate stores ledger may be operated, carrying an account with
every kind of material used. This ledger is controlled by the Raw Material
or Stores account on the general ledger. Entry to the stores ledger accounts
is made from the purchase invoices for receipts, and from formal
requisitions drawn on the stores-keeper for disbursements, i.e., for the
issuance of material. The stores ledger may record not only quantities but
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also values, so that its balance should be the value of the stores on hand.
This is possible because the material is drawn out at cost price.
Oftentimes, for retail concerns, instead of the stock book method, the
percentage method of book inventories described in Volume I, page 506,
gives more satisfactory results when sufficient past experience can be
drawn from.
Necessity of Physical Count. It must not be assumed that a perpetual
inventory system obviates the necessity of taking a physical inventory, for it
does not. All that it accomplishes is to secure a closer supervision over
stock between inventory times and to make possible the showing of
approximate results at interim periods. Where operated, it is possible to take
the physical inventory piecemeal, although there is a marked advantage in
taking a complete inventory periodically. The piecemeal method means that
any department can do its stock-taking during a slack time without regard to
the time when other departments take theirs. Thus there is less interference
with the regular conduct of business. It must be borne in mind, however,
that the physical inventory is just as essential as ever because of the many
inaccuracies that tend to creep into the perpetual inventory system, and
furthermore because of loss, theft, over-measure, and so on, which throw
the book record out of agreement with the actual count.
This is possible because the material is drawn out at cost price.
Oftentimes, for retail concerns, instead of the stock book method, the
percentage method of book inventories described in Volume I, page 506,
gives more satisfactory results when sufficient past experience can be
drawn from.
Necessity of Physical Count. It must not be assumed that a perpetual
inventory system obviates the necessity of taking a physical inventory, for it
does not. All that it accomplishes is to secure a closer supervision over
stock between inventory times and to make possible the showing of
approximate results at interim periods. Where operated, it is possible to take
the physical inventory piecemeal, although there is a marked advantage in
taking a complete inventory periodically. The piecemeal method means that
any department can do its stock-taking during a slack time without regard to
the time when other departments take theirs. Thus there is less interference
with the regular conduct of business. It must be borne in mind, however,
that the physical inventory is just as essential as ever because of the many
inaccuracies that tend to creep into the perpetual inventory system, and
furthermore because of loss, theft, over-measure, and so on, which throw
the book record out of agreement with the actual count.
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CHAPTER XIV
TEMPORARY INVESTMENTS; ACCRUED
AND DEFERRED ITEMS
Temporary Investments
Nature of Temporary Investments
The next item to be considered for valuation in the current assets section
of the balance sheet is temporary investments. These are assets, such as
stocks and bonds of ready marketability, in which current funds are tied up
temporarily. Investments in stocks and bonds for purposes of securing
business connections and privileges essential to the most efficient conduct
of the business do not belong to this category. The term usually covers only
those assets representing the investment of temporarily surplus cash or
those acquired in settlement with debtors with the expectation of early
realization. As A. L. Dickinson[44] so well says, “such investments have no
relation whatever to the business and can be disposed of without in any way
interfering with its earning capacity, other than the loss of the dividends
thereon.”
In the case of concerns affected by seasonal changes in volume of
business, there are periods when sums of surplus cash lie unemployed,
unless the concern depends upon borrowed money to take care of seasonal
increases. Business policy, therefore, demands that the surplus cash be put
where it will earn something. Such investments are frequently of a
somewhat speculative character. In fact, other things being equal, business
acumen demands that the investment be made in those securities in which
there is a chance of gain in addition to the regular income therefrom. It
cannot be stated too strongly, however, that safety, freedom from great
fluctuations, and ready marketability are always prime essentials to be
observed in securing stocks and bonds for temporary investment. While the
procedure is unusual, there may at times be circumstances under which
such investments may be bought on a margin basis.
TEMPORARY INVESTMENTS; ACCRUED
AND DEFERRED ITEMS
Temporary Investments
Nature of Temporary Investments
The next item to be considered for valuation in the current assets section
of the balance sheet is temporary investments. These are assets, such as
stocks and bonds of ready marketability, in which current funds are tied up
temporarily. Investments in stocks and bonds for purposes of securing
business connections and privileges essential to the most efficient conduct
of the business do not belong to this category. The term usually covers only
those assets representing the investment of temporarily surplus cash or
those acquired in settlement with debtors with the expectation of early
realization. As A. L. Dickinson[44] so well says, “such investments have no
relation whatever to the business and can be disposed of without in any way
interfering with its earning capacity, other than the loss of the dividends
thereon.”
In the case of concerns affected by seasonal changes in volume of
business, there are periods when sums of surplus cash lie unemployed,
unless the concern depends upon borrowed money to take care of seasonal
increases. Business policy, therefore, demands that the surplus cash be put
where it will earn something. Such investments are frequently of a
somewhat speculative character. In fact, other things being equal, business
acumen demands that the investment be made in those securities in which
there is a chance of gain in addition to the regular income therefrom. It
cannot be stated too strongly, however, that safety, freedom from great
fluctuations, and ready marketability are always prime essentials to be
observed in securing stocks and bonds for temporary investment. While the
procedure is unusual, there may at times be circumstances under which
such investments may be bought on a margin basis.
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Valuation of Temporary Investments
The usual rule for valuing temporary investments at the time of drawing
up a balance sheet is at cost or market, whichever is the lower. Inasmuch as
they may be needed on short notice, the information desired is what they
will be likely to realize. This is particularly true in the case of a concern
with a rapidly expanding market, for which provision may need to be made
by increasing the plant as well as the working assets. Where reserved profits
have become tied up in fixed plant, the need for ready funds is apparent.
It may be argued that inasmuch as realizable value is the information
desired, valuation at market, whether lower or higher than cost, is the only
proper basis. The rule stated is, however, held to be the correct one from the
standpoint of conservatism and the further fundamental objection to
bringing unrealized profits into the current period, as would result from a
market valuation higher than cost. Of course, a lower valuation than cost
brings unrealized loss into the period’s operations, but this is not regarded
with the same disfavor. Where the market price is fluctuating from day to
day, as is normally the case, the market valuation on the date of the balance
sheet is perhaps no nearer to the amount that will be actually realized than
the cost value, since cost value merely represents one of the many changing
points in the market. If a distinct market tendency in one direction or the
other were likely to continue until the time of realization on the
investments, there might be good reason for taking the profit or loss accrued
to the date of the balance sheet. However, these considerations are of too
speculative and uncertain a character to be given any weight.
There is some valid objection, on theoretical grounds at least, to the
results of the period being affected by the unrealized profits or losses
caused by taking the market valuation of temporary investments onto the
balance sheet. Valuation at cost, with a footnote to show market value, gives
all the information essential to a full understanding of the exact condition of
the investment. The habit of adding footnotes to the balance sheet may,
however, become objectionable and the practice is to be avoided wherever
possible. Also, really essential information usually carries greater weight
when incorporated in the balance sheet figures.
Reserve for Investment Fluctuations
The usual rule for valuing temporary investments at the time of drawing
up a balance sheet is at cost or market, whichever is the lower. Inasmuch as
they may be needed on short notice, the information desired is what they
will be likely to realize. This is particularly true in the case of a concern
with a rapidly expanding market, for which provision may need to be made
by increasing the plant as well as the working assets. Where reserved profits
have become tied up in fixed plant, the need for ready funds is apparent.
It may be argued that inasmuch as realizable value is the information
desired, valuation at market, whether lower or higher than cost, is the only
proper basis. The rule stated is, however, held to be the correct one from the
standpoint of conservatism and the further fundamental objection to
bringing unrealized profits into the current period, as would result from a
market valuation higher than cost. Of course, a lower valuation than cost
brings unrealized loss into the period’s operations, but this is not regarded
with the same disfavor. Where the market price is fluctuating from day to
day, as is normally the case, the market valuation on the date of the balance
sheet is perhaps no nearer to the amount that will be actually realized than
the cost value, since cost value merely represents one of the many changing
points in the market. If a distinct market tendency in one direction or the
other were likely to continue until the time of realization on the
investments, there might be good reason for taking the profit or loss accrued
to the date of the balance sheet. However, these considerations are of too
speculative and uncertain a character to be given any weight.
There is some valid objection, on theoretical grounds at least, to the
results of the period being affected by the unrealized profits or losses
caused by taking the market valuation of temporary investments onto the
balance sheet. Valuation at cost, with a footnote to show market value, gives
all the information essential to a full understanding of the exact condition of
the investment. The habit of adding footnotes to the balance sheet may,
however, become objectionable and the practice is to be avoided wherever
possible. Also, really essential information usually carries greater weight
when incorporated in the balance sheet figures.
Reserve for Investment Fluctuations
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To meet the foregoing objection and, at the same time, that of allowing
unrealized items to affect the period’s profit and loss, use may be made of
an account called, say, “Reserve for Investment Fluctuations.” The account
should be operated in the same way as the Reserve for Market Valuation of
Merchandise discussed in the preceding chapter. That is, if market is lower
than cost, at the close of a fiscal period, surplus is charged and the reserve
credited for the difference. On the balance sheet the reserve is treated as an
offset to the investment account carried at cost. This incorporates the
market valuation as a significant figure of the balance sheet and shows the
cost for purposes of information. The charge to surplus avoids fluctuation in
the current profit and loss results because of an unrealized item and so
makes it more useful for comparative purposes. In case market is higher
than cost, the difference is charged to the asset and credited to the reserve.
On the balance sheet, cost is thus the effective figure and the market price is
given for informational purposes. When the investment is sold, the entry
creating the reserve should be reversed in either case. This brings on the
books in the period when the sale takes place, the actual profit or loss
realized, being the difference between cost and sale prices. The adjusting
entries on account of valuation do not thus permanently affect surplus,
while the actual profit or loss reaches surplus in the usual way—a valuable
desideratum.
“Stock Rights” on Investments
It may occasionally happen that while stocks are held for purposes of
temporary investment, stock rights arise. Such a “right” is a privilege of
subscription to a new issue of stock, granted holders of stock on a certain
date, at a rate below the market quotation of the old stock. The stock
records are closed temporarily to any transfers of stock in order to
determine those entitled to these rights. Up to the date of closing the
records, the market value of the stock carries an increased value to cover
the value of the rights belonging to it, and the stock is quoted “rights-on.”
After this date the rights are dealt in separately and quoted separately on the
exchange. Stock then sells “ex-rights.” Should the end of the fiscal period
of a concern holding stocks subject to rights fall after their issue, the stock
and rights may be booked separately, though often shown together.
unrealized items to affect the period’s profit and loss, use may be made of
an account called, say, “Reserve for Investment Fluctuations.” The account
should be operated in the same way as the Reserve for Market Valuation of
Merchandise discussed in the preceding chapter. That is, if market is lower
than cost, at the close of a fiscal period, surplus is charged and the reserve
credited for the difference. On the balance sheet the reserve is treated as an
offset to the investment account carried at cost. This incorporates the
market valuation as a significant figure of the balance sheet and shows the
cost for purposes of information. The charge to surplus avoids fluctuation in
the current profit and loss results because of an unrealized item and so
makes it more useful for comparative purposes. In case market is higher
than cost, the difference is charged to the asset and credited to the reserve.
On the balance sheet, cost is thus the effective figure and the market price is
given for informational purposes. When the investment is sold, the entry
creating the reserve should be reversed in either case. This brings on the
books in the period when the sale takes place, the actual profit or loss
realized, being the difference between cost and sale prices. The adjusting
entries on account of valuation do not thus permanently affect surplus,
while the actual profit or loss reaches surplus in the usual way—a valuable
desideratum.
“Stock Rights” on Investments
It may occasionally happen that while stocks are held for purposes of
temporary investment, stock rights arise. Such a “right” is a privilege of
subscription to a new issue of stock, granted holders of stock on a certain
date, at a rate below the market quotation of the old stock. The stock
records are closed temporarily to any transfers of stock in order to
determine those entitled to these rights. Up to the date of closing the
records, the market value of the stock carries an increased value to cover
the value of the rights belonging to it, and the stock is quoted “rights-on.”
After this date the rights are dealt in separately and quoted separately on the
exchange. Stock then sells “ex-rights.” Should the end of the fiscal period
of a concern holding stocks subject to rights fall after their issue, the stock
and rights may be booked separately, though often shown together.
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An illustration will show the theoretical method of valuation of rights.
Take a corporation whose stock now sells at 125, issuing the right to
subscribe at par for additional stock to the extent of 10% of present
holdings. The case of a stockholder with fifty shares would work out as
follows:
50 shares at $125 $6,250.00
5 ” at 100 500.00
55 ” at a cost of $6,750.00
The average cost of one share is $122.73. Based on the former quotation
of $125, the right is seen to be worth theoretically the difference, or $2.27.
The quoted market price will usually be less.
Cost of Investments
In connection with the cost of temporary investments it may be well to
point out that cost means full cost to the purchaser, including brokerage and
other costs in connection with the purchase or subsequent thereto. If the
investment is being carried on margin, the customary practice is to charge
to the investment account the interest on the funds borrowed by the broker
to finance the transaction and to credit thereto any dividends or interest
received. The difference between the asset account kept with the investment
and the liability account with the broker thus shows at any time the original
equity in the investment. A credit to the investment account when the stocks
are sold develops the net profit or loss on the entire transaction. There may
be circumstances under which it will be desirable to separate from the asset
account all charges and credits subsequent to the original purchase, carrying
them in a suitable expense and income account.
Valuation of Bonds
In the case where bonds are held for temporary investment, purchased
either at a premium or discount, it is not customary to take account of
amortization, because the investment is temporary. The problem of
amortization is postponed to Chapter XV, in which permanent or long-term
investments are treated.
In brokerage firms, where stocks and bonds comprise the stock-in-trade,
the same principle of valuation applies as with a merchandise stock except
Take a corporation whose stock now sells at 125, issuing the right to
subscribe at par for additional stock to the extent of 10% of present
holdings. The case of a stockholder with fifty shares would work out as
follows:
50 shares at $125 $6,250.00
5 ” at 100 500.00
55 ” at a cost of $6,750.00
The average cost of one share is $122.73. Based on the former quotation
of $125, the right is seen to be worth theoretically the difference, or $2.27.
The quoted market price will usually be less.
Cost of Investments
In connection with the cost of temporary investments it may be well to
point out that cost means full cost to the purchaser, including brokerage and
other costs in connection with the purchase or subsequent thereto. If the
investment is being carried on margin, the customary practice is to charge
to the investment account the interest on the funds borrowed by the broker
to finance the transaction and to credit thereto any dividends or interest
received. The difference between the asset account kept with the investment
and the liability account with the broker thus shows at any time the original
equity in the investment. A credit to the investment account when the stocks
are sold develops the net profit or loss on the entire transaction. There may
be circumstances under which it will be desirable to separate from the asset
account all charges and credits subsequent to the original purchase, carrying
them in a suitable expense and income account.
Valuation of Bonds
In the case where bonds are held for temporary investment, purchased
either at a premium or discount, it is not customary to take account of
amortization, because the investment is temporary. The problem of
amortization is postponed to Chapter XV, in which permanent or long-term
investments are treated.
In brokerage firms, where stocks and bonds comprise the stock-in-trade,
the same principle of valuation applies as with a merchandise stock except
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that the rule of valuation at cost or market, whichever is the lower, is
applied to each individual holding. In this way, decreases in the value of
one stock are not offset by increases in the value of others as would be the
case if total market and cost values for the entire lot were first determined
and then the valuation formula applied. In this chapter the principle of
valuation of stocks and bonds as stock-in-trade is mentioned only by way of
contrast.
Valuation of Unissued Stock
Under the head of temporary investments, the company’s unissued and
treasury stocks or bonds are sometimes included. Such unissued stocks or
bonds manifestly represent an inflation of asset values, offset, it is true, by
an equal inflation of capital stock. In the first place, conceding for the sake
of argument that the inclusion of unissued stocks among the assets is
legitimate, the principle of equilibrium requires that they be valued at par
on the balance sheet, a figure which is not cost and which may be very far
from market. Again, the company’s unissued stocks may be in no sense
current assets. Furthermore, stocks which have never been issued have no
owners and so can command no proprietorship in the enterprise. The most
that can be said about them is that they are contingent assets, showing that
certain legal formalities have been met which authorize their issue if so
desired. The remaining necessary procedure, viz., that the stock be placed
on the market and sold, is, however, the condition which must be met to
create a real asset and to create proprietorship. Until that has been done
there is neither proprietorship nor asset. Reference to Volume I, Chapter
XLIX, where the various methods of opening the books of a corporation are
illustrated, will show that the method to be preferred is one which
eliminates the account Unissued Stock from the books. However, where it
is set up, correct classification would seem to require that it be treated as of
the nature of a valuation or offset account for capital stock. In other words,
the two accounts, Capital Stock and Unissued Capital Stock, must be read
together to show the true status of the proprietorship stockholdings. The
correct method of presentation on the balance sheet is here only indicated
but will be illustrated in Chapter XXI where the problem of valuation of
capital stock is treated.
Valuation of Treasury Stock
applied to each individual holding. In this way, decreases in the value of
one stock are not offset by increases in the value of others as would be the
case if total market and cost values for the entire lot were first determined
and then the valuation formula applied. In this chapter the principle of
valuation of stocks and bonds as stock-in-trade is mentioned only by way of
contrast.
Valuation of Unissued Stock
Under the head of temporary investments, the company’s unissued and
treasury stocks or bonds are sometimes included. Such unissued stocks or
bonds manifestly represent an inflation of asset values, offset, it is true, by
an equal inflation of capital stock. In the first place, conceding for the sake
of argument that the inclusion of unissued stocks among the assets is
legitimate, the principle of equilibrium requires that they be valued at par
on the balance sheet, a figure which is not cost and which may be very far
from market. Again, the company’s unissued stocks may be in no sense
current assets. Furthermore, stocks which have never been issued have no
owners and so can command no proprietorship in the enterprise. The most
that can be said about them is that they are contingent assets, showing that
certain legal formalities have been met which authorize their issue if so
desired. The remaining necessary procedure, viz., that the stock be placed
on the market and sold, is, however, the condition which must be met to
create a real asset and to create proprietorship. Until that has been done
there is neither proprietorship nor asset. Reference to Volume I, Chapter
XLIX, where the various methods of opening the books of a corporation are
illustrated, will show that the method to be preferred is one which
eliminates the account Unissued Stock from the books. However, where it
is set up, correct classification would seem to require that it be treated as of
the nature of a valuation or offset account for capital stock. In other words,
the two accounts, Capital Stock and Unissued Capital Stock, must be read
together to show the true status of the proprietorship stockholdings. The
correct method of presentation on the balance sheet is here only indicated
but will be illustrated in Chapter XXI where the problem of valuation of
capital stock is treated.
Valuation of Treasury Stock
Page 220
The case against the inclusion of treasury stock in temporary
investments is not quite so apparent, but equally convincing upon
examination. Treasury stock differs from unissued stock only in that it has
once been issued but has, through various channels, found its way back into
the possession and control of the company. While outstanding in the hands
of stockholders and under their individual control, the increased stock
proprietorship is reflected in increased assets. If the stock comes back into
the treasury through donation, the decrease in proprietorship stockholdings
is compensated by a new proprietorship element under donated surplus.
Thus, while there are not so many shares outstanding, the value of each is
enhanced by a combined or common proprietorship in donated surplus,
which reflects exactly the status of the treasury stock. Whereas formerly
there was individual control over the stock, now that it is in the treasury,
control is common or combined. Stock proprietorship has been diminished
and the balance sheet should show it by treating Treasury Stock as an offset
account and not as a part of current assets under Temporary Investments.
As to the valuation of treasury stock at some other figure than par, the
same argument holds as in the case of unissued stock. If the treasury stock
has been acquired by purchase on the open market, its price may be a good
and sufficient basis for valuation; but even here individual ownership and
control has been exchanged for common and combined ownership. The
individual stockholdings are decreased, and the decrease is reflected on the
assets by the amount paid for the stock. It would seem, therefore, that a
showing more in accord with the facts would require treasury stock to be
treated as a deduction from the capital stock authorized. Thus the best
practice eliminates a company’s own stocks from the list of its assets.
Where such holdings are small and insignificant, they may without any
serious impropriety be included among the assets and even under the
caption “Temporary Investment” so long as substantial accuracy obtains.
Summary of Valuation Formula
To sum up, then, the valuation formula for current investments requires
their showing at cost or market, whichever is the lower. The most
satisfactory method of applying the formula is by means of the Reserve for
Investment Fluctuations which makes possible the incorporation of market
value whether lower or higher than cost, with the differences between
investments is not quite so apparent, but equally convincing upon
examination. Treasury stock differs from unissued stock only in that it has
once been issued but has, through various channels, found its way back into
the possession and control of the company. While outstanding in the hands
of stockholders and under their individual control, the increased stock
proprietorship is reflected in increased assets. If the stock comes back into
the treasury through donation, the decrease in proprietorship stockholdings
is compensated by a new proprietorship element under donated surplus.
Thus, while there are not so many shares outstanding, the value of each is
enhanced by a combined or common proprietorship in donated surplus,
which reflects exactly the status of the treasury stock. Whereas formerly
there was individual control over the stock, now that it is in the treasury,
control is common or combined. Stock proprietorship has been diminished
and the balance sheet should show it by treating Treasury Stock as an offset
account and not as a part of current assets under Temporary Investments.
As to the valuation of treasury stock at some other figure than par, the
same argument holds as in the case of unissued stock. If the treasury stock
has been acquired by purchase on the open market, its price may be a good
and sufficient basis for valuation; but even here individual ownership and
control has been exchanged for common and combined ownership. The
individual stockholdings are decreased, and the decrease is reflected on the
assets by the amount paid for the stock. It would seem, therefore, that a
showing more in accord with the facts would require treasury stock to be
treated as a deduction from the capital stock authorized. Thus the best
practice eliminates a company’s own stocks from the list of its assets.
Where such holdings are small and insignificant, they may without any
serious impropriety be included among the assets and even under the
caption “Temporary Investment” so long as substantial accuracy obtains.
Summary of Valuation Formula
To sum up, then, the valuation formula for current investments requires
their showing at cost or market, whichever is the lower. The most
satisfactory method of applying the formula is by means of the Reserve for
Investment Fluctuations which makes possible the incorporation of market
value whether lower or higher than cost, with the differences between
Page 221
market and cost carried in the reserve account. Thus the conservatism of the
valuation formula is made effective and at the same time information is
given as to the present market values of the investment.
Accrued and Deferred Items
Nature of Accrued Income
Income derived from many different sources is never fully received at
the close of the fiscal period. For instance, of the sales made many will still
be outstanding as charges to various customers; interest will have accrued
on notes receivable and on investments held; rental income is earned day by
day but is received only periodically; royalties based on the use of some
machine or process are accumulating where the device or process is being
used but settlement is made only periodically; and dividends on stocks or
other investments may have been declared during the current period but are
not payable and therefore will not be received until the next period.
Inadequacy of Cash Method of Handling Accruals
All these accrued items give rise to claims which must find expression
in the accounts either currently or ultimately. In the case of sales of
merchandise the customary practice is to set up the claim on the books
when the sale is made. In the case of the other items usually no record is
made until the income is actually received. Under this method—called the
cash method—it is evident that the true income cannot be shown in the
period in which it is earned and that the period in which it is received
secures the credit for it. This means not only that the current period may at
its beginning receive credit for items of income mostly earned during an
earlier period, but at its end it will be deprived of similar earnings accruing
from day to day up to its close but not credited because their time of
payment overlaps into the next period. This method is defended as being
substantially correct on the principle of averages, i.e., those earnings which
do not entirely belong to the current period but for which credit is taken will
in the long run just about offset the earnings accrued at the end of the period
which are not taken account of.
The statement may be true and, if so, can be easily tested; but, whether
true or not, modern practice requires the accurate accounting of all claims.
valuation formula is made effective and at the same time information is
given as to the present market values of the investment.
Accrued and Deferred Items
Nature of Accrued Income
Income derived from many different sources is never fully received at
the close of the fiscal period. For instance, of the sales made many will still
be outstanding as charges to various customers; interest will have accrued
on notes receivable and on investments held; rental income is earned day by
day but is received only periodically; royalties based on the use of some
machine or process are accumulating where the device or process is being
used but settlement is made only periodically; and dividends on stocks or
other investments may have been declared during the current period but are
not payable and therefore will not be received until the next period.
Inadequacy of Cash Method of Handling Accruals
All these accrued items give rise to claims which must find expression
in the accounts either currently or ultimately. In the case of sales of
merchandise the customary practice is to set up the claim on the books
when the sale is made. In the case of the other items usually no record is
made until the income is actually received. Under this method—called the
cash method—it is evident that the true income cannot be shown in the
period in which it is earned and that the period in which it is received
secures the credit for it. This means not only that the current period may at
its beginning receive credit for items of income mostly earned during an
earlier period, but at its end it will be deprived of similar earnings accruing
from day to day up to its close but not credited because their time of
payment overlaps into the next period. This method is defended as being
substantially correct on the principle of averages, i.e., those earnings which
do not entirely belong to the current period but for which credit is taken will
in the long run just about offset the earnings accrued at the end of the period
which are not taken account of.
The statement may be true and, if so, can be easily tested; but, whether
true or not, modern practice requires the accurate accounting of all claims.
Page 222
It is therefore required that these accrued earnings be brought onto the
books if reliable results are desired.
Correct Method of Handling Accruals
To show all earnings in the period in which they actually accrue is
called the “accrual method.” Under this method the income earned but not
received during the current period is set up among the assets, just as in the
case of sales, with this difference, however: the claim for the broken portion
belonging to this fiscal period need not be recorded day by day but only at
the end of the period. Most income items of this sort are due, either by
contract or by custom, at the end of certain definite periods. The setting up
of a claim for a broken, i.e., an uncompleted portion, does not mean that
such a claim is on that date legally enforceable, but that it is a claim
equitably belonging to the current period.
Showing of Accrued Items on Balance Sheet
As to the section of the balance sheet in which these accrued income
items should be shown, usually they are true current assets and should be so
listed. They frequently arise in connection with current assets, e.g., the
interest accruing on notes, stocks, and bonds held, and are therefore just as
current as the assets themselves, or even more so. Where not so arising, as
in the cases of rents, royalties, etc., usually the contract or customary period
of settlement is so short as to make the claims under them true current
assets. Occasionally the accrued earning is added to the value of the
particular asset and so shown in the balance sheet. A better practice,
because more definite, is to list them separately under the title, Accrued
Income, Accrued Accounts Receivable, or other similar title.
Valuation of Accrued Items
The principle of valuation of accrued income items is apparent. On the
supposition that the concern will continue in business, the accrued income
is proportioned between the two periods on the basis of the portion of the
time belonging to each period. However, this does not mean that the portion
so taken shall be valued at its face. The accrued portion is worth as a
portion neither more nor less than the whole is worth as a whole. If there is
doubt as to the ability to collect it when it falls due, certainly the valuation
placed on the accrued portion should express that doubt. In other words,
books if reliable results are desired.
Correct Method of Handling Accruals
To show all earnings in the period in which they actually accrue is
called the “accrual method.” Under this method the income earned but not
received during the current period is set up among the assets, just as in the
case of sales, with this difference, however: the claim for the broken portion
belonging to this fiscal period need not be recorded day by day but only at
the end of the period. Most income items of this sort are due, either by
contract or by custom, at the end of certain definite periods. The setting up
of a claim for a broken, i.e., an uncompleted portion, does not mean that
such a claim is on that date legally enforceable, but that it is a claim
equitably belonging to the current period.
Showing of Accrued Items on Balance Sheet
As to the section of the balance sheet in which these accrued income
items should be shown, usually they are true current assets and should be so
listed. They frequently arise in connection with current assets, e.g., the
interest accruing on notes, stocks, and bonds held, and are therefore just as
current as the assets themselves, or even more so. Where not so arising, as
in the cases of rents, royalties, etc., usually the contract or customary period
of settlement is so short as to make the claims under them true current
assets. Occasionally the accrued earning is added to the value of the
particular asset and so shown in the balance sheet. A better practice,
because more definite, is to list them separately under the title, Accrued
Income, Accrued Accounts Receivable, or other similar title.
Valuation of Accrued Items
The principle of valuation of accrued income items is apparent. On the
supposition that the concern will continue in business, the accrued income
is proportioned between the two periods on the basis of the portion of the
time belonging to each period. However, this does not mean that the portion
so taken shall be valued at its face. The accrued portion is worth as a
portion neither more nor less than the whole is worth as a whole. If there is
doubt as to the ability to collect it when it falls due, certainly the valuation
placed on the accrued portion should express that doubt. In other words,
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unless the claim is fully secured by collateral or other pledges, valuation
should be on exactly the same basis as for the other receivable items, such
as the claims against trade debtors, other open accounts receivable, notes
receivable of various kinds, etc.
Accounting for Accrued Income
The accounting for accrued income presents no particular difficulties. In
addition to the two methods discussed in Volume I, pages 116 to 119, a third
which is considerably more laborious than either of them is frequently
employed, and is as follows: At the time of adjusting and before closing the
books, for every item of accrued income a separate asset account is set up.
Thus, for royalties an account, Accrued Royalties Receivable, would record
the claim on account of royalties at the same time the accrued income from
royalties is being recorded in a suitable income account. Thus there is
distinct separation of the asset and income elements.
From this point two methods are in use for handling the subsequent
record of the item. Under the first method, the income when actually
received or legally due is recorded in the regular income account. This thus
shows an inflated figure because it is not offset by the portion credited to
the previous period, the asset account covering this, remaining unchanged
throughout the current period. At its close, however, proper adjustment is
made by adding to, or subtracting from, the amount held over from the
close of the previous period such an amount as will make its new balance
show the correct amount of accrued income as at the close of the current
period. The contra credit or debit to the above entry, as the case may be, is
of course to the particular income account, causing it to reflect the true
income for the current period.
Under the second method, the first entries for the new year consist in
transferring all accrued income asset balances to their respective income
accounts, where they serve the purpose of automatically adjusting the full
receipt of income a portion of which was credited in the previous period, to
the amount properly belonging to the current period. At the close of the
period any adjustment on account of accrued income is handled by debiting
the asset account and crediting the income account exactly as before.
An illustration will show the differences between the two methods.
should be on exactly the same basis as for the other receivable items, such
as the claims against trade debtors, other open accounts receivable, notes
receivable of various kinds, etc.
Accounting for Accrued Income
The accounting for accrued income presents no particular difficulties. In
addition to the two methods discussed in Volume I, pages 116 to 119, a third
which is considerably more laborious than either of them is frequently
employed, and is as follows: At the time of adjusting and before closing the
books, for every item of accrued income a separate asset account is set up.
Thus, for royalties an account, Accrued Royalties Receivable, would record
the claim on account of royalties at the same time the accrued income from
royalties is being recorded in a suitable income account. Thus there is
distinct separation of the asset and income elements.
From this point two methods are in use for handling the subsequent
record of the item. Under the first method, the income when actually
received or legally due is recorded in the regular income account. This thus
shows an inflated figure because it is not offset by the portion credited to
the previous period, the asset account covering this, remaining unchanged
throughout the current period. At its close, however, proper adjustment is
made by adding to, or subtracting from, the amount held over from the
close of the previous period such an amount as will make its new balance
show the correct amount of accrued income as at the close of the current
period. The contra credit or debit to the above entry, as the case may be, is
of course to the particular income account, causing it to reflect the true
income for the current period.
Under the second method, the first entries for the new year consist in
transferring all accrued income asset balances to their respective income
accounts, where they serve the purpose of automatically adjusting the full
receipt of income a portion of which was credited in the previous period, to
the amount properly belonging to the current period. At the close of the
period any adjustment on account of accrued income is handled by debiting
the asset account and crediting the income account exactly as before.
An illustration will show the differences between the two methods.
Page 224
Illustration of Different Methods of Recording Accrued Items
Problem. The royalties income accrued December 31,
1916, amounted to $5,000. During 1917 payments were
received on account of royalties to the amount of $35,000.
On December 31, 1917, accrued royalties were $5,250.
Solution—Method 1
Accrued Royalties Receivable
1916
Dec. 31 $5,000.00
1917
Dec. 31 (A) 250.00
Royalties Income
1917
$35,000.00
Dec. 31 (A) 250.00
Method 2
Accrued Royalties Receivable
1916 1917
Dec. 31 $5,000.00 Jan. 1 (A) $5,000.00
1917
Dec. 31 (B) $5,250.00
Royalties Income
1917 1917
Problem. The royalties income accrued December 31,
1916, amounted to $5,000. During 1917 payments were
received on account of royalties to the amount of $35,000.
On December 31, 1917, accrued royalties were $5,250.
Solution—Method 1
Accrued Royalties Receivable
1916
Dec. 31 $5,000.00
1917
Dec. 31 (A) 250.00
Royalties Income
1917
$35,000.00
Dec. 31 (A) 250.00
Method 2
Accrued Royalties Receivable
1916 1917
Dec. 31 $5,000.00 Jan. 1 (A) $5,000.00
1917
Dec. 31 (B) $5,250.00
Royalties Income
1917 1917
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Jan. 1 (A) $5,000.00 $35,000.00
Dec. 31 (B) 5,250.00
Of the two methods, the second is somewhat fuller and probably
presents the facts more consistently, although involving a little more book
work. From a practical standpoint where regard is had to the amount of
book work required, the method used in Volume I, pages 116 to 119,
sometimes known as the inventory method, serves all the purposes of either
of the above methods and requires much less work. By it the above problem
would appear as follows:
Royalties Income
1916 1917
Dec. 31 Accr. $5,000.00 $35,000.00
1917 Dec. 31 Accr. 5,250.00
Dec. 31 P. & I. 35,250.00
$40,250.00 $40,250.00
1918
Jan. 1 Accr. $5,250.00
An objection, not at all serious, is that under this last method the ledger
will show, as on the date of the balance sheet, the current assets in two
places, viz., the current assets section and the income section, instead of
altogether as under the other methods. This objection is more than offset by
the saving in clerical labor. There is in some quarters an all too prevalent
tendency to multiply the number of accounts and increase the bookkeeper’s
work without any adequate return in results.
Prepaid Items—Definitions and Kinds
Closely related to current assets, because through an overexpenditure of
current funds this period a lesser expenditure will be required next period, is
the class of items known as prepaid expenses or deferred charges to
operation. These items are not current in the sense that they will be turned
into cash shortly, but they are analogous in that a saving in the expenditures
Dec. 31 (B) 5,250.00
Of the two methods, the second is somewhat fuller and probably
presents the facts more consistently, although involving a little more book
work. From a practical standpoint where regard is had to the amount of
book work required, the method used in Volume I, pages 116 to 119,
sometimes known as the inventory method, serves all the purposes of either
of the above methods and requires much less work. By it the above problem
would appear as follows:
Royalties Income
1916 1917
Dec. 31 Accr. $5,000.00 $35,000.00
1917 Dec. 31 Accr. 5,250.00
Dec. 31 P. & I. 35,250.00
$40,250.00 $40,250.00
1918
Jan. 1 Accr. $5,250.00
An objection, not at all serious, is that under this last method the ledger
will show, as on the date of the balance sheet, the current assets in two
places, viz., the current assets section and the income section, instead of
altogether as under the other methods. This objection is more than offset by
the saving in clerical labor. There is in some quarters an all too prevalent
tendency to multiply the number of accounts and increase the bookkeeper’s
work without any adequate return in results.
Prepaid Items—Definitions and Kinds
Closely related to current assets, because through an overexpenditure of
current funds this period a lesser expenditure will be required next period, is
the class of items known as prepaid expenses or deferred charges to
operation. These items are not current in the sense that they will be turned
into cash shortly, but they are analogous in that a saving in the expenditures
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of the next period will result. Because of the ease with which they may be
put to improper uses, it is best to segregate them from current assets under a
suitable balance sheet caption, such as “Deferred Charges to Operation.”
Where the two captions, Current and Working Assets, are shown, items of
this class properly belong to the latter. Under this head will be considered
such items as supplies of all sorts—office, factory, power house, stable—
stationery, printing, postage, repair parts, insurance unexpired, advertising
contracts and material, rent, royalties, interest and discounts paid in
advance, salary overdrafts, premiums on long-term investments and
discounts of long-term obligations, and sometimes organization expense,
although this last item is perhaps best handled with the intangible assets.
Valuation of Prepaid Items
The purpose in considering these items at the close of a fiscal period is
to secure a proper and accurate allocation of charges as between the two
periods, without which true results as to profit and loss are not possible. The
same argument as to these items averaging up fairly well between periods
applies here as for accrued income. The only other point to be considered in
connection with them is the basis for their valuation. Realizable values, i.e.,
what the items would bring under the hammer or at other forced sale, are
manifestly inequitable. A three-year insurance policy with one year expired
is to a concern which intends to avail itself of the remaining two years’
protection worth more than the surrender value of the policy calculated on
the short-rate basis with perhaps the expenses of doing business also
subtracted by the insurance company. Evidently to a going concern the
protection enjoyed for the year just expired is worth neither more nor less
than a pro rata share of the entire cost, nor are the remaining two years’
protection to be valued at a less rate because redeemable at a less rate.
Hence, a valuation based on the going concern principle is to be used
for deferred charges. As indicated above, this means, when used in this
connection, a pro rata valuation based on the life of the supply and the
portion unused. In the case of tangible supplies the rule can be most easily
applied as a unit cost figure to the unused units still on hand. That is, an
inventory of supplies is taken and valued at full cost. Although nearly
related to current assets, deferred charges are seldom influenced by market
fluctuations after they are once purchased, because if properly classed as
put to improper uses, it is best to segregate them from current assets under a
suitable balance sheet caption, such as “Deferred Charges to Operation.”
Where the two captions, Current and Working Assets, are shown, items of
this class properly belong to the latter. Under this head will be considered
such items as supplies of all sorts—office, factory, power house, stable—
stationery, printing, postage, repair parts, insurance unexpired, advertising
contracts and material, rent, royalties, interest and discounts paid in
advance, salary overdrafts, premiums on long-term investments and
discounts of long-term obligations, and sometimes organization expense,
although this last item is perhaps best handled with the intangible assets.
Valuation of Prepaid Items
The purpose in considering these items at the close of a fiscal period is
to secure a proper and accurate allocation of charges as between the two
periods, without which true results as to profit and loss are not possible. The
same argument as to these items averaging up fairly well between periods
applies here as for accrued income. The only other point to be considered in
connection with them is the basis for their valuation. Realizable values, i.e.,
what the items would bring under the hammer or at other forced sale, are
manifestly inequitable. A three-year insurance policy with one year expired
is to a concern which intends to avail itself of the remaining two years’
protection worth more than the surrender value of the policy calculated on
the short-rate basis with perhaps the expenses of doing business also
subtracted by the insurance company. Evidently to a going concern the
protection enjoyed for the year just expired is worth neither more nor less
than a pro rata share of the entire cost, nor are the remaining two years’
protection to be valued at a less rate because redeemable at a less rate.
Hence, a valuation based on the going concern principle is to be used
for deferred charges. As indicated above, this means, when used in this
connection, a pro rata valuation based on the life of the supply and the
portion unused. In the case of tangible supplies the rule can be most easily
applied as a unit cost figure to the unused units still on hand. That is, an
inventory of supplies is taken and valued at full cost. Although nearly
related to current assets, deferred charges are seldom influenced by market
fluctuations after they are once purchased, because if properly classed as
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deferred charges they are always held for own use and never for outside
sale.
Danger of Overvaluation
Care must always be exercised—even more than in handling the stock-
in-trade inventory—to see that there is no padding of this class of items. To
this end, before taking inventory, a general clean-up of supply materials all
over the plant is an exceedingly good policy. This should result in
discarding, or reducing to scrap value, all obsolete and unusable supplies.
Without such a clean-up it is easy, even when motives are of the very best,
to carry forward from year to year as assets supply materials which will
never be used and which are therefore nothing but expense items and
should be charged against operation. Only a careful periodic appraisal of
supply materials and an equally careful inventory indicating their usability
can give a correct basis for applying the valuation formula.
Two or three items of deferred charges need a word of further
explanation. In some mining industries, notably coal and precious metals,
leasing is done on a royalty basis with a minimum amount to be paid each
period based on a minimum production of ore to be mined. If less than the
minimum is mined, a frequent provision in the terms of the lease makes
possible the application of any royalties overpaid one period against a
future production of more than the required minimum. That is, no increased
royalties are charged for a production over the minimum until all
accumulated royalties from periods of underproduction are used up. In any
period of underproduction such royalties may properly be treated as
deferred charges only on condition that there is reasonable expectation that
future production will increase to the point where it will consume the
overpaid royalties of earlier periods. At times a company finds itself bound
to such a contract, based on a minimum production, without any hope of
relief because the prospect has not developed as anticipated. Under such
conditions the entire periodical royalty charge is a charge against operation
and must be absorbed entirely by the operations of each fiscal period.
Accounting for Deferred Debit and Other Items
The accounting for deferred debit items proceeds along the same lines
indicated for accrued income. Nothing further need here be said than that
sale.
Danger of Overvaluation
Care must always be exercised—even more than in handling the stock-
in-trade inventory—to see that there is no padding of this class of items. To
this end, before taking inventory, a general clean-up of supply materials all
over the plant is an exceedingly good policy. This should result in
discarding, or reducing to scrap value, all obsolete and unusable supplies.
Without such a clean-up it is easy, even when motives are of the very best,
to carry forward from year to year as assets supply materials which will
never be used and which are therefore nothing but expense items and
should be charged against operation. Only a careful periodic appraisal of
supply materials and an equally careful inventory indicating their usability
can give a correct basis for applying the valuation formula.
Two or three items of deferred charges need a word of further
explanation. In some mining industries, notably coal and precious metals,
leasing is done on a royalty basis with a minimum amount to be paid each
period based on a minimum production of ore to be mined. If less than the
minimum is mined, a frequent provision in the terms of the lease makes
possible the application of any royalties overpaid one period against a
future production of more than the required minimum. That is, no increased
royalties are charged for a production over the minimum until all
accumulated royalties from periods of underproduction are used up. In any
period of underproduction such royalties may properly be treated as
deferred charges only on condition that there is reasonable expectation that
future production will increase to the point where it will consume the
overpaid royalties of earlier periods. At times a company finds itself bound
to such a contract, based on a minimum production, without any hope of
relief because the prospect has not developed as anticipated. Under such
conditions the entire periodical royalty charge is a charge against operation
and must be absorbed entirely by the operations of each fiscal period.
Accounting for Deferred Debit and Other Items
The accounting for deferred debit items proceeds along the same lines
indicated for accrued income. Nothing further need here be said than that
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such items as insurance, supplies of various sorts, etc., are frequently
recorded originally as asset items instead of as expenses. At the close of the
period so much of each of them as has been used is transferred to suitably
named expense accounts and is thus taken into profit and loss. There is no
objection to this and it usually works out very satisfactorily, although the
usual practice is to treat all items of this class as expenses rather than as
assets. This method is usually prescribed by regulatory commissions in the
case of public utility companies.
The treatment of premiums paid on long-term investments and of
discounts arising through the marketing of long-term obligations at a figure
below par is reserved for consideration in the next chapter where their
relation to the interest account and the problem of amortization will be
considered.
recorded originally as asset items instead of as expenses. At the close of the
period so much of each of them as has been used is transferred to suitably
named expense accounts and is thus taken into profit and loss. There is no
objection to this and it usually works out very satisfactorily, although the
usual practice is to treat all items of this class as expenses rather than as
assets. This method is usually prescribed by regulatory commissions in the
case of public utility companies.
The treatment of premiums paid on long-term investments and of
discounts arising through the marketing of long-term obligations at a figure
below par is reserved for consideration in the next chapter where their
relation to the interest account and the problem of amortization will be
considered.
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CHAPTER XV
PERMANENT INVESTMENTS
Nature of Permanent Investments
As distinguished from the type of investment discussed in the preceding chapter,
investments of a more or less permanent character will next claim our attention. These
may be permanent in the sense that at the date of the balance sheet they have a long term
to run before they mature and the expectation is they will be held for a considerable
period of time; or permanency may be indicated because ownership of the investment is
necessary or, at least, a valuable requisite to operation. Ease of conversion into cash may
or may not be a characteristic of such investments, and certainly it is not a determining
test for valuation as is the case with temporary investments, discussed in Chapter XIV.
The necessary test is always the condition in which the company would be placed,
viewed from the standpoint of efficient operation, if the investment were disposed of. If
its efficiency or its contracted or moral obligations would not be impaired, the
investment may be said to be of a temporary character. Examples were given in the
previous chapter. If, however, its efficiency would be materially affected, or its
continuance as a business be hampered or threatened, then the investment must be
considered as of a permanent character. This latter type of permanent investment will be
discussed first, followed by a consideration of the long-term securities (bonds, stocks,
and land) held as investments for certain funds (such as the building fund, bond and
redemption fund, etc.).
Permanent Investments as an Aid to Operation
These permanent investments may take the form of ownership of the stock or bonds
of other corporations, as in the case of the holding company. They may represent
interests, active or silent, in partnerships; or they may take the form of advances of
working capital or funds to other concerns. Whatever the form may be, and whether
evidenced by formal securities, collateral, or merely by open book accounts, they serve
the purpose of securing some essential facility without which operation could not be
successfully carried on. A newspaper may secure full or controlling interest in a paper
mill to insure its supply of print paper; a railway may become a heavy owner in a
terminal company in order to give it terminal facilities; a refinery may purchase a
controlling interest in an oil production company in order to give it a sure supply of
crude oil; etc. Thus, the permanent or fixed investment is always a means of bringing
about the efficient operation of a business. It may be effected in any one of three ways,
viz.:
PERMANENT INVESTMENTS
Nature of Permanent Investments
As distinguished from the type of investment discussed in the preceding chapter,
investments of a more or less permanent character will next claim our attention. These
may be permanent in the sense that at the date of the balance sheet they have a long term
to run before they mature and the expectation is they will be held for a considerable
period of time; or permanency may be indicated because ownership of the investment is
necessary or, at least, a valuable requisite to operation. Ease of conversion into cash may
or may not be a characteristic of such investments, and certainly it is not a determining
test for valuation as is the case with temporary investments, discussed in Chapter XIV.
The necessary test is always the condition in which the company would be placed,
viewed from the standpoint of efficient operation, if the investment were disposed of. If
its efficiency or its contracted or moral obligations would not be impaired, the
investment may be said to be of a temporary character. Examples were given in the
previous chapter. If, however, its efficiency would be materially affected, or its
continuance as a business be hampered or threatened, then the investment must be
considered as of a permanent character. This latter type of permanent investment will be
discussed first, followed by a consideration of the long-term securities (bonds, stocks,
and land) held as investments for certain funds (such as the building fund, bond and
redemption fund, etc.).
Permanent Investments as an Aid to Operation
These permanent investments may take the form of ownership of the stock or bonds
of other corporations, as in the case of the holding company. They may represent
interests, active or silent, in partnerships; or they may take the form of advances of
working capital or funds to other concerns. Whatever the form may be, and whether
evidenced by formal securities, collateral, or merely by open book accounts, they serve
the purpose of securing some essential facility without which operation could not be
successfully carried on. A newspaper may secure full or controlling interest in a paper
mill to insure its supply of print paper; a railway may become a heavy owner in a
terminal company in order to give it terminal facilities; a refinery may purchase a
controlling interest in an oil production company in order to give it a sure supply of
crude oil; etc. Thus, the permanent or fixed investment is always a means of bringing
about the efficient operation of a business. It may be effected in any one of three ways,
viz.:
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1. By practically full ownership of the subsidiary enterprise to
secure complete control and so direct its policies.
2. By only a controlling ownership.
3. Through the agency of advances, particularly when, because
of poor credit, the usual money markets may be closed to
the borrowing company.
Valuation of Permanent Investments
The problem of the valuation of investments under the three forms mentioned
presents some interesting features. It might seem that, inasmuch as the investment is in
the nature of a fixed asset, valuation should always be at full cost; that market
fluctuations should have no effect. The last half of this statement is correct but the first
part needs modification. It is to be expected that a concern in purchasing the stock of
another will not pay more than it considers the stock to be worth. The price may be more
or less than the face value of the stock, depending upon the existence of an element of
good-will or the overstatement of the assets on the books of the vendee company; or
again, where the stock is bought on the open market many other factors may cause a
variance of purchase price from par value of the stocks.
Were the investment simply an inanimate asset to be used, cost, perhaps less
depreciation, would be the proper basis for valuation. Since, however, a corporation
cannot remain stationary—it must usually record a gain or a loss from year to year—
ownership in that corporation must accordingly suffer change from year to year. So
many things can happen to an operating corporation that cannot befall an inanimate asset
held for use that the proposal to value both on the same basis is hardly tenable.
Furthermore, if proper principles of valuation are applied to the subsidiary concern, its
true value can be determined with fair accuracy. Accordingly, a true basis is secured for
valuing it as an investment on the books of the holding company. Any increase in value
over cost is due to the profits made by the subsidiary enterprise, and in the case of its
complete ownership by the holding company these profits belong in full to the holding
corporation. If all the profits are disbursed as dividends to the holding company, the
subsidiary enterprise suffers no change in condition and therefore no change in value. If,
however, some of the profits are retained, this would result in an increased value which
should be reflected in the valuation of the subsidiary enterprise on the books of the
holding company. How this may best be shown also requires consideration.
Holding Company and Subsidiary Enterprises
A holding company may have but few assets aside from its holdings in subsidiary
concerns. A balance sheet showing only these few assets and its investments in the other
concerns does not usually give much useful information. Therefore, as the assets of the
subsidiaries belong to the holding company and really comprise its operating plant, a
more intelligent way of showing the investments of the holding company is to combine
or consolidate the balance sheets of the subsidiaries and incorporate them in the balance
secure complete control and so direct its policies.
2. By only a controlling ownership.
3. Through the agency of advances, particularly when, because
of poor credit, the usual money markets may be closed to
the borrowing company.
Valuation of Permanent Investments
The problem of the valuation of investments under the three forms mentioned
presents some interesting features. It might seem that, inasmuch as the investment is in
the nature of a fixed asset, valuation should always be at full cost; that market
fluctuations should have no effect. The last half of this statement is correct but the first
part needs modification. It is to be expected that a concern in purchasing the stock of
another will not pay more than it considers the stock to be worth. The price may be more
or less than the face value of the stock, depending upon the existence of an element of
good-will or the overstatement of the assets on the books of the vendee company; or
again, where the stock is bought on the open market many other factors may cause a
variance of purchase price from par value of the stocks.
Were the investment simply an inanimate asset to be used, cost, perhaps less
depreciation, would be the proper basis for valuation. Since, however, a corporation
cannot remain stationary—it must usually record a gain or a loss from year to year—
ownership in that corporation must accordingly suffer change from year to year. So
many things can happen to an operating corporation that cannot befall an inanimate asset
held for use that the proposal to value both on the same basis is hardly tenable.
Furthermore, if proper principles of valuation are applied to the subsidiary concern, its
true value can be determined with fair accuracy. Accordingly, a true basis is secured for
valuing it as an investment on the books of the holding company. Any increase in value
over cost is due to the profits made by the subsidiary enterprise, and in the case of its
complete ownership by the holding company these profits belong in full to the holding
corporation. If all the profits are disbursed as dividends to the holding company, the
subsidiary enterprise suffers no change in condition and therefore no change in value. If,
however, some of the profits are retained, this would result in an increased value which
should be reflected in the valuation of the subsidiary enterprise on the books of the
holding company. How this may best be shown also requires consideration.
Holding Company and Subsidiary Enterprises
A holding company may have but few assets aside from its holdings in subsidiary
concerns. A balance sheet showing only these few assets and its investments in the other
concerns does not usually give much useful information. Therefore, as the assets of the
subsidiaries belong to the holding company and really comprise its operating plant, a
more intelligent way of showing the investments of the holding company is to combine
or consolidate the balance sheets of the subsidiaries and incorporate them in the balance
Page 231
sheet of the holding company in place of the item of investments. This method is known
as the “consolidated balance sheet” and is given fuller treatment in a subsequent chapter.
Here attention is called to it merely as a device for showing the valuation of permanent
investments represented by substantially full ownership of the subsidiary companies.
Controlling Investments
Where ownership is not complete but still controlling, the method of the
consolidated balance sheet is not so fully applicable and often is not used. In this case
the investment will appear as such on the balance sheet with whatever adjustments in
value may be necessary due to the success or failure of the subsidiary’s operation for the
past period. Whatever profits are made enhance its value and in the enhanced value the
controlling company has a pro rata share, the effect of which should be taken up in the
valuation of its investment therein. The net amount of the enhancement in value is the
difference between the net profit made by the subsidiary concern and that portion paid
out in dividends—in other words, the portion reinvested in the business.
This portion, i.e., such part of it as belongs to the controlling company, may be taken
up directly by charging the investment account and crediting a proper income account;
or the share of the entire net profit belonging to the controlling company may be charged
to the investment and credited to an income account. In the event of dividends being
paid by the subsidiary company, these would be credited to the investment account of the
controlling company, which account would then show, as in the first method, the new
value due to the profits reinvested in the business. That this policy of increasing the
value of the investment is conservative and sound is apparent when one considers that
the holding company’s ownership of the subsidiary concern controls the latter’s policies,
including the dividend policy. The profit taken onto the books of the holding company
by the above method is a real, not a book, profit.
Advances to Subsidiary Concerns
Where control is secured through the medium of advances made on open account or
by means of such advances together with ownership of stocks and bonds, a valuation
must be made of these claims separately from the stocks owned. Where ownership is
complete and valuation is shown by the consolidated balance sheet method,
intercompany accounts and claims are, of course, eliminated and so do not show. In all
cases, however, where claims against a subsidiary arise on account of advances, or even
of sales, and these must be shown on the balance sheet of the owner of the claims, more
than average care must be taken in placing a value on them. In the case of advances,
frequently their exact status is not known at the time when made. The record is carried in
a suspense account until its final status is determined, when record is made accordingly.
The advance may be temporary, for the purpose, say, of enabling the subsidiary concern
to take advantage of very favorable market conditions in the purchase of raw materials,
in which case, of course, the claim is a current asset; or possibly the subsidiary company
is about to make additions to plant and equipment and is financing the expansion
as the “consolidated balance sheet” and is given fuller treatment in a subsequent chapter.
Here attention is called to it merely as a device for showing the valuation of permanent
investments represented by substantially full ownership of the subsidiary companies.
Controlling Investments
Where ownership is not complete but still controlling, the method of the
consolidated balance sheet is not so fully applicable and often is not used. In this case
the investment will appear as such on the balance sheet with whatever adjustments in
value may be necessary due to the success or failure of the subsidiary’s operation for the
past period. Whatever profits are made enhance its value and in the enhanced value the
controlling company has a pro rata share, the effect of which should be taken up in the
valuation of its investment therein. The net amount of the enhancement in value is the
difference between the net profit made by the subsidiary concern and that portion paid
out in dividends—in other words, the portion reinvested in the business.
This portion, i.e., such part of it as belongs to the controlling company, may be taken
up directly by charging the investment account and crediting a proper income account;
or the share of the entire net profit belonging to the controlling company may be charged
to the investment and credited to an income account. In the event of dividends being
paid by the subsidiary company, these would be credited to the investment account of the
controlling company, which account would then show, as in the first method, the new
value due to the profits reinvested in the business. That this policy of increasing the
value of the investment is conservative and sound is apparent when one considers that
the holding company’s ownership of the subsidiary concern controls the latter’s policies,
including the dividend policy. The profit taken onto the books of the holding company
by the above method is a real, not a book, profit.
Advances to Subsidiary Concerns
Where control is secured through the medium of advances made on open account or
by means of such advances together with ownership of stocks and bonds, a valuation
must be made of these claims separately from the stocks owned. Where ownership is
complete and valuation is shown by the consolidated balance sheet method,
intercompany accounts and claims are, of course, eliminated and so do not show. In all
cases, however, where claims against a subsidiary arise on account of advances, or even
of sales, and these must be shown on the balance sheet of the owner of the claims, more
than average care must be taken in placing a value on them. In the case of advances,
frequently their exact status is not known at the time when made. The record is carried in
a suspense account until its final status is determined, when record is made accordingly.
The advance may be temporary, for the purpose, say, of enabling the subsidiary concern
to take advantage of very favorable market conditions in the purchase of raw materials,
in which case, of course, the claim is a current asset; or possibly the subsidiary company
is about to make additions to plant and equipment and is financing the expansion
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temporarily by means of borrowings from the parent company. Whatever method of
permanent finance is finally settled upon, this should convert the open-account claim of
the parent company on account of advances, into the regular securities or obligations of
the subsidiary concern. Again, it is unfortunately true that advances to the subsidiary
company often become necessary to recoup it because of operation at a loss. This may
continue with little hope of repayment for years to come, if ever. The parent company
may ultimately lose all the funds advanced to the subsidiary company because of the
latter’s financial instability.
Rules for Valuation
Because of the many factors involved, it is apparent that no absolute rule can be laid
down for valuing the advances to a subsidiary enterprise. Each case will require careful
investigation and must be settled on the basis thus established. If the investigation shows
the loan to be temporary with good expectation of its full return, it should be shown at
its face value among the current assets. If the advance is to be converted into the
securities of the subsidiary concern and the latter is in good condition, the advance may
be carried at par among the fixed assets. When the securities are received they should be
valued as any other permanent stock investments, with due regard to the basis of
conversion in comparison with the value of the securities given in settlement. If
conditions upon examination are found to be serious, it may be necessary to treat
advances made as expenses, i.e., they are of no realizable value. If the bankruptcy of the
subsidiary concern seems probable, a question of financial policy and law arises, viz.:
whether the interests of the parent company are best conserved by allowing its claims to
remain on open account and so rank with other creditors, or to be converted into stock
and rank with those of other owners. It may be necessary to take that phase of the matter
into account when determining the value of claims against the subsidiary concern.
Investments in Partial Holdings
For the sake of business connections, prestige, and good-will, oftentimes more or
less permanent investments are made of such a nature or in such amounts as not to
secure a controlling interest. Here, because the reins of business control are not held by
the investing company, manifestly such an investment is on a very different basis from
those in companies whose control is held by the investor. In the one case, business
policy can be determined and made effective; in the other case, success or failure is
under the control of others. Accordingly, the valuation of these partial holdings differs
from investments in companies entirely owned or controlled by the investor. Where the
holdings of these minor interests are not particularly substantial in comparison with
other properties owned, there is no serious objection to valuing them at cost. They are
held to secure certain benefits, and so long as the real values of the companies concerned
are being maintained or enhanced, there is little probability of the investment being
disposed of. Market fluctuations, therefore, should be given little or no consideration.
Where, however, partial or minor holdings form a comparatively large portion of the
investments, it may sometimes be wise to value them on the same basis as temporary
permanent finance is finally settled upon, this should convert the open-account claim of
the parent company on account of advances, into the regular securities or obligations of
the subsidiary concern. Again, it is unfortunately true that advances to the subsidiary
company often become necessary to recoup it because of operation at a loss. This may
continue with little hope of repayment for years to come, if ever. The parent company
may ultimately lose all the funds advanced to the subsidiary company because of the
latter’s financial instability.
Rules for Valuation
Because of the many factors involved, it is apparent that no absolute rule can be laid
down for valuing the advances to a subsidiary enterprise. Each case will require careful
investigation and must be settled on the basis thus established. If the investigation shows
the loan to be temporary with good expectation of its full return, it should be shown at
its face value among the current assets. If the advance is to be converted into the
securities of the subsidiary concern and the latter is in good condition, the advance may
be carried at par among the fixed assets. When the securities are received they should be
valued as any other permanent stock investments, with due regard to the basis of
conversion in comparison with the value of the securities given in settlement. If
conditions upon examination are found to be serious, it may be necessary to treat
advances made as expenses, i.e., they are of no realizable value. If the bankruptcy of the
subsidiary concern seems probable, a question of financial policy and law arises, viz.:
whether the interests of the parent company are best conserved by allowing its claims to
remain on open account and so rank with other creditors, or to be converted into stock
and rank with those of other owners. It may be necessary to take that phase of the matter
into account when determining the value of claims against the subsidiary concern.
Investments in Partial Holdings
For the sake of business connections, prestige, and good-will, oftentimes more or
less permanent investments are made of such a nature or in such amounts as not to
secure a controlling interest. Here, because the reins of business control are not held by
the investing company, manifestly such an investment is on a very different basis from
those in companies whose control is held by the investor. In the one case, business
policy can be determined and made effective; in the other case, success or failure is
under the control of others. Accordingly, the valuation of these partial holdings differs
from investments in companies entirely owned or controlled by the investor. Where the
holdings of these minor interests are not particularly substantial in comparison with
other properties owned, there is no serious objection to valuing them at cost. They are
held to secure certain benefits, and so long as the real values of the companies concerned
are being maintained or enhanced, there is little probability of the investment being
disposed of. Market fluctuations, therefore, should be given little or no consideration.
Where, however, partial or minor holdings form a comparatively large portion of the
investments, it may sometimes be wise to value them on the same basis as temporary
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investments of a current nature. In this case the profit or loss attendant upon bringing
market values into the books should be handled as with temporary investments.
Where investments of this kind are shown on the balance sheet at cost, it is sound
policy to call attention in a footnote or otherwise to their market values, as oftentimes
the market gives some indication of the condition of the company. The savings banks of
the State of New York, in reporting to the State Department of Banking, must show the
market value of the securities held. Usually three values are shown, viz.: market, par,
and so-called investment value, to be explained later. Where the securities held are not
listed on any exchange or are held closely and not traded in extensively, it is often
difficult to secure reliable market quotations for them. Here cost, unless known
conditions demand otherwise, seems the best basis for valuation.
Investments Producing No Income
Some investments may be of a permanent type and yet of themselves produce no
income. Such are memberships on stock and produce exchanges, boards of trade, and the
like, which are valuable for the privileges and prestige accruing therefrom and the
business associations secured thereby. They should usually be valued at cost, thus
allowing the period in which they are sold, if disposal becomes necessary, to get the
profit or loss incident thereto.
Bond Values and Market Interest Rates
In connection with the valuation of bonds, some additional considerations should be
taken into account. Assuming that the margin of security for the mortgage covering the
bonds is ample, the value of a bond, i.e., its price on the market, is largely dependent
upon the prevailing interest rate in the money market. Thus, if a bond bearing 5%
interest is offered for sale in a market where the rate is 6%, it can be sold only at a
discount sufficient to provide approximately 6% on the money invested. Similarly, a 6%
bond offered in a 5% market should bring something more than par. It is not intended to
convey the impression that whenever a bond sells below par it is because the market is
demanding a higher rate than that offered by the bond; nor when a bond sells at a
premium need the entire amount of the premium be a reflection of money market
conditions. An additional factor is oftentimes the credit standing of the issuing company.
Thus, even though a bond may be amply protected, the poor credit rating of the issuing
concern will be reflected in a downward tendency of the price of the bond, for under
such circumstances foreclosure proceedings preliminary to sale and conversion of the
security always loom large in the background. On the other hand, bonds of the United
States are often above par because of the government’s credit standing.
On the assumption that there is reasonable expectation that the bonds will be paid at
maturity, their valuation on the balance sheet during the time they are held by an
investor must have regard to the price paid as determined by the bond interest rate and
the money market rate at the time of purchase. A bond bought at a discount and held to
maturity is redeemed at par. If the bond is carried at cost until the period of redemption,
market values into the books should be handled as with temporary investments.
Where investments of this kind are shown on the balance sheet at cost, it is sound
policy to call attention in a footnote or otherwise to their market values, as oftentimes
the market gives some indication of the condition of the company. The savings banks of
the State of New York, in reporting to the State Department of Banking, must show the
market value of the securities held. Usually three values are shown, viz.: market, par,
and so-called investment value, to be explained later. Where the securities held are not
listed on any exchange or are held closely and not traded in extensively, it is often
difficult to secure reliable market quotations for them. Here cost, unless known
conditions demand otherwise, seems the best basis for valuation.
Investments Producing No Income
Some investments may be of a permanent type and yet of themselves produce no
income. Such are memberships on stock and produce exchanges, boards of trade, and the
like, which are valuable for the privileges and prestige accruing therefrom and the
business associations secured thereby. They should usually be valued at cost, thus
allowing the period in which they are sold, if disposal becomes necessary, to get the
profit or loss incident thereto.
Bond Values and Market Interest Rates
In connection with the valuation of bonds, some additional considerations should be
taken into account. Assuming that the margin of security for the mortgage covering the
bonds is ample, the value of a bond, i.e., its price on the market, is largely dependent
upon the prevailing interest rate in the money market. Thus, if a bond bearing 5%
interest is offered for sale in a market where the rate is 6%, it can be sold only at a
discount sufficient to provide approximately 6% on the money invested. Similarly, a 6%
bond offered in a 5% market should bring something more than par. It is not intended to
convey the impression that whenever a bond sells below par it is because the market is
demanding a higher rate than that offered by the bond; nor when a bond sells at a
premium need the entire amount of the premium be a reflection of money market
conditions. An additional factor is oftentimes the credit standing of the issuing company.
Thus, even though a bond may be amply protected, the poor credit rating of the issuing
concern will be reflected in a downward tendency of the price of the bond, for under
such circumstances foreclosure proceedings preliminary to sale and conversion of the
security always loom large in the background. On the other hand, bonds of the United
States are often above par because of the government’s credit standing.
On the assumption that there is reasonable expectation that the bonds will be paid at
maturity, their valuation on the balance sheet during the time they are held by an
investor must have regard to the price paid as determined by the bond interest rate and
the money market rate at the time of purchase. A bond bought at a discount and held to
maturity is redeemed at par. If the bond is carried at cost until the period of redemption,
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that period would secure the credit for the difference between cost and par. Similarly for
a bond bought at a premium, and carried at cost constantly, the period of redemption
would bear the loss between cost and redemption price.
Nature of Bond Discount or Premium
To bring out more clearly the real nature of bond discount or premium, under the
limitation stated above, consider a bond selling at 90 and bearing 4½% interest. This
should be interpreted to mean that the issuing company, because of the low rate offered
on the bond, will have to pay at maturity $1,000 for every $900 now received. It is, as it
were, having to prepay $100 interest on every bond sold, in addition to its promise to
pay the stipulated bond rate of interest periodically. It is selling a $1,000 security for
$900 and is thus depriving itself of $100 which it might have had by contracting to pay
the present market rate of interest. From the other (i.e., investor’s) point of view, he is
willing to lend money at the bond rate only because he expects to be compensated by the
$100 to be received in a lump sum at the maturity of the bond.
The wisdom of fixing the bond interest rate so that the bond will command either a
premium or a discount hinges upon the soundness of the forecast as to the money market
in the future. It is, of course, a speculative transaction. Since, then, discount on bonds is,
from the standpoint of the issuing concern, a prepayment of a portion of the interest in
amount sufficient to make the income rate on the bond correspond with the rates
prevailing in the market, this prepayment is applicable to the whole period of the life of
the bonds and should be spread equitably over that period. To accomplish this it is
necessary, every time bond interest is paid, to transfer to the Bond Interest account a
portion of the Discount on Bonds account, thus gradually wiping off the Discount
account and making the Interest account show every period the real amount (and real
rate) of interest as distinguished from the amount paid as indicated by the bond rate.
In the present discussion, the chief concern with the problem of bond discount and
premium is from the point of view of the investor. Having established from the other
point of view the true relation between premium and discount and bond interest, there
will be considered the two additional problems as to the manner of carrying the record
on the investor’s books and as to the method of valuing the investment at each balance
sheet period. First, then, is the problem of making the record.
Record of Bond Investments
When bonds are purchased the record may be made in two ways. Accounts may be
kept with the bonds at par, separate valuation accounts being carried for the discount or
premium. An account with bond interest is also opened and sometimes one with prepaid
interest on bonds, where, as is usually the case, the bonds are bought with accrued
interest to date of purchase. The accrued interest, however, is more conveniently
recorded as a charge in the bond interest account, thus automatically adjusting the
income from the bonds when the first coupon after date of purchase is redeemed. As
stated in Chapter XIV, the amount of the discount or premium is to be spread equitably
a bond bought at a premium, and carried at cost constantly, the period of redemption
would bear the loss between cost and redemption price.
Nature of Bond Discount or Premium
To bring out more clearly the real nature of bond discount or premium, under the
limitation stated above, consider a bond selling at 90 and bearing 4½% interest. This
should be interpreted to mean that the issuing company, because of the low rate offered
on the bond, will have to pay at maturity $1,000 for every $900 now received. It is, as it
were, having to prepay $100 interest on every bond sold, in addition to its promise to
pay the stipulated bond rate of interest periodically. It is selling a $1,000 security for
$900 and is thus depriving itself of $100 which it might have had by contracting to pay
the present market rate of interest. From the other (i.e., investor’s) point of view, he is
willing to lend money at the bond rate only because he expects to be compensated by the
$100 to be received in a lump sum at the maturity of the bond.
The wisdom of fixing the bond interest rate so that the bond will command either a
premium or a discount hinges upon the soundness of the forecast as to the money market
in the future. It is, of course, a speculative transaction. Since, then, discount on bonds is,
from the standpoint of the issuing concern, a prepayment of a portion of the interest in
amount sufficient to make the income rate on the bond correspond with the rates
prevailing in the market, this prepayment is applicable to the whole period of the life of
the bonds and should be spread equitably over that period. To accomplish this it is
necessary, every time bond interest is paid, to transfer to the Bond Interest account a
portion of the Discount on Bonds account, thus gradually wiping off the Discount
account and making the Interest account show every period the real amount (and real
rate) of interest as distinguished from the amount paid as indicated by the bond rate.
In the present discussion, the chief concern with the problem of bond discount and
premium is from the point of view of the investor. Having established from the other
point of view the true relation between premium and discount and bond interest, there
will be considered the two additional problems as to the manner of carrying the record
on the investor’s books and as to the method of valuing the investment at each balance
sheet period. First, then, is the problem of making the record.
Record of Bond Investments
When bonds are purchased the record may be made in two ways. Accounts may be
kept with the bonds at par, separate valuation accounts being carried for the discount or
premium. An account with bond interest is also opened and sometimes one with prepaid
interest on bonds, where, as is usually the case, the bonds are bought with accrued
interest to date of purchase. The accrued interest, however, is more conveniently
recorded as a charge in the bond interest account, thus automatically adjusting the
income from the bonds when the first coupon after date of purchase is redeemed. As
stated in Chapter XIV, the amount of the discount or premium is to be spread equitably
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over the life of the bond. The method of making an equitable distribution is a problem to
which consideration will be given in later pages of this chapter. The entry to effect the
distribution is a transfer entry between the premium or discount account and the bond
interest account for the portion accrued as on the date of each payment on the coupons.
The result of the transfer is to establish with the bond account at par a true valuation of
the bonds held as on that date, and to secure the correct amount of income from bond
interest to be credited to the current period.
The second method of making record of the bond investments is to record the
purchases at cost in the bond account, carrying there full information as to premium or
discount, no separate accounts with these being opened. When the bond interest falls
due, the bond account itself is written up or down for the amount of the discount or
premium accrued during the current period. The contra entry is in the bond interest
account just as above. This latter method does not commend itself when the only record
kept of bonds is that mentioned above. If the investments are so numerous as to require a
subsidiary ledger for their record, where with each kind of bond accounts will be kept
with its par, discount or premium, and interest, there is no objection to handling the
controlling account on the general ledger by making the discount or premium adjustment
directly to the bond account. Fuller information is given and the record is less involved,
however, when handled by the first method.
Amortization of Bond Discount and Premium
The equitable distribution (technically known as “amortization”) of the discount and
premium on bond investments is the essence of the problem of their valuation. There are
two methods of making this distribution, termed the “straight line” and the “scientific”
method. Under the straight line method the amount of the discount or premium is
divided by the interest periods the bond has yet to run, and the quotient is made the
amount of periodic amortization. Although not scientifically accurate, the method
commends itself because of its simplicity and consequent ease of operation. Its use is
allowed by the Department of Banking of the State of New York for valuing the
investments of savings banks. The scientific method is based upon compound interest
calculations and will be best understood by means of examples. Under this method the
discount or premium is looked upon as the amount of an annuity. The portion which
must be written off for any period is the present worth of the annuity on that date, taking
into consideration the rate of interest and the time in interest periods the bond has still to
run.
In practice, however, the amount of amortization is not found in that way. To find the
periodic amortization, it is necessary to know the cost of the bond, its coupon interest
rate, and the effective rate. By effective rate is meant the real income rate on the basis of
the price paid for the bond. Assume that a 3% bond, interest payable January and July,
has 3 years (6 periods) to run and is bought for $971.99 so as to yield 4% on the
investment. At the end of the first semiannual period the actual interest received will be
$15, but the real income on the investment is $19.44 because it was purchased on a 4%
which consideration will be given in later pages of this chapter. The entry to effect the
distribution is a transfer entry between the premium or discount account and the bond
interest account for the portion accrued as on the date of each payment on the coupons.
The result of the transfer is to establish with the bond account at par a true valuation of
the bonds held as on that date, and to secure the correct amount of income from bond
interest to be credited to the current period.
The second method of making record of the bond investments is to record the
purchases at cost in the bond account, carrying there full information as to premium or
discount, no separate accounts with these being opened. When the bond interest falls
due, the bond account itself is written up or down for the amount of the discount or
premium accrued during the current period. The contra entry is in the bond interest
account just as above. This latter method does not commend itself when the only record
kept of bonds is that mentioned above. If the investments are so numerous as to require a
subsidiary ledger for their record, where with each kind of bond accounts will be kept
with its par, discount or premium, and interest, there is no objection to handling the
controlling account on the general ledger by making the discount or premium adjustment
directly to the bond account. Fuller information is given and the record is less involved,
however, when handled by the first method.
Amortization of Bond Discount and Premium
The equitable distribution (technically known as “amortization”) of the discount and
premium on bond investments is the essence of the problem of their valuation. There are
two methods of making this distribution, termed the “straight line” and the “scientific”
method. Under the straight line method the amount of the discount or premium is
divided by the interest periods the bond has yet to run, and the quotient is made the
amount of periodic amortization. Although not scientifically accurate, the method
commends itself because of its simplicity and consequent ease of operation. Its use is
allowed by the Department of Banking of the State of New York for valuing the
investments of savings banks. The scientific method is based upon compound interest
calculations and will be best understood by means of examples. Under this method the
discount or premium is looked upon as the amount of an annuity. The portion which
must be written off for any period is the present worth of the annuity on that date, taking
into consideration the rate of interest and the time in interest periods the bond has still to
run.
In practice, however, the amount of amortization is not found in that way. To find the
periodic amortization, it is necessary to know the cost of the bond, its coupon interest
rate, and the effective rate. By effective rate is meant the real income rate on the basis of
the price paid for the bond. Assume that a 3% bond, interest payable January and July,
has 3 years (6 periods) to run and is bought for $971.99 so as to yield 4% on the
investment. At the end of the first semiannual period the actual interest received will be
$15, but the real income on the investment is $19.44 because it was purchased on a 4%
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basis for $971.99 (2% on $971.99). Of the total discount of $28.01, $4.44 (19.44-15.00)
is to be credited to the current period. The adjustment of discount brings about a new
valuation of the bond, it being now worth $976.43 (971.99 + 4.44), because nearer by
six months to maturity when it will be worth par or $1,000. So, for the next period the
coupon is $15 and the effective income, $19.53 (2% on $976.43), hence the amortization
is $4.53; and so on for the six periods, at the end of which the discount will have been
completely distributed, i.e., amortized.
The following schedule shows the periodic amortization and new values of the bond:
3% bond, par $1,000; bought on a 4% basis for $971.99;
3 years to run; interest January and July.
Discount
Nominal Effective Periodic Value of
Date Adjusted
Income Income Amortization Bond
Amounts
Jan. 1, 1915 $..... $..... $..... $971.99 $28.01
July 1, 1915 15.00 19.44 4.44 976.43 23.57
Jan. 1, 1916 15.00 19.53 4.53 980.96 19.04
July 1, 1916 15.00 19.62 4.62 985.58 14.42
Jan. 1, 1917 15.00 19.71 4.71 990.29 9.71
July 1, 1917 15.00 19.81 4.81 995.10 4.90
Jan. 1, 1918 15.00 19.90 4.90 1,000.00 .....
Total discount amortized $28.01
A similar schedule for a bond bought at a premium immediately follows:
5% bond, par $1,000; bought on a 4% basis for
$1,028.01; 3 years to run; interest May and November.
Discount
Nominal Effective Periodic Value of
Date Adjusted
Income Income Amortization Bond
Amounts
May 1, 1917 $..... $..... $..... $1,028.01 $28.01
Nov. 1, 1917 25.00 20.56 4.44 1,023.57 23.57
May 1, 1918 25.00 20.47 4.53 1,019.04 19.04
Nov. 1, 1918 25.00 20.38 4.62 1,014.42 14.42
May 1, 1919 25.00 20.29 4.71 1,009.71 9.71
is to be credited to the current period. The adjustment of discount brings about a new
valuation of the bond, it being now worth $976.43 (971.99 + 4.44), because nearer by
six months to maturity when it will be worth par or $1,000. So, for the next period the
coupon is $15 and the effective income, $19.53 (2% on $976.43), hence the amortization
is $4.53; and so on for the six periods, at the end of which the discount will have been
completely distributed, i.e., amortized.
The following schedule shows the periodic amortization and new values of the bond:
3% bond, par $1,000; bought on a 4% basis for $971.99;
3 years to run; interest January and July.
Discount
Nominal Effective Periodic Value of
Date Adjusted
Income Income Amortization Bond
Amounts
Jan. 1, 1915 $..... $..... $..... $971.99 $28.01
July 1, 1915 15.00 19.44 4.44 976.43 23.57
Jan. 1, 1916 15.00 19.53 4.53 980.96 19.04
July 1, 1916 15.00 19.62 4.62 985.58 14.42
Jan. 1, 1917 15.00 19.71 4.71 990.29 9.71
July 1, 1917 15.00 19.81 4.81 995.10 4.90
Jan. 1, 1918 15.00 19.90 4.90 1,000.00 .....
Total discount amortized $28.01
A similar schedule for a bond bought at a premium immediately follows:
5% bond, par $1,000; bought on a 4% basis for
$1,028.01; 3 years to run; interest May and November.
Discount
Nominal Effective Periodic Value of
Date Adjusted
Income Income Amortization Bond
Amounts
May 1, 1917 $..... $..... $..... $1,028.01 $28.01
Nov. 1, 1917 25.00 20.56 4.44 1,023.57 23.57
May 1, 1918 25.00 20.47 4.53 1,019.04 19.04
Nov. 1, 1918 25.00 20.38 4.62 1,014.42 14.42
May 1, 1919 25.00 20.29 4.71 1,009.71 9.71
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Discount
Nominal Effective Periodic Value of
Date Adjusted
Income Income Amortization Bond
Amounts
Nov. 1, 1919 25.00 20.19 4.81 1,004.90 4.90
May 1, 1920 25.00 20.10 4.90 1,000.00 .....
Total premium amortized $28.01
The problem of amortization is thus seen to be comparatively simple when the cost
of the bond, its nominal rate, and effective rate are known, and successive valuations of
the bond are equally simple. The crux of the whole calculation is thus seen to be the
determination of the original purchase price of the bond. At the time of the purchase of
the bond the following facts are known: the par of the bond, the time it has to run, its
rate of interest, and the rate of earning desired on the investment. There are three
methods or formulas by which this price can be determined and they will be explained in
turn. However, the development of the formulas will be more easily understood if some
points in compound interest and annuity calculations applicable to the three methods of
valuing the bond are first explained.
Formulas for Compound Interest
In the determination of the present worth of a sum of money at compound interest
due a certain number of years hence, the following symbols will be used:
A = the sum which placed at interest at the given rate will
accumulate to the given amount in the given time.
B = the given amount accumulated
r = given rate of interest per period
R = 1+r
n = the given number of periods
The present worth of B is manifestly A, the sum which, when placed at interest,
amounts to B. At compound interest the amount to which A will accumulate in n periods
is given by the formula:
(1) B = A(1 + r)(1 + r) ... to n factors,
which reduces to
= ARⁿ,
whence solving the equation for A
Nominal Effective Periodic Value of
Date Adjusted
Income Income Amortization Bond
Amounts
Nov. 1, 1919 25.00 20.19 4.81 1,004.90 4.90
May 1, 1920 25.00 20.10 4.90 1,000.00 .....
Total premium amortized $28.01
The problem of amortization is thus seen to be comparatively simple when the cost
of the bond, its nominal rate, and effective rate are known, and successive valuations of
the bond are equally simple. The crux of the whole calculation is thus seen to be the
determination of the original purchase price of the bond. At the time of the purchase of
the bond the following facts are known: the par of the bond, the time it has to run, its
rate of interest, and the rate of earning desired on the investment. There are three
methods or formulas by which this price can be determined and they will be explained in
turn. However, the development of the formulas will be more easily understood if some
points in compound interest and annuity calculations applicable to the three methods of
valuing the bond are first explained.
Formulas for Compound Interest
In the determination of the present worth of a sum of money at compound interest
due a certain number of years hence, the following symbols will be used:
A = the sum which placed at interest at the given rate will
accumulate to the given amount in the given time.
B = the given amount accumulated
r = given rate of interest per period
R = 1+r
n = the given number of periods
The present worth of B is manifestly A, the sum which, when placed at interest,
amounts to B. At compound interest the amount to which A will accumulate in n periods
is given by the formula:
(1) B = A(1 + r)(1 + r) ... to n factors,
which reduces to
= ARⁿ,
whence solving the equation for A
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B
(2) A = ——, i.e., the present worth
Rⁿ
B
= ——.
Rⁿ
From this, the present worth of $1 is seen to be 1/Rⁿ .
Formulas for Annuities
An annuity is a given sum of money placed at interest usually at the end of each
successive year or period, and allowed to accumulate at compound interest for a number
of periods. For bond valuations it is necessary to know the amount of an annuity and the
present worth of this amount. The following terminology will be used in the solution of
the problem:
A = the sum put at interest periodically
B = the amount to which A accumulates
r = the rate of interest per period
R = 1+r
n = the number of periods
P. W. = the present worth of the annuity
The first sum, A, placed at interest at the end of the first period will accumulate for n-1
periods and, according to formula (1) above, will amount to ARⁿ⁻¹. The second sum, A,
placed at interest at the end of the second period will amount to ARⁿ⁻²; etc. The last
sum, A, will not accumulate and so is worth just A.
The amount of the annuity is thus seen to be the sum of the amounts of the several
periodic sums. Expressed as a formula:
B = ARⁿ⁻¹ + ARⁿ⁻² ... + AR + A
= A(Rⁿ⁻¹ + Rⁿ⁻² ... + R + 1),
whence
Rⁿ⁻¹ Rⁿ⁻¹
(3) B = A —— or A ——
(2) A = ——, i.e., the present worth
Rⁿ
B
= ——.
Rⁿ
From this, the present worth of $1 is seen to be 1/Rⁿ .
Formulas for Annuities
An annuity is a given sum of money placed at interest usually at the end of each
successive year or period, and allowed to accumulate at compound interest for a number
of periods. For bond valuations it is necessary to know the amount of an annuity and the
present worth of this amount. The following terminology will be used in the solution of
the problem:
A = the sum put at interest periodically
B = the amount to which A accumulates
r = the rate of interest per period
R = 1+r
n = the number of periods
P. W. = the present worth of the annuity
The first sum, A, placed at interest at the end of the first period will accumulate for n-1
periods and, according to formula (1) above, will amount to ARⁿ⁻¹. The second sum, A,
placed at interest at the end of the second period will amount to ARⁿ⁻²; etc. The last
sum, A, will not accumulate and so is worth just A.
The amount of the annuity is thus seen to be the sum of the amounts of the several
periodic sums. Expressed as a formula:
B = ARⁿ⁻¹ + ARⁿ⁻² ... + AR + A
= A(Rⁿ⁻¹ + Rⁿ⁻² ... + R + 1),
whence
Rⁿ⁻¹ Rⁿ⁻¹
(3) B = A —— or A ——
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R-1 r
The expression in parentheses is a geometric series whose sum may be written in the
fractional form shown.
The present worth of B, i.e., of
Rⁿ⁻¹
A ——
r
is found from formula (2) above to be:
Rⁿ⁻¹
A —— divided by Rⁿ.
r
Expressed as a formula:
Rⁿ⁻¹
(4) P. W. = A ——
Rⁿr
Formulas for Bond Valuation
The method of valuing a bond makes use of the formulas (1) to (4) just established.
The symbols used in the bond formulas will be:
P = the par or face value of the bond
r = the effective rate
c = the nominal rate—the rate specified in the bond
C = Pc, i.e., the value or amount of a matured interest
coupon, the nominal yield of the bond
Pr = the interest yield on par at the effective rate
V = present worth or value of the bond
First Method. The present value of a bond may be looked upon as the sum of two
present worths, viz.: the present worth of the face of the bond and the present worth of
the annuity represented by the periodic interest payments, i.e., the coupons. The present
worth of the face is, according to formula (2), P/Rⁿ. The present worth of the coupon
annuity is, from formula (4), seen to be
The expression in parentheses is a geometric series whose sum may be written in the
fractional form shown.
The present worth of B, i.e., of
Rⁿ⁻¹
A ——
r
is found from formula (2) above to be:
Rⁿ⁻¹
A —— divided by Rⁿ.
r
Expressed as a formula:
Rⁿ⁻¹
(4) P. W. = A ——
Rⁿr
Formulas for Bond Valuation
The method of valuing a bond makes use of the formulas (1) to (4) just established.
The symbols used in the bond formulas will be:
P = the par or face value of the bond
r = the effective rate
c = the nominal rate—the rate specified in the bond
C = Pc, i.e., the value or amount of a matured interest
coupon, the nominal yield of the bond
Pr = the interest yield on par at the effective rate
V = present worth or value of the bond
First Method. The present value of a bond may be looked upon as the sum of two
present worths, viz.: the present worth of the face of the bond and the present worth of
the annuity represented by the periodic interest payments, i.e., the coupons. The present
worth of the face is, according to formula (2), P/Rⁿ. The present worth of the coupon
annuity is, from formula (4), seen to be
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C(Rⁿ⁻¹)
Rⁿr
Hence the present value of the bond is the sum of these two present worths, i.e.:
P C(Rⁿ⁻¹) Pr + C(Rⁿ⁻¹)
(5) V= + or
Rⁿ Rⁿr rRⁿ
Second Method. Here, the determination of the amount of premium or discount
which is fair payment for a bond is the point of attack. That is, using par as a basis, how
much above or below par is the bond worth? The fair premium is based upon the
difference between the nominal yield of the bond and the interest return in the present
money market. Stated otherwise, in the case of a bond selling at a premium, the nominal
interest return may be looked upon as composed of two parts, viz.: (1) a portion
representing interest at the effective, i.e., current money market rate on the par value of
the bond, and (2) a portion—the difference between the nominal yield and (1)—which is
of the nature of an annuity for the life of the bond. The present worth of this annuity is
the fair premium on the bond.
To illustrate: A 6% bond sold in a 5% market would have a nominal yield annually
of $60. All that can be secured, however, on the par value is $50. Hence, on the basis of
valuation at par there is a $10 excess of nominal over market yield which would be
received every period. The present worth of this $10 annuity is the fair premium which
the bond will command. With the use of the previous symbols, this annuity is expressed
by the quantity (C-Pr) whose present worth, as determined by formula (4) is
(C - Pr)(Rⁿ⁻¹)
rRⁿ
Therefore, the value of the bond is the face or par of the bond plus the present worth of
this annuity, i.e.:
(C - Pr)(Rⁿ - 1)
(6) V= P +
rRⁿ
This formula when simplified reduces to
Pr + C(Rⁿ - 1)
rRⁿ
which is identical with formula (5) and, of course, values the bond at the same amount.
Third Method. Valuation by either of the methods above is rather complex, requiring
for easy solution the use of logarithm or compound interest tables. A third method,
Rⁿr
Hence the present value of the bond is the sum of these two present worths, i.e.:
P C(Rⁿ⁻¹) Pr + C(Rⁿ⁻¹)
(5) V= + or
Rⁿ Rⁿr rRⁿ
Second Method. Here, the determination of the amount of premium or discount
which is fair payment for a bond is the point of attack. That is, using par as a basis, how
much above or below par is the bond worth? The fair premium is based upon the
difference between the nominal yield of the bond and the interest return in the present
money market. Stated otherwise, in the case of a bond selling at a premium, the nominal
interest return may be looked upon as composed of two parts, viz.: (1) a portion
representing interest at the effective, i.e., current money market rate on the par value of
the bond, and (2) a portion—the difference between the nominal yield and (1)—which is
of the nature of an annuity for the life of the bond. The present worth of this annuity is
the fair premium on the bond.
To illustrate: A 6% bond sold in a 5% market would have a nominal yield annually
of $60. All that can be secured, however, on the par value is $50. Hence, on the basis of
valuation at par there is a $10 excess of nominal over market yield which would be
received every period. The present worth of this $10 annuity is the fair premium which
the bond will command. With the use of the previous symbols, this annuity is expressed
by the quantity (C-Pr) whose present worth, as determined by formula (4) is
(C - Pr)(Rⁿ⁻¹)
rRⁿ
Therefore, the value of the bond is the face or par of the bond plus the present worth of
this annuity, i.e.:
(C - Pr)(Rⁿ - 1)
(6) V= P +
rRⁿ
This formula when simplified reduces to
Pr + C(Rⁿ - 1)
rRⁿ
which is identical with formula (5) and, of course, values the bond at the same amount.
Third Method. Valuation by either of the methods above is rather complex, requiring
for easy solution the use of logarithm or compound interest tables. A third method,
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requiring only the ordinary arithmetic processes is sometimes used, although very
burdensome when the periods are numerous. This is sometimes called the periodic
method because working backwards from par, the value at the next preceding period is
determined, and from that the next is found, and so on till the value at the desired period
is reached. Reference to the second amortization schedule shown on page 270 will help
in understanding the process. Using the same terminology as above and this additional:
P₁ = the first preceding value above par
($1,004.90 in the schedule)
P₂ = the second preceding value above
par ($1,009.71 in the schedule)
Etc.
formulas 7 to 9 below may be developed.
It was noted that any particular value of the bond is found by subtracting from the
next preceding value the difference between the nominal and effective incomes. The
nominal income is always based on par, and the effective on the value at the last interest
period. For example, in the schedule referred to: $1,004.90-($25-$20.10) = $1,000, the
$20.10 being the effective income, 2% on $1,004.90. Using symbols the above equation
may be generalized as follows:
P + Pc
(7) P₁ - (Pc - P₁r) = P, whence P₁ = and,
1+r
P + Pc
(8) P₂ - (Pc - P₃r) = P₁, whence P₂ = and, generalized,
1+r
Pₙ₋₁ + Pc
(9) Pₙ - (Pc - Pₙr) = Pₙ₋₁, whence Pₙ =
1+r
This gives a working rule whereby it is possible to work back from the known value,
par, by successive operations until any desired value is found. The calculation is
somewhat as follows for the example used in the schedule:
1,000 + (1,000 × .025) 1,025
= = 1,004.90
1.02 1.02
1,004.90 + (1,000 × .025) 1,029.90
= = 1,009.71
1.02 1.02
Similar calculations will develop the other values in the schedule. In the case of a
bond with, say, 30 periods still to run, the burdensome nature of the calculation by this
burdensome when the periods are numerous. This is sometimes called the periodic
method because working backwards from par, the value at the next preceding period is
determined, and from that the next is found, and so on till the value at the desired period
is reached. Reference to the second amortization schedule shown on page 270 will help
in understanding the process. Using the same terminology as above and this additional:
P₁ = the first preceding value above par
($1,004.90 in the schedule)
P₂ = the second preceding value above
par ($1,009.71 in the schedule)
Etc.
formulas 7 to 9 below may be developed.
It was noted that any particular value of the bond is found by subtracting from the
next preceding value the difference between the nominal and effective incomes. The
nominal income is always based on par, and the effective on the value at the last interest
period. For example, in the schedule referred to: $1,004.90-($25-$20.10) = $1,000, the
$20.10 being the effective income, 2% on $1,004.90. Using symbols the above equation
may be generalized as follows:
P + Pc
(7) P₁ - (Pc - P₁r) = P, whence P₁ = and,
1+r
P + Pc
(8) P₂ - (Pc - P₃r) = P₁, whence P₂ = and, generalized,
1+r
Pₙ₋₁ + Pc
(9) Pₙ - (Pc - Pₙr) = Pₙ₋₁, whence Pₙ =
1+r
This gives a working rule whereby it is possible to work back from the known value,
par, by successive operations until any desired value is found. The calculation is
somewhat as follows for the example used in the schedule:
1,000 + (1,000 × .025) 1,025
= = 1,004.90
1.02 1.02
1,004.90 + (1,000 × .025) 1,029.90
= = 1,009.71
1.02 1.02
Similar calculations will develop the other values in the schedule. In the case of a
bond with, say, 30 periods still to run, the burdensome nature of the calculation by this
Page 242
method is apparent.
While commercial houses rarely need to use the algebraic formulas for calculating
bond values, it is the only really correct method of valuing bonds which are held for
long-time investment, and the accountant should be conversant with it. For the balance
sheets of savings banks, insurance companies, and other investment concerns, scientific
valuation of bonds with the attendant amortization up and down of discounts and
premiums is not only theoretically correct but practical considerations, in a market such
as prevails in a time of marked but temporary depression, demand that it, or some
approximation to it, be used.
A discussion of the valuation of serial and short terminal bonds, or those carrying
more than one rate of interest, or those redeemable by lot at various times, is beyond the
scope of the present work.
Valuation of Sinking Funds
The section of the balance sheet under consideration usually includes the various
funds representing the investment of reserves. Sinking funds, building funds, insurance,
pension, endowment funds, and the like, are examples of this class of asset. The use of
the term fund should be strictly limited to specific assets set aside for specific purposes.
The problem of valuation in connection with funds will be considered under two sets of
conditions, viz., when the funds are invested in a concern’s own securities and when
invested in outside securities. The practical questions in connection with funds are those
of finance rather than of accounting.
The determination of a policy of investment as between the concern’s own and
outside securities depends on many considerations, some of which do not come strictly
in the purview of the accountant. It is argued that for the sake of immediate availability,
investment of funds to be used for a specific purpose at a definite time should be in the
securities of other concerns over whom control does not extend. In some cases, however,
provision is made in the trust deed of a sinking fund to the effect that the funds set aside
shall be used to purchase the bonds to retire which the funds have been created. These
bonds may be canceled or held for the sake of their income in the fund till maturity.
There would seem to be no choice between a concern’s own and outside securities,
provided the same standards of moral obligation are observed in both cases. If the
securities purchased for the funds are the concern’s own bonds, they should as a rule be
valued at cost and the premium or discount amortized over the remaining life of the
security. They may, of course, be carried on the books at par and the premium charged
immediately against any income in the fund. The showing on the balance sheet should
be in exact accord with the facts. If the bonds have been purchased and canceled
together with their coupons, the amount of such cancellations should be shown as a
deduction from the bond liability. The fund is thus serving its purpose currently by
reducing that liability. Any uninvested balance in the fund should, of course, be shown
among the assets. When the bonds are purchased and held uncanceled for the sake of
their income, it is probably better to carry them among the assets, indicating, if the
While commercial houses rarely need to use the algebraic formulas for calculating
bond values, it is the only really correct method of valuing bonds which are held for
long-time investment, and the accountant should be conversant with it. For the balance
sheets of savings banks, insurance companies, and other investment concerns, scientific
valuation of bonds with the attendant amortization up and down of discounts and
premiums is not only theoretically correct but practical considerations, in a market such
as prevails in a time of marked but temporary depression, demand that it, or some
approximation to it, be used.
A discussion of the valuation of serial and short terminal bonds, or those carrying
more than one rate of interest, or those redeemable by lot at various times, is beyond the
scope of the present work.
Valuation of Sinking Funds
The section of the balance sheet under consideration usually includes the various
funds representing the investment of reserves. Sinking funds, building funds, insurance,
pension, endowment funds, and the like, are examples of this class of asset. The use of
the term fund should be strictly limited to specific assets set aside for specific purposes.
The problem of valuation in connection with funds will be considered under two sets of
conditions, viz., when the funds are invested in a concern’s own securities and when
invested in outside securities. The practical questions in connection with funds are those
of finance rather than of accounting.
The determination of a policy of investment as between the concern’s own and
outside securities depends on many considerations, some of which do not come strictly
in the purview of the accountant. It is argued that for the sake of immediate availability,
investment of funds to be used for a specific purpose at a definite time should be in the
securities of other concerns over whom control does not extend. In some cases, however,
provision is made in the trust deed of a sinking fund to the effect that the funds set aside
shall be used to purchase the bonds to retire which the funds have been created. These
bonds may be canceled or held for the sake of their income in the fund till maturity.
There would seem to be no choice between a concern’s own and outside securities,
provided the same standards of moral obligation are observed in both cases. If the
securities purchased for the funds are the concern’s own bonds, they should as a rule be
valued at cost and the premium or discount amortized over the remaining life of the
security. They may, of course, be carried on the books at par and the premium charged
immediately against any income in the fund. The showing on the balance sheet should
be in exact accord with the facts. If the bonds have been purchased and canceled
together with their coupons, the amount of such cancellations should be shown as a
deduction from the bond liability. The fund is thus serving its purpose currently by
reducing that liability. Any uninvested balance in the fund should, of course, be shown
among the assets. When the bonds are purchased and held uncanceled for the sake of
their income, it is probably better to carry them among the assets, indicating, if the
Page 243
information should be considered vital, that the securities in the fund are the concern’s
own securities.
If the funds are invested in outside securities, these should be valued on the basis of
long-time investments. If bonds, their premiums or discounts should be amortized. If,
however, the credit of the issuing concern is such as to cast doubt on its ability to redeem
them at maturity, other bases for valuation should be taken. It might even be necessary to
set up special reserves to replenish the expected shrinkage upon realization of the
securities held in the fund. A final injunction may not be out of place, to the effect that
all funds should be definitely labeled so as to show their purpose.
Valuation of Investments in Land
Investments of a more or less permanent nature sometimes take the form of
investments in land. This may be for the purpose of securing an income; it may be of a
speculative nature, as when land is held for appreciation in value; it may be to secure
room for future expansion; or it may be for the purpose of preventing a competitor from
securing favorable holdings as to trade location or facilities. For whatever purpose
acquired, as here considered, the land is a permanent investment and should be separated
in the records from land held for operating purposes. The manner of accounting for these
investment holdings is somewhat dependent on the purpose for which they are held. In
most cases, particularly if the land is income-producing, at least a land expense and
income account will be needed in addition to the asset account or accounts with the land.
As to the valuation of these holdings, full cost with no account taken of depreciation
or appreciation in value is the correct basis. As stated in Chapter XVII, page 307, under
certain conditions the carrying charges on non-income-producing lands may be added to
the value of the holdings. If lands are held over a long period to secure appreciation in
value, certainly all carrying costs should be loaded on to the asset account, offset, as
shown in Chapter XVII, by a suitable reserve. Care must always be taken not to secure
inflated values by these methods. If any of these holdings are disposed of, the profit or
loss then actually realized must be taken into account; but no unrealized profit or loss
should be brought onto the books—except, perhaps, as a balance sheet footnote.
own securities.
If the funds are invested in outside securities, these should be valued on the basis of
long-time investments. If bonds, their premiums or discounts should be amortized. If,
however, the credit of the issuing concern is such as to cast doubt on its ability to redeem
them at maturity, other bases for valuation should be taken. It might even be necessary to
set up special reserves to replenish the expected shrinkage upon realization of the
securities held in the fund. A final injunction may not be out of place, to the effect that
all funds should be definitely labeled so as to show their purpose.
Valuation of Investments in Land
Investments of a more or less permanent nature sometimes take the form of
investments in land. This may be for the purpose of securing an income; it may be of a
speculative nature, as when land is held for appreciation in value; it may be to secure
room for future expansion; or it may be for the purpose of preventing a competitor from
securing favorable holdings as to trade location or facilities. For whatever purpose
acquired, as here considered, the land is a permanent investment and should be separated
in the records from land held for operating purposes. The manner of accounting for these
investment holdings is somewhat dependent on the purpose for which they are held. In
most cases, particularly if the land is income-producing, at least a land expense and
income account will be needed in addition to the asset account or accounts with the land.
As to the valuation of these holdings, full cost with no account taken of depreciation
or appreciation in value is the correct basis. As stated in Chapter XVII, page 307, under
certain conditions the carrying charges on non-income-producing lands may be added to
the value of the holdings. If lands are held over a long period to secure appreciation in
value, certainly all carrying costs should be loaded on to the asset account, offset, as
shown in Chapter XVII, by a suitable reserve. Care must always be taken not to secure
inflated values by these methods. If any of these holdings are disposed of, the profit or
loss then actually realized must be taken into account; but no unrealized profit or loss
should be brought onto the books—except, perhaps, as a balance sheet footnote.
Page 244
CHAPTER XVI
MACHINERY AND TOOLS,
FURNITURE AND FIXTURES,
AND OTHER EQUIPMENT
General Considerations
The valuation of assets grouped under the head of equipment presents
nothing new in principle but requires consideration of many points in the
application of principles and of some features in accounting. Here the
principle of value as a going concern is particularly effective. As in the
valuation of prepaid expenses on a going concern basis, so here forced sale
or liquidation value has no place. The business is viewed as established and
as expecting to operate continuously. Capital has become tied up in certain
equipment essential to the undertaking, in the sense that to dispose of it in
its entirety would mean a break-up of the business. It cannot therefore be
freed or put to other uses without a reconstruction of the present enterprise.
Accordingly, the possible market value, as second-hand property, should not
in any way influence the valuation at which this group of assets is carried
on the books. Only full cost at the time of installation and depreciation,
using the term in its broad sense, need be considered in the problem of
valuation.
Distinction between Personalty and Real Property
The present chapter deals with such fixed asset equipment as machinery
and tools, furniture and fixtures, delivery equipments, patterns, lasts, dies,
maps, drawings, electrotypes, ovens, furnaces, etc., as distinguished from
the more fixed group of lands, buildings, leaseholds, and the like. In the
main, the point of differentiation is the legal one of personalty and real
property, although the intricacies of the law on this vexed subject are never,
so far as is known, reflected in the books of account, nor is it the purpose
here to attempt to lay down any working rules or standards by which such
differentiation can be made. There seem to be none except certain broad
MACHINERY AND TOOLS,
FURNITURE AND FIXTURES,
AND OTHER EQUIPMENT
General Considerations
The valuation of assets grouped under the head of equipment presents
nothing new in principle but requires consideration of many points in the
application of principles and of some features in accounting. Here the
principle of value as a going concern is particularly effective. As in the
valuation of prepaid expenses on a going concern basis, so here forced sale
or liquidation value has no place. The business is viewed as established and
as expecting to operate continuously. Capital has become tied up in certain
equipment essential to the undertaking, in the sense that to dispose of it in
its entirety would mean a break-up of the business. It cannot therefore be
freed or put to other uses without a reconstruction of the present enterprise.
Accordingly, the possible market value, as second-hand property, should not
in any way influence the valuation at which this group of assets is carried
on the books. Only full cost at the time of installation and depreciation,
using the term in its broad sense, need be considered in the problem of
valuation.
Distinction between Personalty and Real Property
The present chapter deals with such fixed asset equipment as machinery
and tools, furniture and fixtures, delivery equipments, patterns, lasts, dies,
maps, drawings, electrotypes, ovens, furnaces, etc., as distinguished from
the more fixed group of lands, buildings, leaseholds, and the like. In the
main, the point of differentiation is the legal one of personalty and real
property, although the intricacies of the law on this vexed subject are never,
so far as is known, reflected in the books of account, nor is it the purpose
here to attempt to lay down any working rules or standards by which such
differentiation can be made. There seem to be none except certain broad
Page 245
generalizations, each case resting on its own peculiar surroundings.
Circumstances, however, may arise under which a clear-cut distinction is
desirable. A bond issue supported by a mortgage on real property or on
personal property may depend, although not usually, on such a distinction
for a large share of its security. The margin of safety may hinge on this
point. It may be desirable to be able to trace on the face of a balance sheet
the particular property covered by a mortgage. And should foreclosure of
the mortgage become necessary, it is, of course, essential to know exactly
the property subject to the lien. These are not points under contemplation in
a going concern, although the possibility of their arising should not be lost
to view. Here the problem of valuation and accounting for such valuation is
viewed from the standpoint of a going concern and not one facing partial or
total liquidation. Furthermore, as stated above, the point is, in its final
analysis, one of law and not of accounting.
It is not intended by the foregoing statement to sanction any method of
keeping the records in non-accord with fundamental rulings of the law, but
only to state that, so long as substantial agreement is secured, accounting
has served its intended purpose. Wherever any specific property is known to
be subject to a lien, it is of value to the management for the accounts to
reflect the fact. There may, however, be circumstances under which it is not
desirable that the accounting records give this information. Conditions must
govern each particular case without prejudice, and the principle holds that
so long as substantial accuracy is reflected in the accounts as to this point
nothing more is necessary.
Machinery and Tools
Under this head will be included not only the assets carried under that
ledger caption, but also power machinery, power transmission, shafting,
connections, electric transmission cables, and the like. The term is used in a
very broad sense. While all these items are subject to one general rule of
valuation, usually each must be separately considered to determine the
practical application of the rule. The valuation involves, of course, the
factor of depreciation, and it is readily apparent that not only do different
pieces of machinery differ in this respect, but the same machines in
different factories will vary as to this element and even in the same factory
two similar machines will not usually be affected in the same way. This
Circumstances, however, may arise under which a clear-cut distinction is
desirable. A bond issue supported by a mortgage on real property or on
personal property may depend, although not usually, on such a distinction
for a large share of its security. The margin of safety may hinge on this
point. It may be desirable to be able to trace on the face of a balance sheet
the particular property covered by a mortgage. And should foreclosure of
the mortgage become necessary, it is, of course, essential to know exactly
the property subject to the lien. These are not points under contemplation in
a going concern, although the possibility of their arising should not be lost
to view. Here the problem of valuation and accounting for such valuation is
viewed from the standpoint of a going concern and not one facing partial or
total liquidation. Furthermore, as stated above, the point is, in its final
analysis, one of law and not of accounting.
It is not intended by the foregoing statement to sanction any method of
keeping the records in non-accord with fundamental rulings of the law, but
only to state that, so long as substantial agreement is secured, accounting
has served its intended purpose. Wherever any specific property is known to
be subject to a lien, it is of value to the management for the accounts to
reflect the fact. There may, however, be circumstances under which it is not
desirable that the accounting records give this information. Conditions must
govern each particular case without prejudice, and the principle holds that
so long as substantial accuracy is reflected in the accounts as to this point
nothing more is necessary.
Machinery and Tools
Under this head will be included not only the assets carried under that
ledger caption, but also power machinery, power transmission, shafting,
connections, electric transmission cables, and the like. The term is used in a
very broad sense. While all these items are subject to one general rule of
valuation, usually each must be separately considered to determine the
practical application of the rule. The valuation involves, of course, the
factor of depreciation, and it is readily apparent that not only do different
pieces of machinery differ in this respect, but the same machines in
different factories will vary as to this element and even in the same factory
two similar machines will not usually be affected in the same way. This
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may be caused by defects or differences in quality, almost invariably latent,
inhering in the machine and also by the different conditions under which
they are operated. As pointed out in Chapter VI on depreciation, many of
these are engineering problems which the accountant alone cannot solve but
the existence of which he should know. Manifestly, all that can be attempted
here is to point out their existence.
Accounting Records
The valuation of machinery and tools as here contemplated is dependent
largely on the accounting records. Therefore, it is desirable to keep separate
records for each of the two classes. This is so because of the greater degree
of fixity of the one over the other. As to tools a distinction is also made
between machine tools and general shop or hand tools. Machine tools are
those with which the machine does its work. Thus, cutting tools for use with
any particular machine, auxiliary equipment used for some operations, but
not for others, and the like, constitute a very essential and component part
of the machine and should be recorded and valued with the machine even
though the tools need to be replaced much more frequently than the
machine. On the other hand, shop tools comprise those of general utility
which are largely used by hand. Hammers, wrenches, hand shears, pliers,
chisels, bits, and the like, are examples of shop or hand tools.
Where the number of machines is large, proper accounting requires a
subsidiary record known as a machinery ledger or register controlled by the
machinery account on the general ledger. In this subsidiary record accounts
should be kept with each class of machines, and with each machine
separately if the record as to the performance of any specific machine
furnishes essential information.
Operation of Machine Accounts
Every machine should be charged with its full cost. Full cost is
understood to include invoice price, insurance during transit, freight, duty,
and drayage charges, and installation costs. The last item usually includes
the platform or stand on which the machine is erected, with all costs in
connection therewith, when special supports or platforms in addition to the
regular factory floor are needed. The cost of attaching the machine to the
power and meters for measuring its power consumption are not usually
inhering in the machine and also by the different conditions under which
they are operated. As pointed out in Chapter VI on depreciation, many of
these are engineering problems which the accountant alone cannot solve but
the existence of which he should know. Manifestly, all that can be attempted
here is to point out their existence.
Accounting Records
The valuation of machinery and tools as here contemplated is dependent
largely on the accounting records. Therefore, it is desirable to keep separate
records for each of the two classes. This is so because of the greater degree
of fixity of the one over the other. As to tools a distinction is also made
between machine tools and general shop or hand tools. Machine tools are
those with which the machine does its work. Thus, cutting tools for use with
any particular machine, auxiliary equipment used for some operations, but
not for others, and the like, constitute a very essential and component part
of the machine and should be recorded and valued with the machine even
though the tools need to be replaced much more frequently than the
machine. On the other hand, shop tools comprise those of general utility
which are largely used by hand. Hammers, wrenches, hand shears, pliers,
chisels, bits, and the like, are examples of shop or hand tools.
Where the number of machines is large, proper accounting requires a
subsidiary record known as a machinery ledger or register controlled by the
machinery account on the general ledger. In this subsidiary record accounts
should be kept with each class of machines, and with each machine
separately if the record as to the performance of any specific machine
furnishes essential information.
Operation of Machine Accounts
Every machine should be charged with its full cost. Full cost is
understood to include invoice price, insurance during transit, freight, duty,
and drayage charges, and installation costs. The last item usually includes
the platform or stand on which the machine is erected, with all costs in
connection therewith, when special supports or platforms in addition to the
regular factory floor are needed. The cost of attaching the machine to the
power and meters for measuring its power consumption are not usually
Page 247
included therein, these being classed as costs of power equipment—
although practice is not entirely uniform in this regard. The machine record
should also show the name of its manufacturer and its order number and
any other useful information such as terms and period of guarantee,
estimated life, rate of depreciation to be applied, numbers and kinds of tool
equipment, etc. All deductions from the value of the machine must be on
the same basis of full cost. Such deductions might arise because of fire,
sale, or replacement. The proper handling of the account when deductions
are necessary will be explained at the close of the chapter, as the method is
applicable to all classes of asset equipment.
Valuations of Machinery and Tools
The statement of the principle of valuation for machinery is simple, but
the application of the rule is complex. The valuation formula for machinery
is cost less depreciation. As stated above, the condition of the market has no
influence on the going concern valuation of fixed assets. If the market is
now lower than at the date of purchase, this simply means that more capital
was then required to start operations than is now required. If the forces of
competition are free to act, the margin of profit or the margin of return on
the investment in machinery will be somewhat less in the one case than in
the other. If the market is now higher, then the situation is in favor of the
earlier investment rather than the present one. In neither case should costs
of production be falsified by valuing the machinery and other equipment at
any other figure than cost.
Estimate of Depreciation
Estimating the depreciation on machines is the chief and vital problem
in their valuation, because depreciation is reflected in the cost of the article
manufactured, being a cost of production just as truly as the raw material
used. As brought out fully in Chapter V, page 93, the so-called depreciating
assets are really of the nature of deferred charges to operation and a
depreciation estimate is the amount of the periodic charge against
production. Because of the speculative nature of an investment in
machinery (neither the quality of the machine being exactly determinable
nor the conditions of its operation known), its depreciation is always an
estimate. For this reason it should be based on the best possible knowledge
available at the time of installation.
although practice is not entirely uniform in this regard. The machine record
should also show the name of its manufacturer and its order number and
any other useful information such as terms and period of guarantee,
estimated life, rate of depreciation to be applied, numbers and kinds of tool
equipment, etc. All deductions from the value of the machine must be on
the same basis of full cost. Such deductions might arise because of fire,
sale, or replacement. The proper handling of the account when deductions
are necessary will be explained at the close of the chapter, as the method is
applicable to all classes of asset equipment.
Valuations of Machinery and Tools
The statement of the principle of valuation for machinery is simple, but
the application of the rule is complex. The valuation formula for machinery
is cost less depreciation. As stated above, the condition of the market has no
influence on the going concern valuation of fixed assets. If the market is
now lower than at the date of purchase, this simply means that more capital
was then required to start operations than is now required. If the forces of
competition are free to act, the margin of profit or the margin of return on
the investment in machinery will be somewhat less in the one case than in
the other. If the market is now higher, then the situation is in favor of the
earlier investment rather than the present one. In neither case should costs
of production be falsified by valuing the machinery and other equipment at
any other figure than cost.
Estimate of Depreciation
Estimating the depreciation on machines is the chief and vital problem
in their valuation, because depreciation is reflected in the cost of the article
manufactured, being a cost of production just as truly as the raw material
used. As brought out fully in Chapter V, page 93, the so-called depreciating
assets are really of the nature of deferred charges to operation and a
depreciation estimate is the amount of the periodic charge against
production. Because of the speculative nature of an investment in
machinery (neither the quality of the machine being exactly determinable
nor the conditions of its operation known), its depreciation is always an
estimate. For this reason it should be based on the best possible knowledge
available at the time of installation.
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Any estimate so made must be the subject of periodic revision. How
frequently this revision should be made will depend both on the length of
estimated life and the way in which actual experience compares with the
expected or estimated conditions. The experience on which the estimate is
based should, of course, be with the same or similar machines, gained, if
possible, amid the same surroundings and conditions under which the new
machine will operate. In default of such experience or as a valuable check
thereon, the results of others in the use of the machine and the expert advice
of those who have studied the problem of depreciation in its practical
applications should all contribute to the making of this estimate.
History of Machine
This need of experience data creates the necessity of a means for
gathering and preserving the data, and the machinery record above referred
to serves the purpose. Therein should be set forth the complete life history
of the machine—not only the original cost and the additional data given
above, but also the time and cost of all replacements and all information
relevant thereto and, as a memorandum, the cost of maintenance, repairs,
up-keep, etc. The record is not complete without the data as to repairs. A
periodic statement should also be made as to any abnormal conditions under
which the machine has been operated, such as overtime, overload capacity,
etc. Where possible, the output of the machine in units of product should be
included in the record. Where a group or battery of similar machines is
operated, the average experience of all of them is the best possible data on
which to base future estimates of depreciation.
The more life histories available, the more reliable will be the average
obtained therefrom. After making due allowance for changed conditions of
operation, this average should prove a reliable forecast of future experience.
After all, an estimate of depreciation is in many respects very like an
insurance charge, and the time may come when the life histories of a
sufficiently large number of machines will provide a very reliable basis for
estimate at any given time of the expected life of a machine when operating
conditions are known.
Standards of Operation
frequently this revision should be made will depend both on the length of
estimated life and the way in which actual experience compares with the
expected or estimated conditions. The experience on which the estimate is
based should, of course, be with the same or similar machines, gained, if
possible, amid the same surroundings and conditions under which the new
machine will operate. In default of such experience or as a valuable check
thereon, the results of others in the use of the machine and the expert advice
of those who have studied the problem of depreciation in its practical
applications should all contribute to the making of this estimate.
History of Machine
This need of experience data creates the necessity of a means for
gathering and preserving the data, and the machinery record above referred
to serves the purpose. Therein should be set forth the complete life history
of the machine—not only the original cost and the additional data given
above, but also the time and cost of all replacements and all information
relevant thereto and, as a memorandum, the cost of maintenance, repairs,
up-keep, etc. The record is not complete without the data as to repairs. A
periodic statement should also be made as to any abnormal conditions under
which the machine has been operated, such as overtime, overload capacity,
etc. Where possible, the output of the machine in units of product should be
included in the record. Where a group or battery of similar machines is
operated, the average experience of all of them is the best possible data on
which to base future estimates of depreciation.
The more life histories available, the more reliable will be the average
obtained therefrom. After making due allowance for changed conditions of
operation, this average should prove a reliable forecast of future experience.
After all, an estimate of depreciation is in many respects very like an
insurance charge, and the time may come when the life histories of a
sufficiently large number of machines will provide a very reliable basis for
estimate at any given time of the expected life of a machine when operating
conditions are known.
Standards of Operation
Page 249
One phase of the modern efficiency movement relates to the study of
machine operation. This has helped in the study of depreciation, in that
standardized methods of use have been established. These comprise a
standard speed of operation, proper periods of rest, correct methods of
throwing in the power, the proper adjustment of parts for each machine; and
for each kind of machine tool, the proper degree of hardness to which the
cutting edge must be tempered, the speed of cutting, and the number of
operations before resharpening—all these standards have been established,
resulting in an average performance of maximum efficiency which may be
called the normal operating conditions of the machine. Where such studies
have been made and where the set standards are uniformly observed, a very
reliable basis is furnished for forecasting the future. To insure the
observance of these standards a permanent card should be attached to every
machine, giving all the information essential to standardized operation. A
copy of this standard should be made a part of the record in the machine
ledger.
Abnormal Operation
To make the periodic revision of the estimate of depreciation accord
with the fact or rather with the best possible estimate of the fact, any
abnormal operation of the machine should be considered. Thus, if the
machine has been worked overtime, say on a three-shift day instead of one-
shift, or if it has been crowded beyond its capacity, if repairs have not been
made when they were needed, if the wage policy has been changed from a
per diem or per hour basis to a piece-work basis—all these points must be
considered.
Machines which are seldom used require careful consideration. It is
oftentimes necessary to include in the equipment special machines for
infrequent operations and processes. The normal operation of such must be
estimated for each particular factory and depreciation based on such use.
All of the foregoing points must be taken into account in connection
with the operation of both machines and power equipment. In the case of
the power machinery, a consideration of kind and quantity of fuel, manner
of feeding and cleaning, quality of the boiler water, etc., with the set
standards, forms the basis for a revision of depreciation rates and estimates.
machine operation. This has helped in the study of depreciation, in that
standardized methods of use have been established. These comprise a
standard speed of operation, proper periods of rest, correct methods of
throwing in the power, the proper adjustment of parts for each machine; and
for each kind of machine tool, the proper degree of hardness to which the
cutting edge must be tempered, the speed of cutting, and the number of
operations before resharpening—all these standards have been established,
resulting in an average performance of maximum efficiency which may be
called the normal operating conditions of the machine. Where such studies
have been made and where the set standards are uniformly observed, a very
reliable basis is furnished for forecasting the future. To insure the
observance of these standards a permanent card should be attached to every
machine, giving all the information essential to standardized operation. A
copy of this standard should be made a part of the record in the machine
ledger.
Abnormal Operation
To make the periodic revision of the estimate of depreciation accord
with the fact or rather with the best possible estimate of the fact, any
abnormal operation of the machine should be considered. Thus, if the
machine has been worked overtime, say on a three-shift day instead of one-
shift, or if it has been crowded beyond its capacity, if repairs have not been
made when they were needed, if the wage policy has been changed from a
per diem or per hour basis to a piece-work basis—all these points must be
considered.
Machines which are seldom used require careful consideration. It is
oftentimes necessary to include in the equipment special machines for
infrequent operations and processes. The normal operation of such must be
estimated for each particular factory and depreciation based on such use.
All of the foregoing points must be taken into account in connection
with the operation of both machines and power equipment. In the case of
the power machinery, a consideration of kind and quantity of fuel, manner
of feeding and cleaning, quality of the boiler water, etc., with the set
standards, forms the basis for a revision of depreciation rates and estimates.
Page 250
Map of Machine Location
In connection with the machinery record, a complete map showing
location and number of every machine is especially desirable. In case of fire
it makes identification easy.
Methods of Application of Depreciation
In the application of depreciation, three methods are used more
generally than any others. The straight line method, as discussed in Chapter
IX, is the one most widely employed. It is to be preferred to all others,
giving satisfactory results and being easy of application. The fixed rate of
diminishing value method also has many adherents, and depreciation based
on the number of units of product turned out is a third method often used
where applicable—though applicable in a very limited degree.
Under the straight line method, it may be ventured as an opinion that
10% is a fair average minimum rate and 15% to 20% an average maximum.
The knowledge as to what constitutes an average rate serves little useful
purpose, however, although it does give a rough estimate when spread over
a large variety of machines. It has been said that from a mechanical point of
view no machine can depreciate actually more than 30% and be operated
efficiently. This does not, of course, mean that the depreciation reserve
should never show more than a 30% offset to the value of the machine, as
this would indicate too high a rate were the machine still in operation. It
does mean that, according to a theoretical standard of operating efficiency,
any machine which cannot fulfill at least a 70% efficiency test should no
longer be used. It should be remembered that the depreciation reserve is a
device for financing depreciation and nothing else.
Basis of Valuation
The basis, therefore, for the valuation of machinery is its full cost less
estimated depreciation. Such an appraisal is subject to periodic revision by
comparing the estimated with actual depreciation as more of the facts
brought out by the period of life already expired become available. Perhaps
the method of inventory, as will be explained in connection with hand tools,
is best applicable to machine tools and even to certain small bench
machines on the boundary line between tools and machines. However,
In connection with the machinery record, a complete map showing
location and number of every machine is especially desirable. In case of fire
it makes identification easy.
Methods of Application of Depreciation
In the application of depreciation, three methods are used more
generally than any others. The straight line method, as discussed in Chapter
IX, is the one most widely employed. It is to be preferred to all others,
giving satisfactory results and being easy of application. The fixed rate of
diminishing value method also has many adherents, and depreciation based
on the number of units of product turned out is a third method often used
where applicable—though applicable in a very limited degree.
Under the straight line method, it may be ventured as an opinion that
10% is a fair average minimum rate and 15% to 20% an average maximum.
The knowledge as to what constitutes an average rate serves little useful
purpose, however, although it does give a rough estimate when spread over
a large variety of machines. It has been said that from a mechanical point of
view no machine can depreciate actually more than 30% and be operated
efficiently. This does not, of course, mean that the depreciation reserve
should never show more than a 30% offset to the value of the machine, as
this would indicate too high a rate were the machine still in operation. It
does mean that, according to a theoretical standard of operating efficiency,
any machine which cannot fulfill at least a 70% efficiency test should no
longer be used. It should be remembered that the depreciation reserve is a
device for financing depreciation and nothing else.
Basis of Valuation
The basis, therefore, for the valuation of machinery is its full cost less
estimated depreciation. Such an appraisal is subject to periodic revision by
comparing the estimated with actual depreciation as more of the facts
brought out by the period of life already expired become available. Perhaps
the method of inventory, as will be explained in connection with hand tools,
is best applicable to machine tools and even to certain small bench
machines on the boundary line between tools and machines. However,
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special tools made for a particular purpose and perhaps not adapted to any
other use should be charged against the job and not carried as an asset.
Scrap Material
A financial consideration in connection with machinery is the disposal
of scrap material. This should be disposed of as advantageously as possible.
It should be held until the market for old metals is high, if at the time of its
discard prices are abnormally low.
Accounting for Tools
With regard to the method of accounting for hand and shop tools and
the basis for valuing them, the additional factor of possibility of loss claims
consideration. Unlike machines, which are for the most part securely
attached to the premises, tools are loose, they may be carried off or lost, and
so not only loss in value due to depreciation but loss from theft or
carelessness must be taken account of. Unless an adequate control is
established over the physical handling of loose tools, a very considerable
leak may result at this point.
In accounting for tools, different practices are encountered. Thus, the
Public Service Commission for the First District of the State of New York,
in its Uniform System of Accounts for Gas Corporations, authorized that,
“hand and other small portable tools liable to be lost or stolen shall, when
first acquired and before issued for use, be carried in a suitable Materials
and Supplies account; when issued, they shall be charged to the appropriate
expense account. Portable tools and apparatus of special value may,
however, be charged to the appropriate tangible capital account, and remain
therein so long as record is kept of the persons to whom such tools and
apparatus are issued and such persons are made responsible therefor.”
Sometimes the practice is found of charging all purchases of tools to an
asset account for a short period of, say, two or three years, and thereafter to
a suitable expense account, with a periodic revision based on an inventory
about once in five or six years. Again, the Loose Tools account may be
handled just as any other asset account, i.e., charged with all purchases,
credited with losses, and depreciation provided for. The manner of handling
the record is not vital, any method sufficing that fits particular needs. All
methods must, however, take cognizance of the fundamental distinction
other use should be charged against the job and not carried as an asset.
Scrap Material
A financial consideration in connection with machinery is the disposal
of scrap material. This should be disposed of as advantageously as possible.
It should be held until the market for old metals is high, if at the time of its
discard prices are abnormally low.
Accounting for Tools
With regard to the method of accounting for hand and shop tools and
the basis for valuing them, the additional factor of possibility of loss claims
consideration. Unlike machines, which are for the most part securely
attached to the premises, tools are loose, they may be carried off or lost, and
so not only loss in value due to depreciation but loss from theft or
carelessness must be taken account of. Unless an adequate control is
established over the physical handling of loose tools, a very considerable
leak may result at this point.
In accounting for tools, different practices are encountered. Thus, the
Public Service Commission for the First District of the State of New York,
in its Uniform System of Accounts for Gas Corporations, authorized that,
“hand and other small portable tools liable to be lost or stolen shall, when
first acquired and before issued for use, be carried in a suitable Materials
and Supplies account; when issued, they shall be charged to the appropriate
expense account. Portable tools and apparatus of special value may,
however, be charged to the appropriate tangible capital account, and remain
therein so long as record is kept of the persons to whom such tools and
apparatus are issued and such persons are made responsible therefor.”
Sometimes the practice is found of charging all purchases of tools to an
asset account for a short period of, say, two or three years, and thereafter to
a suitable expense account, with a periodic revision based on an inventory
about once in five or six years. Again, the Loose Tools account may be
handled just as any other asset account, i.e., charged with all purchases,
credited with losses, and depreciation provided for. The manner of handling
the record is not vital, any method sufficing that fits particular needs. All
methods must, however, take cognizance of the fundamental distinction
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between capital and revenue charges and provide some means by which the
Loose Tools account, as an asset account, shall represent substantially
correct asset values. A successful method of securing control over the
physical handling of tools, where the plant is large enough to justify it, is to
place all tools when purchased in the care of a stores-keeper and issue them
only on authorized requisition, thus securing an accurate record of them.
Depreciation on Hand Tools
As to the valuation of hand tools, depreciation is often left out of
account on the theory that, so long as a tool can be used to perform the
service expected of it, it is worth approximately what it cost. Where as an
adjunct to this method of valuation, a physical inventory of tools is taken
periodically and all losses so shown are charged to expense, substantially
correct asset values are secured. Of course, theoretically, tools are as much
subject to depreciation as other similar assets, but the method of the
inventory valued at cost, and therefore disregarding depreciation, is perhaps
the best practical way of handling the valuation of tools, and it gives
sufficiently satisfactory results for most purposes.
Valuation of Home-Made Machinery and Tools
Machinery and tools made in own factory offer a problem in valuation.
It may be stated thus: Shall such be valued at the market price at the time
when made, or shall valuation be the cost to manufacture? It is argued that
had the machinery been purchased on the market, as is usually the case, the
cost would have been market price; the machinery is worth that price and
should be so valued. If the cost to make is less than the market, to bring the
machine on the books at market would necessitate the taking of a profit of
the difference between cost and market. No profit has been made, only a
saving in capital investment. This confusion between profit and savings is
referred to in Chapter XIII.
In the long run, i.e., in the period covered by the life of the machine, it
makes no difference in profits for that period whether the machine is carried
at cost to make or at market, because its value is written off to depreciation
during its life and the higher value means an increased depreciation charge.
This will exactly offset during the period of the life of the machine the
profit taken by bringing it onto the books in the beginning at market instead
Loose Tools account, as an asset account, shall represent substantially
correct asset values. A successful method of securing control over the
physical handling of tools, where the plant is large enough to justify it, is to
place all tools when purchased in the care of a stores-keeper and issue them
only on authorized requisition, thus securing an accurate record of them.
Depreciation on Hand Tools
As to the valuation of hand tools, depreciation is often left out of
account on the theory that, so long as a tool can be used to perform the
service expected of it, it is worth approximately what it cost. Where as an
adjunct to this method of valuation, a physical inventory of tools is taken
periodically and all losses so shown are charged to expense, substantially
correct asset values are secured. Of course, theoretically, tools are as much
subject to depreciation as other similar assets, but the method of the
inventory valued at cost, and therefore disregarding depreciation, is perhaps
the best practical way of handling the valuation of tools, and it gives
sufficiently satisfactory results for most purposes.
Valuation of Home-Made Machinery and Tools
Machinery and tools made in own factory offer a problem in valuation.
It may be stated thus: Shall such be valued at the market price at the time
when made, or shall valuation be the cost to manufacture? It is argued that
had the machinery been purchased on the market, as is usually the case, the
cost would have been market price; the machinery is worth that price and
should be so valued. If the cost to make is less than the market, to bring the
machine on the books at market would necessitate the taking of a profit of
the difference between cost and market. No profit has been made, only a
saving in capital investment. This confusion between profit and savings is
referred to in Chapter XIII.
In the long run, i.e., in the period covered by the life of the machine, it
makes no difference in profits for that period whether the machine is carried
at cost to make or at market, because its value is written off to depreciation
during its life and the higher value means an increased depreciation charge.
This will exactly offset during the period of the life of the machine the
profit taken by bringing it onto the books in the beginning at market instead
Page 253
of cost. As a matter of principle, however, the point involved is of sufficient
importance not to justify the practice. By cost to make is meant full cost,
which includes materials used, labor applied, and a fair share of the
overhead expenses. Whatever the cost to make, whether lower or higher
than the identical equipment could be purchased for on the market, that
represents the capital outlay and is the true basis for valuation, taking
cognizance of depreciation for the elapsed period.
Expenditure for Rearrangement of Machinery
In connection with expenditures made in the rearrangement of
machinery within the plant for various purposes, the question of the effect
of it on the value at which the machinery is being carried requires some
consideration. In Chapter V where an attempt was made to mark out broad
boundary lines for capital and revenue expenditures, it was stated that any
expenditure which produces greater earning capacity or without which a
lessened earning capacity would result (assuming that all normal
expenditures for maintenance and repairs are being made concurrently),
may be treated as a capital expenditure or at least as a deferred charge to be
spread over several periods.
In the case of depreciating assets, the practical identity of the two
methods is apparent. Thus, if the expenditures for rearrangement of the
machinery have either of the effects mentioned above, there is no serious
objection on theoretical grounds to capitalizing them. Instead, however, of
injecting such intangible values into the machinery account, it is far better,
because more exact and accurate, to show them separately. Practical
considerations demand that such expenditures shall not usually influence
the valuation of machinery and a conservatism born of the fear of inflation
requires that when treated as deferred charges, they should be written off as
quickly as may be done without undue burden on the periods’ profits.
Definition of Furniture and Fixtures
Furniture and fixtures, as an asset title, is not clearly defined. It may
include the usual tables, desks, filing cabinets, bookcases, typewriters and
other mechanical equipment, safes, chairs, counters, and in addition, light,
heat, and plumbing fixtures, show windows, partitioning, shelving, and the
like. The account should be charged originally with all such items at full
importance not to justify the practice. By cost to make is meant full cost,
which includes materials used, labor applied, and a fair share of the
overhead expenses. Whatever the cost to make, whether lower or higher
than the identical equipment could be purchased for on the market, that
represents the capital outlay and is the true basis for valuation, taking
cognizance of depreciation for the elapsed period.
Expenditure for Rearrangement of Machinery
In connection with expenditures made in the rearrangement of
machinery within the plant for various purposes, the question of the effect
of it on the value at which the machinery is being carried requires some
consideration. In Chapter V where an attempt was made to mark out broad
boundary lines for capital and revenue expenditures, it was stated that any
expenditure which produces greater earning capacity or without which a
lessened earning capacity would result (assuming that all normal
expenditures for maintenance and repairs are being made concurrently),
may be treated as a capital expenditure or at least as a deferred charge to be
spread over several periods.
In the case of depreciating assets, the practical identity of the two
methods is apparent. Thus, if the expenditures for rearrangement of the
machinery have either of the effects mentioned above, there is no serious
objection on theoretical grounds to capitalizing them. Instead, however, of
injecting such intangible values into the machinery account, it is far better,
because more exact and accurate, to show them separately. Practical
considerations demand that such expenditures shall not usually influence
the valuation of machinery and a conservatism born of the fear of inflation
requires that when treated as deferred charges, they should be written off as
quickly as may be done without undue burden on the periods’ profits.
Definition of Furniture and Fixtures
Furniture and fixtures, as an asset title, is not clearly defined. It may
include the usual tables, desks, filing cabinets, bookcases, typewriters and
other mechanical equipment, safes, chairs, counters, and in addition, light,
heat, and plumbing fixtures, show windows, partitioning, shelving, and the
like. The account should be charged originally with all such items at full
Page 254
cost. Great care must be exercised in handling repairs and betterments to
avoid an inflation of values. The distinction between capital and revenue
expenditures as regards all such assets already acquired is usually so slight
and uncertain as to justify the establishment of a policy of charging all these
to expense. Otherwise, the ease of inflation is apparent. All new purchases
should be charged at full cost to the asset.
Valuation of Furniture and Fixtures
The basis for the valuation of furniture and fixtures is at cost less
depreciation. In applying depreciation, account should always be taken of
the usually very small residual values in this class of asset. Scrap value in
some cases is only as kindling wood and therefore almost or entirely
negligible. In some cases of easily movable equipment, the method of the
inventory as used for loose tools will give better results in valuation than an
appraisal method based on cost less depreciation. One often finds the
conservative practice of bringing onto the books a rapid depreciation to
scrap value during the first few years, at which nominal value the asset is
carried thereafter. This is a common practice in financial institutions. While
not theoretically justifiable, in comparison with the opposite tendency based
on too great optimism as to the life of the asset, the practice is to be
commended.
The average range for depreciation of this class of asset is from 10% to
20%, estimated by the straight line method. Where premises are leased and
any equipment of this kind is, according to the terms of the lease, to remain
with the building, it is necessary that a depreciation rate be taken high
enough to accomplish complete writing off by the end of the lease. This rule
also applies if the equipment may be removed but would be in a badly
damaged condition, resulting in little remaining value.
Delivery Equipment—Definition and Valuation
Delivery equipment includes all property, direct or auxiliary, used in
connection with the delivery of goods both inward and outward. Horses,
wagons, and harnesses, motor trucks and cars, repair parts, and repair
equipment, containers, holders, and the like, are common examples of this
class of asset. In the main, these assets are handled very much as all the
others of the general equipment group. Valuation is on the basis of cost less
avoid an inflation of values. The distinction between capital and revenue
expenditures as regards all such assets already acquired is usually so slight
and uncertain as to justify the establishment of a policy of charging all these
to expense. Otherwise, the ease of inflation is apparent. All new purchases
should be charged at full cost to the asset.
Valuation of Furniture and Fixtures
The basis for the valuation of furniture and fixtures is at cost less
depreciation. In applying depreciation, account should always be taken of
the usually very small residual values in this class of asset. Scrap value in
some cases is only as kindling wood and therefore almost or entirely
negligible. In some cases of easily movable equipment, the method of the
inventory as used for loose tools will give better results in valuation than an
appraisal method based on cost less depreciation. One often finds the
conservative practice of bringing onto the books a rapid depreciation to
scrap value during the first few years, at which nominal value the asset is
carried thereafter. This is a common practice in financial institutions. While
not theoretically justifiable, in comparison with the opposite tendency based
on too great optimism as to the life of the asset, the practice is to be
commended.
The average range for depreciation of this class of asset is from 10% to
20%, estimated by the straight line method. Where premises are leased and
any equipment of this kind is, according to the terms of the lease, to remain
with the building, it is necessary that a depreciation rate be taken high
enough to accomplish complete writing off by the end of the lease. This rule
also applies if the equipment may be removed but would be in a badly
damaged condition, resulting in little remaining value.
Delivery Equipment—Definition and Valuation
Delivery equipment includes all property, direct or auxiliary, used in
connection with the delivery of goods both inward and outward. Horses,
wagons, and harnesses, motor trucks and cars, repair parts, and repair
equipment, containers, holders, and the like, are common examples of this
class of asset. In the main, these assets are handled very much as all the
others of the general equipment group. Valuation is on the basis of cost less
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depreciation for the most part, but in many instances the method of the
inventory should be applied.
If horses comprise a part of the equipment, not only must depreciation
due to wear and tear be reckoned, but accidental causes such as death and
disablement must be given consideration. Experience in each business
based on the particular kind of work to be performed and the conditions
under which it is being performed furnishes the only adequate basis for
estimating the depreciation rate. Thus, heavy or light draughting, speed to
be maintained, kind of road on which the haul is made—cobble stones,
brick, asphalt, wood blocks, or dirt—and the standard of appearance to be
maintained—all these affect not only the cost of up-keep but also the rate of
deterioration. Sometimes it may be safe, as with loose tools, to charge all
purchases to capital for the first few years until the equipment is complete,
and thereafter all renewals to revenue, depreciating the asset account, say,
20%, and maintaining it at that figure. Any marked increase or decrease in
numbers would require respectively an added capital charge or a reduction
of the original charge. Whether this method or the method of the inventory
be used for valuation purposes, there should be a periodic appraisal by an
expert horse dealer and adjustment of values based on this appraisal.
Wagons, trucks, and motor vehicles should be numbered and all
accounted for periodically by physical inventory. It may be desirable in
some cases to maintain a register for these, wherein the performance of
each can be recorded and so compared. This is particularly desirable when a
change of delivery policy is under contemplation and comparative records
are needed of the performance of various types of vehicles. This class of
delivery equipment is best valued on the basis of cost less adequate
depreciation, with the periodic inventory as a check on numbers and
condition.
Carriers and Containers—Valuation
The most difficult of all the items of delivery equipment to handle and
value is that class represented by carriers and containers. These may be
barrels, kegs, casks, bottles, baskets, and boxes, and are met in the brewery,
dairy, bakery, laundry, and oil businesses. In some lines it is feasible and is
the practice to charge the customer with the fair cost of the carrier, giving a
return privilege with refund, dependent upon the condition of the returned
inventory should be applied.
If horses comprise a part of the equipment, not only must depreciation
due to wear and tear be reckoned, but accidental causes such as death and
disablement must be given consideration. Experience in each business
based on the particular kind of work to be performed and the conditions
under which it is being performed furnishes the only adequate basis for
estimating the depreciation rate. Thus, heavy or light draughting, speed to
be maintained, kind of road on which the haul is made—cobble stones,
brick, asphalt, wood blocks, or dirt—and the standard of appearance to be
maintained—all these affect not only the cost of up-keep but also the rate of
deterioration. Sometimes it may be safe, as with loose tools, to charge all
purchases to capital for the first few years until the equipment is complete,
and thereafter all renewals to revenue, depreciating the asset account, say,
20%, and maintaining it at that figure. Any marked increase or decrease in
numbers would require respectively an added capital charge or a reduction
of the original charge. Whether this method or the method of the inventory
be used for valuation purposes, there should be a periodic appraisal by an
expert horse dealer and adjustment of values based on this appraisal.
Wagons, trucks, and motor vehicles should be numbered and all
accounted for periodically by physical inventory. It may be desirable in
some cases to maintain a register for these, wherein the performance of
each can be recorded and so compared. This is particularly desirable when a
change of delivery policy is under contemplation and comparative records
are needed of the performance of various types of vehicles. This class of
delivery equipment is best valued on the basis of cost less adequate
depreciation, with the periodic inventory as a check on numbers and
condition.
Carriers and Containers—Valuation
The most difficult of all the items of delivery equipment to handle and
value is that class represented by carriers and containers. These may be
barrels, kegs, casks, bottles, baskets, and boxes, and are met in the brewery,
dairy, bakery, laundry, and oil businesses. In some lines it is feasible and is
the practice to charge the customer with the fair cost of the carrier, giving a
return privilege with refund, dependent upon the condition of the returned
Page 256
carrier. This is good where applicable, although it necessitates having an
adequate redemption fund which may be operated somewhat as a bank’s
reserve is, i.e., only large enough for normal needs but capable of ready
enlargement when the need arises. In other lines of business such a method
of handling the container cannot be used. Here, as in the bottled milk trade,
only experience will give a proper basis for estimating the depreciation
through loss, theft, and breakage. The rate is almost invariably high, and
liberal depreciation should be provided for. Taken all in all, throughout the
various kinds of delivery equipment rates ranging from 16⅔% to 25%
constitute fair average rates.
Patterns, Molds, etc.—Valuation
The last kind of equipment items requiring consideration is comprised
of such items as patterns, lasts, molds, dies, drawings, electrotypes, wood
cuts, forms, models, and the like. Wherever possible, these should be
charged to the particular job for which they were made and not carried as
assets. Unless there is a probability that the pattern, mold, etc., will serve
for other uses than those for which it was made, the costs of making should
be borne by the job on which it was used. This is very often not the case,
however, and these items can be used for successive production. This is
particularly true of a standardized product which is not apt to be much
affected by change in style or the whims of a purchasing public. At the best,
however, they constitute a treacherous and highly speculative asset and
require careful handling to avoid inflation of value. Thus, it is easy in the
publishing business to allow electrotypes, wood cuts, etc., to assume
unwieldy proportions to the other assets. In manufactories of wearing
apparel, the fickleness of fashions requires that patterns, lasts, and models
be written down ruthlessly to the lowest possible figure. Here obsolescence
is a big factor.
Under the limitations set, valuation should be based on cost with a very
liberal periodic depreciation. The rate will average anywhere from 20% to
50%, though a lower rate may sometimes be proper.
Disposal of Assets
In connection with the handling of the asset and its valuation account,
the disposal of all or some portion of the asset requires consideration. It is a
adequate redemption fund which may be operated somewhat as a bank’s
reserve is, i.e., only large enough for normal needs but capable of ready
enlargement when the need arises. In other lines of business such a method
of handling the container cannot be used. Here, as in the bottled milk trade,
only experience will give a proper basis for estimating the depreciation
through loss, theft, and breakage. The rate is almost invariably high, and
liberal depreciation should be provided for. Taken all in all, throughout the
various kinds of delivery equipment rates ranging from 16⅔% to 25%
constitute fair average rates.
Patterns, Molds, etc.—Valuation
The last kind of equipment items requiring consideration is comprised
of such items as patterns, lasts, molds, dies, drawings, electrotypes, wood
cuts, forms, models, and the like. Wherever possible, these should be
charged to the particular job for which they were made and not carried as
assets. Unless there is a probability that the pattern, mold, etc., will serve
for other uses than those for which it was made, the costs of making should
be borne by the job on which it was used. This is very often not the case,
however, and these items can be used for successive production. This is
particularly true of a standardized product which is not apt to be much
affected by change in style or the whims of a purchasing public. At the best,
however, they constitute a treacherous and highly speculative asset and
require careful handling to avoid inflation of value. Thus, it is easy in the
publishing business to allow electrotypes, wood cuts, etc., to assume
unwieldy proportions to the other assets. In manufactories of wearing
apparel, the fickleness of fashions requires that patterns, lasts, and models
be written down ruthlessly to the lowest possible figure. Here obsolescence
is a big factor.
Under the limitations set, valuation should be based on cost with a very
liberal periodic depreciation. The rate will average anywhere from 20% to
50%, though a lower rate may sometimes be proper.
Disposal of Assets
In connection with the handling of the asset and its valuation account,
the disposal of all or some portion of the asset requires consideration. It is a
Page 257
fundamental principle that whatever is taken out of the asset account must
be taken at the same cost as it was introduced into the record. Thus, an asset
recorded at cost of $5,000 and sold for $4,500 would be shown as taken out
of its account at $5,000, the apparent loss of $500 being recorded in a
suitable expense account. If the asset has suffered depreciation between the
date of purchase and sale, and the depreciation reserve shows this, that must
be taken into account. Practically, it is best handled by transferring to the
asset account from the depreciation reserve the part of the reserve
applicable to the portion of the asset disposed of. Upon disposal there is an
additional credit to the asset account of the difference between cost and the
depreciation to date, i.e., the amount of this credit is the present appraised
value of the asset sold, taking into account not only the recorded
depreciation but the accrued as well. This brings out the true as
distinguished from the apparent profit and leaves in the reserve only that
portion which is applicable to the asset remaining.
An illustration will show the process of handling. Assume that the
$5,000 asset is a portion of a $50,000 machinery account, for which the
recorded depreciation reserve is $10,000 and the depreciation on the portion
sold accrued to the date of sale is $200. The entries, necessary to effect the
sale, are:
(1) Depreciation $ 200.00
Depreciation Reserve Machinery $ 200.00
Accrued depreciation to date
on the asset sold.
(2) Depreciation Reserve Machinery 1,200.00
Machinery 1,200.00
To write down to appraised
value the asset sold.
(3) Cash 4,500.00
Machinery 3,800.00
Profit on Sale of Machinery 700.00
To record sale of machine
and the profit on it.
be taken at the same cost as it was introduced into the record. Thus, an asset
recorded at cost of $5,000 and sold for $4,500 would be shown as taken out
of its account at $5,000, the apparent loss of $500 being recorded in a
suitable expense account. If the asset has suffered depreciation between the
date of purchase and sale, and the depreciation reserve shows this, that must
be taken into account. Practically, it is best handled by transferring to the
asset account from the depreciation reserve the part of the reserve
applicable to the portion of the asset disposed of. Upon disposal there is an
additional credit to the asset account of the difference between cost and the
depreciation to date, i.e., the amount of this credit is the present appraised
value of the asset sold, taking into account not only the recorded
depreciation but the accrued as well. This brings out the true as
distinguished from the apparent profit and leaves in the reserve only that
portion which is applicable to the asset remaining.
An illustration will show the process of handling. Assume that the
$5,000 asset is a portion of a $50,000 machinery account, for which the
recorded depreciation reserve is $10,000 and the depreciation on the portion
sold accrued to the date of sale is $200. The entries, necessary to effect the
sale, are:
(1) Depreciation $ 200.00
Depreciation Reserve Machinery $ 200.00
Accrued depreciation to date
on the asset sold.
(2) Depreciation Reserve Machinery 1,200.00
Machinery 1,200.00
To write down to appraised
value the asset sold.
(3) Cash 4,500.00
Machinery 3,800.00
Profit on Sale of Machinery 700.00
To record sale of machine
and the profit on it.
Page 258
CHAPTER XVII
BUILDINGS, LAND, AND WASTING ASSETS
Definition of Real Property
The movable fixed assets—paradoxical as the limiting adjectives may
seem—having now been considered, the present chapter will treat of the
immovable tangible fixed assets. By immovable is meant real property as
distinguished from personalty, and by tangible the intention is to exclude
from the present consideration such intangible items as good-will, patents,
copyrights, trade-marks, franchises, and the like.
In accounting for this group of assets there is no place for the caption
“real estate.” In its stead the two titles, “land” and “buildings,” are used.
This is to avoid confusion and to afford a better basis for calculating
depreciation. The term real estate or real property has a very definite legal
connotation, but in the popular mind is held to include land and buildings.
From the accountant’s point of view there is no objection to the use of the
term in the balance sheet, but in the accounts themselves the two assets
should be carefully separated. For the private commercial enterprise, land
as a fixed asset is subject neither to depreciation nor to appreciation;
whereas buildings are constantly depreciating in value. While depreciation
can be calculated with fair accuracy on the combined basis, the single basis
of building values is the only scientific basis. The separation of the two
values is also essential for insurance purposes and the proper adjustment of
fire losses. They will therefore be separately treated in this discussion.
Cost of Buildings
Buildings as fixed assets should be valued by the formula for the fixed
asset group, viz., full cost less depreciation. Some points in connection with
proper methods of accounting and special cases of valuation require
comment.
First, as to making the proper record of cost of the buildings. Three
cases must here be considered:
BUILDINGS, LAND, AND WASTING ASSETS
Definition of Real Property
The movable fixed assets—paradoxical as the limiting adjectives may
seem—having now been considered, the present chapter will treat of the
immovable tangible fixed assets. By immovable is meant real property as
distinguished from personalty, and by tangible the intention is to exclude
from the present consideration such intangible items as good-will, patents,
copyrights, trade-marks, franchises, and the like.
In accounting for this group of assets there is no place for the caption
“real estate.” In its stead the two titles, “land” and “buildings,” are used.
This is to avoid confusion and to afford a better basis for calculating
depreciation. The term real estate or real property has a very definite legal
connotation, but in the popular mind is held to include land and buildings.
From the accountant’s point of view there is no objection to the use of the
term in the balance sheet, but in the accounts themselves the two assets
should be carefully separated. For the private commercial enterprise, land
as a fixed asset is subject neither to depreciation nor to appreciation;
whereas buildings are constantly depreciating in value. While depreciation
can be calculated with fair accuracy on the combined basis, the single basis
of building values is the only scientific basis. The separation of the two
values is also essential for insurance purposes and the proper adjustment of
fire losses. They will therefore be separately treated in this discussion.
Cost of Buildings
Buildings as fixed assets should be valued by the formula for the fixed
asset group, viz., full cost less depreciation. Some points in connection with
proper methods of accounting and special cases of valuation require
comment.
First, as to making the proper record of cost of the buildings. Three
cases must here be considered:
Page 259
1. If the building is purchased outright for cash, whatever costs are
incurred in securing full title and expert opinion as to the sufficiency of the
title are proper charges against the building. If the building is erected on
contract, the full cost of the contract and any necessary supplementary
charges comprise the carrying value of the structure.
2. If the building is bought by the issue of stocks or bonds, the present
value of those securities and all costs in connection with their issue should
constitute the cost of the building. Determination of the present value of the
securities is oftentimes a difficult matter. When sales on the market take
place concurrently, that determines the price. When, as is usually the case,
several existing companies are bought up or merged to form a larger
company, the old stockholders are given shares in the new company for
their equities in the old. The book value of their old holdings may be the
basis for the issue of the new stock or the issue may be on the basis of a
larger or smaller value than this. This whole question of the value of the
assets taken over is equally a question of the value of the securities issued
therefor. This is considered in full in Chapters XX and XXI and will be
given only brief treatment here.
Manifestly all considerations relating to buildings purchased by stocks
and bonds have equal application to all other fixed assets so purchased, and
the treatment in later chapters will therefore be more inclusive than could
be any statement of the case applicable only to buildings. It suffices to say
here that usually the par value of the securities issued constitutes the value
placed on the assets bought. The valuation as a rule is made by an appraisal
committee from the board of directors which inspects the various properties
taken over and places a value on them. In the absence of fraudulent intent,
the courts will usually sanction and uphold these values as having been
made by interested parties competent to act. This is the method generally
used for injecting water into properties.
3. When buildings are put up by the concern itself, full cost may include
not only cost of material and labor and a fair proportion of the overhead
where supervision of construction is local, but all other expenses directly
incurred in connection with construction. These will include architects’ fees
for plans and supervision, cost of permits and licenses, interest on borrowed
moneys and insurance during construction, accidents and injuries to
workmen during the construction period, easements, damages, strike costs,
incurred in securing full title and expert opinion as to the sufficiency of the
title are proper charges against the building. If the building is erected on
contract, the full cost of the contract and any necessary supplementary
charges comprise the carrying value of the structure.
2. If the building is bought by the issue of stocks or bonds, the present
value of those securities and all costs in connection with their issue should
constitute the cost of the building. Determination of the present value of the
securities is oftentimes a difficult matter. When sales on the market take
place concurrently, that determines the price. When, as is usually the case,
several existing companies are bought up or merged to form a larger
company, the old stockholders are given shares in the new company for
their equities in the old. The book value of their old holdings may be the
basis for the issue of the new stock or the issue may be on the basis of a
larger or smaller value than this. This whole question of the value of the
assets taken over is equally a question of the value of the securities issued
therefor. This is considered in full in Chapters XX and XXI and will be
given only brief treatment here.
Manifestly all considerations relating to buildings purchased by stocks
and bonds have equal application to all other fixed assets so purchased, and
the treatment in later chapters will therefore be more inclusive than could
be any statement of the case applicable only to buildings. It suffices to say
here that usually the par value of the securities issued constitutes the value
placed on the assets bought. The valuation as a rule is made by an appraisal
committee from the board of directors which inspects the various properties
taken over and places a value on them. In the absence of fraudulent intent,
the courts will usually sanction and uphold these values as having been
made by interested parties competent to act. This is the method generally
used for injecting water into properties.
3. When buildings are put up by the concern itself, full cost may include
not only cost of material and labor and a fair proportion of the overhead
where supervision of construction is local, but all other expenses directly
incurred in connection with construction. These will include architects’ fees
for plans and supervision, cost of permits and licenses, interest on borrowed
moneys and insurance during construction, accidents and injuries to
workmen during the construction period, easements, damages, strike costs,
Page 260
and the like. If the structure is being erected on a site occupied by an old
building, the cost of wrecking less any salvage value is a proper charge
against the new structure. If bonuses have to be paid tenants in the old
building to secure release of their quarters, these, too, are similar charges to
the new structure. Charges such as interest and insurance during
construction are capital charges only up to the point of fitting the building
for occupancy and so making it an operating and income-producing unit.
Thereafter these must be treated as revenue charges.
Some interesting and at times complicated situations arise when, as in
the case of an office building, the structure is occupied in sections as
completed. Theoretically, only the portions of the charges of this kind
applicable to the completed sections now become revenue charges, the rest
still being capitalized so long as sections remain uncompleted. Practically
all that is desired is substantial accuracy. The items may be comparatively
insignificant but when in doubt the bias should always be on the side of
conservatism.
Valuation of Buildings
In the valuation of buildings a much more difficult problem is
encountered after the structure is completed and repairs and alterations are
made. It is the old problem of the proper differentiation between capital and
revenue charges, and is particularly difficult of solution in some instances.
Nothing more can be said here than was stated in Chapter V where the
fundamental rules to be observed in distinguishing between repairs,
renewals, and betterments were laid down. Changes in interior arrangement
to accommodate new fixtures and equipment, or a different distribution and
arrangement of existing equipment with a view to better operating
conditions require particularly careful handling. Such expenses were
mentioned in connection with the treatment of machinery on page 290, and
the reader is referred to it. Whatever decision is reached on any doubtful
item of this or a similar kind, the supporting vouchers, bills, and papers
constituting the full evidence should be carefully preserved and made
available for review in case of any future questioning of the charges.
Betterments on Leased Buildings
building, the cost of wrecking less any salvage value is a proper charge
against the new structure. If bonuses have to be paid tenants in the old
building to secure release of their quarters, these, too, are similar charges to
the new structure. Charges such as interest and insurance during
construction are capital charges only up to the point of fitting the building
for occupancy and so making it an operating and income-producing unit.
Thereafter these must be treated as revenue charges.
Some interesting and at times complicated situations arise when, as in
the case of an office building, the structure is occupied in sections as
completed. Theoretically, only the portions of the charges of this kind
applicable to the completed sections now become revenue charges, the rest
still being capitalized so long as sections remain uncompleted. Practically
all that is desired is substantial accuracy. The items may be comparatively
insignificant but when in doubt the bias should always be on the side of
conservatism.
Valuation of Buildings
In the valuation of buildings a much more difficult problem is
encountered after the structure is completed and repairs and alterations are
made. It is the old problem of the proper differentiation between capital and
revenue charges, and is particularly difficult of solution in some instances.
Nothing more can be said here than was stated in Chapter V where the
fundamental rules to be observed in distinguishing between repairs,
renewals, and betterments were laid down. Changes in interior arrangement
to accommodate new fixtures and equipment, or a different distribution and
arrangement of existing equipment with a view to better operating
conditions require particularly careful handling. Such expenses were
mentioned in connection with the treatment of machinery on page 290, and
the reader is referred to it. Whatever decision is reached on any doubtful
item of this or a similar kind, the supporting vouchers, bills, and papers
constituting the full evidence should be carefully preserved and made
available for review in case of any future questioning of the charges.
Betterments on Leased Buildings
Page 261
In the case of betterments made on leased buildings, provision must be
made to write off their entire cost by the time of the expiration of the lease,
as they almost invariably revert with the building to the owner. Sometimes
the betterment, if material and so agreed as between lessee and owner, may
be taken over at a depreciated value upon expiration of the lease. Here
depreciation of the betterment must be provided for. Whether all or only
part of the cost of the betterment is to be charged off periodically, record of
this is best accomplished as an addition to the periodic rent charge.
Application of Depreciation
As stated above, the basis for valuation of buildings is at full cost less
depreciation. It is the method of appraisal, although the inventory may
provide a good check in the case of concerns owning many structures. A
subsidiary record of buildings showing separate costs and location, or at
least a map showing location, may then prove very essential, particularly in
the case of fire losses. In the application of depreciation to buildings many
things must be carefully considered. Not only must the depreciation of use,
i.e., wear and tear and lapse of time, be considered but also obsolescence
and inadequacy as factors in shortening the service life of the structure.
Buildings used for some purposes deteriorate more rapidly than when
put to other uses. Vibrations, whether caused by own use or due to exterior
causes, increase the rapidity of deterioration. Susceptibility to fire,
explosion, and the like, due to the nature of their use, should be taken into
account. It is stated that power plants operating under normal conditions
provide for an entire replacement of plant every five years. Power houses
depreciate more rapidly than store houses. A building put to various uses
will be subject in its different parts to varying rates of depreciation.
Although a composite rate applicable to the whole structure will give a
satisfactory valuation, if accurate departmental costs are required it would
be desirable to apply the different rates to the building values distributed
over the various departments. In practice this is seldom done.
According to different authorities, rates of depreciation ranging from
1% to 5% constitute a fair average. The nature of the structure, whether
occupied by owner or tenant, its location, kind of composition, etc., are
additional factors for consideration. While some authoritative rates are
available, no standard rates, unless compulsory, should be used without a
made to write off their entire cost by the time of the expiration of the lease,
as they almost invariably revert with the building to the owner. Sometimes
the betterment, if material and so agreed as between lessee and owner, may
be taken over at a depreciated value upon expiration of the lease. Here
depreciation of the betterment must be provided for. Whether all or only
part of the cost of the betterment is to be charged off periodically, record of
this is best accomplished as an addition to the periodic rent charge.
Application of Depreciation
As stated above, the basis for valuation of buildings is at full cost less
depreciation. It is the method of appraisal, although the inventory may
provide a good check in the case of concerns owning many structures. A
subsidiary record of buildings showing separate costs and location, or at
least a map showing location, may then prove very essential, particularly in
the case of fire losses. In the application of depreciation to buildings many
things must be carefully considered. Not only must the depreciation of use,
i.e., wear and tear and lapse of time, be considered but also obsolescence
and inadequacy as factors in shortening the service life of the structure.
Buildings used for some purposes deteriorate more rapidly than when
put to other uses. Vibrations, whether caused by own use or due to exterior
causes, increase the rapidity of deterioration. Susceptibility to fire,
explosion, and the like, due to the nature of their use, should be taken into
account. It is stated that power plants operating under normal conditions
provide for an entire replacement of plant every five years. Power houses
depreciate more rapidly than store houses. A building put to various uses
will be subject in its different parts to varying rates of depreciation.
Although a composite rate applicable to the whole structure will give a
satisfactory valuation, if accurate departmental costs are required it would
be desirable to apply the different rates to the building values distributed
over the various departments. In practice this is seldom done.
According to different authorities, rates of depreciation ranging from
1% to 5% constitute a fair average. The nature of the structure, whether
occupied by owner or tenant, its location, kind of composition, etc., are
additional factors for consideration. While some authoritative rates are
available, no standard rates, unless compulsory, should be used without a
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careful study of local conditions. Structures which are temporary should, of
course, be charged for their net cost, i.e., full cost less salvage value, against
the product or the job which makes use of them. Other cheap structures
such as mine buildings, shaft houses, temporary housings for lumber mills,
and the like, should be written down very rapidly. Having practically no
realizable salvage value and their life being brief, they should be charged
off the books at least during the period of their use.
Buildings owned as a freehold for life, or, stated otherwise, a life
interest in buildings, are not subject to depreciation, the remainderman
taking the building in its condition as released by the party owning the life
interest.
Accounting for Land
In accounting for land as a fixed asset used in the conduct of a business,
one or more accounts may be carried as seems best. If the land is in several
different plots, perhaps widely separated and each plot held with other
groups of assets and under varying conditions as to taxes and other
obligations, some plots being subject to mortgages and others not so
subject, separate accounts with each plot would be desirable. Otherwise,
usually the one account will suffice.
The record should be as complete and full as possible. Notation after the
title or elsewhere, giving the description and location of the holdings, is an
advantage as a means of exact reference. The various items in the account
should be supported by full explanatory matter together with documents
available for the analysis of the various items and proof as to their
legitimacy. It should thus be possible, at any time, to determine the items
comprising full cost. The purchase contract price, the attorney’s fees, and
broker’s commissions or a fair portion of the purchasing agent’s salary, the
costs of search and guarantee of title (if these are borne by the purchaser),
notarial and recording fees, the assumption of taxes owing at date of
purchase, local improvement taxes and assessments, such as sewer, water,
curbing, paving, and the like—all these should be indicated with clearness
and definiteness.
Where accounts with a “large number” of plots are kept, it may be
advantageous to carry these accounts on a subsidiary record specially ruled
to give the detailed information desired and control them all by one general
course, be charged for their net cost, i.e., full cost less salvage value, against
the product or the job which makes use of them. Other cheap structures
such as mine buildings, shaft houses, temporary housings for lumber mills,
and the like, should be written down very rapidly. Having practically no
realizable salvage value and their life being brief, they should be charged
off the books at least during the period of their use.
Buildings owned as a freehold for life, or, stated otherwise, a life
interest in buildings, are not subject to depreciation, the remainderman
taking the building in its condition as released by the party owning the life
interest.
Accounting for Land
In accounting for land as a fixed asset used in the conduct of a business,
one or more accounts may be carried as seems best. If the land is in several
different plots, perhaps widely separated and each plot held with other
groups of assets and under varying conditions as to taxes and other
obligations, some plots being subject to mortgages and others not so
subject, separate accounts with each plot would be desirable. Otherwise,
usually the one account will suffice.
The record should be as complete and full as possible. Notation after the
title or elsewhere, giving the description and location of the holdings, is an
advantage as a means of exact reference. The various items in the account
should be supported by full explanatory matter together with documents
available for the analysis of the various items and proof as to their
legitimacy. It should thus be possible, at any time, to determine the items
comprising full cost. The purchase contract price, the attorney’s fees, and
broker’s commissions or a fair portion of the purchasing agent’s salary, the
costs of search and guarantee of title (if these are borne by the purchaser),
notarial and recording fees, the assumption of taxes owing at date of
purchase, local improvement taxes and assessments, such as sewer, water,
curbing, paving, and the like—all these should be indicated with clearness
and definiteness.
Where accounts with a “large number” of plots are kept, it may be
advantageous to carry these accounts on a subsidiary record specially ruled
to give the detailed information desired and control them all by one general
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ledger account. Local conditions and the information desired will determine
the manner of keeping the records. In all cases, the account should carry a
notation as to where the supporting legal papers and documents covering
each parcel or plot may be found. This prevents much needless loss of time
and worry when quick reference to those papers is desired.
Valuation of Land
The basis for valuing land with unclouded title, as a fixed asset for
business purposes has already been clearly indicated. Full cost, usually with
neither depreciation nor appreciation, constitutes the valuation formula. By
full cost is meant complete cost in condition ready for use or, at least, up to
full-title date. In addition to the items enumerated in the preceding section,
there may sometimes properly be included such expenses as leveling,
grading, filling, and draining. Even the costs of dikes, dams, and
embankments, and in the case of railway construction the cost of the care
and up-keep of growing trees planted to prevent land or snowslides,
tunneling, and the like, may be carried as a part of land costs, although
some of these may more accurately be recorded as improvements. In the
case of mining land, the cost of stripping the surface to reach the ore body,
and the cost of shaft-sinking and of tunneling are proper capital charges and
may be recorded under the land account, although preferably under a
development account.
Whatever costs are necessarily incurred to make the land serve its
intended use are proper capital charges and should be recorded in the land
account unless better purposes are served by record in some supplementary
account.
Depreciation or Appreciation of Land
The relation of depreciation and appreciation to land valuation is not
difficult in theory but is often very perplexing and gives rise to complicated
situations in practice. In theory, so long as the land is used for its intended
purpose, fluctuations in the market either up or down should not affect the
valuation at which it is carried on the books. Just as with the equipment
group of assets discussed in Chapter XVI, any increase or decrease in the
value of the land cannot be realized so long as the land is employed in
operation. Its cost represents the capital tied up in it and the amount on
the manner of keeping the records. In all cases, the account should carry a
notation as to where the supporting legal papers and documents covering
each parcel or plot may be found. This prevents much needless loss of time
and worry when quick reference to those papers is desired.
Valuation of Land
The basis for valuing land with unclouded title, as a fixed asset for
business purposes has already been clearly indicated. Full cost, usually with
neither depreciation nor appreciation, constitutes the valuation formula. By
full cost is meant complete cost in condition ready for use or, at least, up to
full-title date. In addition to the items enumerated in the preceding section,
there may sometimes properly be included such expenses as leveling,
grading, filling, and draining. Even the costs of dikes, dams, and
embankments, and in the case of railway construction the cost of the care
and up-keep of growing trees planted to prevent land or snowslides,
tunneling, and the like, may be carried as a part of land costs, although
some of these may more accurately be recorded as improvements. In the
case of mining land, the cost of stripping the surface to reach the ore body,
and the cost of shaft-sinking and of tunneling are proper capital charges and
may be recorded under the land account, although preferably under a
development account.
Whatever costs are necessarily incurred to make the land serve its
intended use are proper capital charges and should be recorded in the land
account unless better purposes are served by record in some supplementary
account.
Depreciation or Appreciation of Land
The relation of depreciation and appreciation to land valuation is not
difficult in theory but is often very perplexing and gives rise to complicated
situations in practice. In theory, so long as the land is used for its intended
purpose, fluctuations in the market either up or down should not affect the
valuation at which it is carried on the books. Just as with the equipment
group of assets discussed in Chapter XVI, any increase or decrease in the
value of the land cannot be realized so long as the land is employed in
operation. Its cost represents the capital tied up in it and the amount on
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which profits must be earned. This is therefore the value at which it should
be carried on the books. Sometimes other considerations than those of
accounting influence business policy in connection with the market value of
land; but so long as it is used for the business purposes for which it was
purchased, full cost price should be its valuation. This may sometimes place
a prospective borrower at a disadvantage when using his balance sheet as
the basis for credit. A footnote or other notation giving market value will
usually suffice, although such value is often difficult of determination
without a disinterested appraisal.
Appreciation of Land Values
When land is held over long periods in a growing community,
appreciation in value almost always results; occasionally depreciation
ensues. The amount of appreciation is oftentimes not as much as it seems
because land with buildings on it may not be convertible to some other use
at the market price of similarly located vacant land; the cost of scrapping
the buildings often being as much or more than the appreciation in land
value. Also, appreciation may sometimes be of a temporary character, in the
nature rather of a market fluctuation. If so, the distinction must be carefully
observed. Perhaps in the majority of cases requiring consideration,
appreciation not only is very real but also very considerable.
It may sometimes be desired to base an issue of bonds on real estate—
land and buildings—which is being carried at an old cost figure as of many
years ago but which has a greatly appreciated and available market value at
the present time. Prudent financial considerations would require an
independent appraisal to determine the amount of the bond issue. Upon the
assumption that the issue is for a larger amount than the original cost of the
security, a peculiar situation arises. In showing the transaction on the books
and balance sheet, not only would no margin of security appear, but even an
insufficiency of security so long as the original value of the security is
carried. Here it would undoubtedly be wise to bring the appraised value of
the security on the books, offsetting the appreciation in value by a suitably
named surplus or reserve account, such as “Reserve for Land Value
Increment” or “Appreciated Land Value Surplus.” Another method and
perhaps a better one where possible of application is to reorganize the
be carried on the books. Sometimes other considerations than those of
accounting influence business policy in connection with the market value of
land; but so long as it is used for the business purposes for which it was
purchased, full cost price should be its valuation. This may sometimes place
a prospective borrower at a disadvantage when using his balance sheet as
the basis for credit. A footnote or other notation giving market value will
usually suffice, although such value is often difficult of determination
without a disinterested appraisal.
Appreciation of Land Values
When land is held over long periods in a growing community,
appreciation in value almost always results; occasionally depreciation
ensues. The amount of appreciation is oftentimes not as much as it seems
because land with buildings on it may not be convertible to some other use
at the market price of similarly located vacant land; the cost of scrapping
the buildings often being as much or more than the appreciation in land
value. Also, appreciation may sometimes be of a temporary character, in the
nature rather of a market fluctuation. If so, the distinction must be carefully
observed. Perhaps in the majority of cases requiring consideration,
appreciation not only is very real but also very considerable.
It may sometimes be desired to base an issue of bonds on real estate—
land and buildings—which is being carried at an old cost figure as of many
years ago but which has a greatly appreciated and available market value at
the present time. Prudent financial considerations would require an
independent appraisal to determine the amount of the bond issue. Upon the
assumption that the issue is for a larger amount than the original cost of the
security, a peculiar situation arises. In showing the transaction on the books
and balance sheet, not only would no margin of security appear, but even an
insufficiency of security so long as the original value of the security is
carried. Here it would undoubtedly be wise to bring the appraised value of
the security on the books, offsetting the appreciation in value by a suitably
named surplus or reserve account, such as “Reserve for Land Value
Increment” or “Appreciated Land Value Surplus.” Another method and
perhaps a better one where possible of application is to reorganize the
Page 265
concern by a sale of the old to a new company and so capitalize the
increment in value of the old company’s assets.
Another financial consideration in connection with appreciated real
estate values concerns the advisability of the sale of the old and the erection
of a new plant on less valuable land. Usually, the appreciation of land
values is not reflected in increased profits; it may even result in lessened
profits due to higher rates of taxation and other expenses. If there are
equally favorable locations for the particular kind of business, it may be the
part of business sagacity to use the old location for rental purposes so that
the benefit of the appreciation may be secured, or to sell and move to a less
expensive site. In the one case the status of the land has been changed from
that of an operating fixed asset to an investment, perhaps best considered
permanent. In the other case, the increased value is through sale realized in
a lump sum and, as a surplus item, is available for any purpose to which
surplus may legitimately be applied. Of course, the amount of such surplus
is the difference between the sum realized by sale and the cost of an equally
efficient plant on the new site. It will usually happen that a better plant is
erected, thus consuming some of the surplus arising from the sale.
Depreciation in Land Values
In a great many instances land depreciates. Decrease in value due to use
will be considered under the discussion of wasting assets, page 311. When
land suffers depreciation it is usually because of obsolescence or
inadequacy. Due to certain natural facilities giving out, or to the removal,
dismantling, or decay of artificial facilities, a site may depreciate so much
as to become untenable. Business and residence property in a mining town
may be of mushroom growth and have practically no value when the
market, which is dependent on mining operations, declines. Ventures of this
sort are recognized as highly speculative from the beginning and should be
handled as such in the accounts. Wherever depreciation due to these causes
can be foreseen, suitable provision should be made; otherwise the burden
will fall entirely on the period when the plant has to be abandoned and this
stage is usually preceded by periods of lessened profits. Depreciation of
land is therefore always a local question.
Valuation of Land Investments
increment in value of the old company’s assets.
Another financial consideration in connection with appreciated real
estate values concerns the advisability of the sale of the old and the erection
of a new plant on less valuable land. Usually, the appreciation of land
values is not reflected in increased profits; it may even result in lessened
profits due to higher rates of taxation and other expenses. If there are
equally favorable locations for the particular kind of business, it may be the
part of business sagacity to use the old location for rental purposes so that
the benefit of the appreciation may be secured, or to sell and move to a less
expensive site. In the one case the status of the land has been changed from
that of an operating fixed asset to an investment, perhaps best considered
permanent. In the other case, the increased value is through sale realized in
a lump sum and, as a surplus item, is available for any purpose to which
surplus may legitimately be applied. Of course, the amount of such surplus
is the difference between the sum realized by sale and the cost of an equally
efficient plant on the new site. It will usually happen that a better plant is
erected, thus consuming some of the surplus arising from the sale.
Depreciation in Land Values
In a great many instances land depreciates. Decrease in value due to use
will be considered under the discussion of wasting assets, page 311. When
land suffers depreciation it is usually because of obsolescence or
inadequacy. Due to certain natural facilities giving out, or to the removal,
dismantling, or decay of artificial facilities, a site may depreciate so much
as to become untenable. Business and residence property in a mining town
may be of mushroom growth and have practically no value when the
market, which is dependent on mining operations, declines. Ventures of this
sort are recognized as highly speculative from the beginning and should be
handled as such in the accounts. Wherever depreciation due to these causes
can be foreseen, suitable provision should be made; otherwise the burden
will fall entirely on the period when the plant has to be abandoned and this
stage is usually preceded by periods of lessened profits. Depreciation of
land is therefore always a local question.
Valuation of Land Investments
Page 266
Business considerations oftentimes make advisable the purchase of
adjoining or otherwise located tracts of land, with an eye to the future when
enlarged facilities will be required. These should be carefully differentiated
and segregated in the accounts from the land in use for business purposes.
Some points in their valuation, in addition to those treated under the
discussion of investments in land on page 278, need to be considered. Such
tracts of land may usually without prejudice be valued at cost.
If later developments should turn out as originally expected, there can
be no objection to loading the carrying costs of these lands, including taxes
and interest on any borrowed purchase money, on their value year by year.
The only reason for their purchase at the present time is because it is
expected that the transaction can be more advantageously made now than
later. If such should not be the case, the cost of the land proves to be higher
than if purchased later. Only by loading these carrying charges can this
information be developed. If the land is finally put to its intended use, no
serious objection is seen in carrying it at the figure of full cost to the date of
use. Because of the speculative nature of the transaction, it is usually
advisable to set up a reserve of the same amount as the accumulating
carrying charges. This reserve becomes free when the land is put to its
intended use.
Because of the ease of inflation of values in transactions of this kind,
due largely to an overoptimism as to the future and even sometimes to
fraud, all such transactions must be scrutinized very carefully and ample
provision against an unfavorable outcome should be insisted upon. It is
interesting to note in this connection that in the case of valuations for rate-
making purposes, as a usual thing carrying costs on land of this kind are not
allowed as expenses to be covered by the rate of the service rendered. But
when these lands come into use such expenses become a part of the cost of
the service.
Mortgages on Land
Mortgages on land require consideration as affecting the manner of
showing the land value. Freehold land, i.e., land held in fee simple, if
afterwards mortgaged should be shown on the balance sheet at full face
value with the mortgage listed among the liabilities. The liability is usually
a note or other bond which in case of the deficiency of the security would
adjoining or otherwise located tracts of land, with an eye to the future when
enlarged facilities will be required. These should be carefully differentiated
and segregated in the accounts from the land in use for business purposes.
Some points in their valuation, in addition to those treated under the
discussion of investments in land on page 278, need to be considered. Such
tracts of land may usually without prejudice be valued at cost.
If later developments should turn out as originally expected, there can
be no objection to loading the carrying costs of these lands, including taxes
and interest on any borrowed purchase money, on their value year by year.
The only reason for their purchase at the present time is because it is
expected that the transaction can be more advantageously made now than
later. If such should not be the case, the cost of the land proves to be higher
than if purchased later. Only by loading these carrying charges can this
information be developed. If the land is finally put to its intended use, no
serious objection is seen in carrying it at the figure of full cost to the date of
use. Because of the speculative nature of the transaction, it is usually
advisable to set up a reserve of the same amount as the accumulating
carrying charges. This reserve becomes free when the land is put to its
intended use.
Because of the ease of inflation of values in transactions of this kind,
due largely to an overoptimism as to the future and even sometimes to
fraud, all such transactions must be scrutinized very carefully and ample
provision against an unfavorable outcome should be insisted upon. It is
interesting to note in this connection that in the case of valuations for rate-
making purposes, as a usual thing carrying costs on land of this kind are not
allowed as expenses to be covered by the rate of the service rendered. But
when these lands come into use such expenses become a part of the cost of
the service.
Mortgages on Land
Mortgages on land require consideration as affecting the manner of
showing the land value. Freehold land, i.e., land held in fee simple, if
afterwards mortgaged should be shown on the balance sheet at full face
value with the mortgage listed among the liabilities. The liability is usually
a note or other bond which in case of the deficiency of the security would
Page 267
be a general claim against the free assets of the concern. It is therefore best,
theoretically, not to show such a mortgage as an offset to its security. In the
case of the purchase of land subject to mortgage without the assumption of
the mortgage as a direct liability, theoretically the mortgage may be shown
as a deduction from the full land value and only the equity value of land be
extended as a significant asset. This differentiation is almost entirely an
academic one and is seldom seen in practice. The land is usually listed
among the assets and the mortgage as a liability.
Donated Land
The valuation of donated lands presents some interesting points. A town
may offer a free site to secure the erection of a plant within its midst rather
than allow it to go elsewhere. Sometimes the donation may be outright and
absolute; at other times it may be conditional, depending upon the doing of
certain things by the donee, such as the employment of a minimum force of
men for a certain number of years, or the circulation of a certain amount of
advertising, or the purchase of given amounts of raw material supplied
locally. In the case of an outright gift, the cost to the company is usually nil,
but for the proper statement of the concern’s financial condition the land
must be shown as an asset. If the acceptance of the gift necessitates the
scrapping of the old plant and removal expense to the new site, such costs
would provide a minimum carrying value for the land. Where this is not the
case, the land might be given a nominal value, with suitable explanation.
Usually, however, neither of these methods is so satisfactory as that of
bringing the land onto the books at a fair appraised value and showing the
contra side of the transaction as surplus, or donated surplus, or donated land
surplus. Any gift received increases the proprietorship of a concern and
should be so shown, and there need be no suspicion of inflated value in
such a surplus item, if conservatively set up, and with the supporting
records available. Any expense in connection with the acceptance of the gift
is a proper charge against the donated surplus. Aside from this, it is free
surplus available for customary uses so far as this transaction is concerned.
In the case of a conditional gift subject to reversion until the satisfactory
fulfillment of the condition, no title nor asset value, other than a contingent
one, inheres in the land. It is not therefore proper to show any. If a
condition, extending over a period of, say, five years must be met, at the
theoretically, not to show such a mortgage as an offset to its security. In the
case of the purchase of land subject to mortgage without the assumption of
the mortgage as a direct liability, theoretically the mortgage may be shown
as a deduction from the full land value and only the equity value of land be
extended as a significant asset. This differentiation is almost entirely an
academic one and is seldom seen in practice. The land is usually listed
among the assets and the mortgage as a liability.
Donated Land
The valuation of donated lands presents some interesting points. A town
may offer a free site to secure the erection of a plant within its midst rather
than allow it to go elsewhere. Sometimes the donation may be outright and
absolute; at other times it may be conditional, depending upon the doing of
certain things by the donee, such as the employment of a minimum force of
men for a certain number of years, or the circulation of a certain amount of
advertising, or the purchase of given amounts of raw material supplied
locally. In the case of an outright gift, the cost to the company is usually nil,
but for the proper statement of the concern’s financial condition the land
must be shown as an asset. If the acceptance of the gift necessitates the
scrapping of the old plant and removal expense to the new site, such costs
would provide a minimum carrying value for the land. Where this is not the
case, the land might be given a nominal value, with suitable explanation.
Usually, however, neither of these methods is so satisfactory as that of
bringing the land onto the books at a fair appraised value and showing the
contra side of the transaction as surplus, or donated surplus, or donated land
surplus. Any gift received increases the proprietorship of a concern and
should be so shown, and there need be no suspicion of inflated value in
such a surplus item, if conservatively set up, and with the supporting
records available. Any expense in connection with the acceptance of the gift
is a proper charge against the donated surplus. Aside from this, it is free
surplus available for customary uses so far as this transaction is concerned.
In the case of a conditional gift subject to reversion until the satisfactory
fulfillment of the condition, no title nor asset value, other than a contingent
one, inheres in the land. It is not therefore proper to show any. If a
condition, extending over a period of, say, five years must be met, at the
Page 268
end of the first year one-fifth of the time has elapsed and the condition is
nearer to fulfillment—the contingency has become more nearly a fact. But
until its full satisfaction and the danger of a lapse has passed, there is no
value in the gift. To show the progress and status of condition, the pro rata
portion of the gift may be shown periodically by a charge to Donated Land
or Equity in Land, offset by an equal credit to some suitable reserve such as
Donated Land Reserve or Unrealized Profit on Land. On the balance sheet
the reserve would be treated as a valuation item, no value being extended
among the assets. This would seem to satisfy all demands for information
and show the exact status of the transaction.
Land as Stock-in-Trade
A final consideration, not logically belonging here but treated as a
matter of convenience, is that of land as stock-in-trade. In the case of a land
company developing a tract of land for certain purposes, the individual
plots, or the whole piece if division is not contemplated, constitute its stock-
in-trade and it should be valued as such, i.e., as a current asset and not a
fixed. All costs necessary to put it in condition ready for the market are
capital charges and should be loaded onto the cost of the lands. These
include all of the usual costs mentioned in connection with land as a fixed
asset, and in addition all improvement costs such as parking, the laying out
of streets, roading, etc. The loss in the use of land for these purposes should
be prorated over the plots, or otherwise equitably distributed. Plots of land
so developed are not usually sold all at one time. Any unsold plots should
be inventoried at cost. Sometimes the first plots may be sold at a loss to
make the rest of the proposition move. The practice is met of loading the
loss in the early sales onto the unsold plots, and it is quite common to add
any carrying charges to the cost of the unsold plots.
Both of these practices are to be deprecated and opposed. They are not
right in theory and serve no necessary purpose. All costs after the stage of
sale is reached are operating costs—charges against revenue which should
not be capitalized. It may be desirable to know at what price the unsold
plots must be disposed of to cover all expenses and losses and to make a
profit, but that does not justify an inflation of the carrying values of the
asset. If it is desired that the books shall show this, an amount equal to these
costs and losses may be added to the carrying values if offset by a valuation
nearer to fulfillment—the contingency has become more nearly a fact. But
until its full satisfaction and the danger of a lapse has passed, there is no
value in the gift. To show the progress and status of condition, the pro rata
portion of the gift may be shown periodically by a charge to Donated Land
or Equity in Land, offset by an equal credit to some suitable reserve such as
Donated Land Reserve or Unrealized Profit on Land. On the balance sheet
the reserve would be treated as a valuation item, no value being extended
among the assets. This would seem to satisfy all demands for information
and show the exact status of the transaction.
Land as Stock-in-Trade
A final consideration, not logically belonging here but treated as a
matter of convenience, is that of land as stock-in-trade. In the case of a land
company developing a tract of land for certain purposes, the individual
plots, or the whole piece if division is not contemplated, constitute its stock-
in-trade and it should be valued as such, i.e., as a current asset and not a
fixed. All costs necessary to put it in condition ready for the market are
capital charges and should be loaded onto the cost of the lands. These
include all of the usual costs mentioned in connection with land as a fixed
asset, and in addition all improvement costs such as parking, the laying out
of streets, roading, etc. The loss in the use of land for these purposes should
be prorated over the plots, or otherwise equitably distributed. Plots of land
so developed are not usually sold all at one time. Any unsold plots should
be inventoried at cost. Sometimes the first plots may be sold at a loss to
make the rest of the proposition move. The practice is met of loading the
loss in the early sales onto the unsold plots, and it is quite common to add
any carrying charges to the cost of the unsold plots.
Both of these practices are to be deprecated and opposed. They are not
right in theory and serve no necessary purpose. All costs after the stage of
sale is reached are operating costs—charges against revenue which should
not be capitalized. It may be desirable to know at what price the unsold
plots must be disposed of to cover all expenses and losses and to make a
profit, but that does not justify an inflation of the carrying values of the
asset. If it is desired that the books shall show this, an amount equal to these
costs and losses may be added to the carrying values if offset by a valuation
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reserve of equal amount, the costs and losses themselves being handled as
operating expenses of the current period—or spread over several periods if
applicable.
Wasting Assets—Definition and Characteristics
Wasting assets, as they are usually called, are better described as assets
subject to depletion. They differ from depreciating assets in that, whereas
the latter wear out through use or the effect of age, wasting assets simply
“give out.” They are subject to depletion because they comprise stores of
raw materials and natural resources the supply of which, through being
mined and disposed of, is definitely and finally diminished. The stores will
in every case finally come to an end through yielding up their product.
Examples of enterprises of this kind are minerals and deposits of all sorts,
such as coal, gold, silver, lead, clays, slate, gravel, stone quarries, oil,
asphalt, nitrate, timber, and “all growing plants yielding recurring crops,
such as tea and rubber.”
Dividends May Include Return of Capital
The law recognizes the distinction by requiring in the case of
depreciating assets that the decrease in value must be made good before the
payment of dividends—i.e., dividends cannot be paid out of capital—while
in the case of assets subject to depletion it is recognized that some portion
of the dividends paid may represent a return of the capital originally
invested in the undertaking.
If the latter is the policy pursued, there will be no liquidating dividends
at the time of the break-up of the undertaking, inasmuch as the regular
dividends have already included a return of all or some portion of the
capital. If, however, it is a matter of business policy to continue the
enterprise elsewhere when the present natural stores are exhausted, then the
dividends should represent only profits. During the process of operation,
assets in other forms which represent the capital investment of the
undertaking are retained in the business. This is accomplished on the books
by a charge to each period’s operations of such an amount as represents the
depletion of the stores of product prepared for the market during that period
and by a credit to a depletion reserve account or direct to the property or
stores account.
operating expenses of the current period—or spread over several periods if
applicable.
Wasting Assets—Definition and Characteristics
Wasting assets, as they are usually called, are better described as assets
subject to depletion. They differ from depreciating assets in that, whereas
the latter wear out through use or the effect of age, wasting assets simply
“give out.” They are subject to depletion because they comprise stores of
raw materials and natural resources the supply of which, through being
mined and disposed of, is definitely and finally diminished. The stores will
in every case finally come to an end through yielding up their product.
Examples of enterprises of this kind are minerals and deposits of all sorts,
such as coal, gold, silver, lead, clays, slate, gravel, stone quarries, oil,
asphalt, nitrate, timber, and “all growing plants yielding recurring crops,
such as tea and rubber.”
Dividends May Include Return of Capital
The law recognizes the distinction by requiring in the case of
depreciating assets that the decrease in value must be made good before the
payment of dividends—i.e., dividends cannot be paid out of capital—while
in the case of assets subject to depletion it is recognized that some portion
of the dividends paid may represent a return of the capital originally
invested in the undertaking.
If the latter is the policy pursued, there will be no liquidating dividends
at the time of the break-up of the undertaking, inasmuch as the regular
dividends have already included a return of all or some portion of the
capital. If, however, it is a matter of business policy to continue the
enterprise elsewhere when the present natural stores are exhausted, then the
dividends should represent only profits. During the process of operation,
assets in other forms which represent the capital investment of the
undertaking are retained in the business. This is accomplished on the books
by a charge to each period’s operations of such an amount as represents the
depletion of the stores of product prepared for the market during that period
and by a credit to a depletion reserve account or direct to the property or
stores account.
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Basis of Depletion Charge
The amount of the period’s depletion charge is reckoned by comparing
the amount of product worked during the period with the total estimated
amount owned. Whatever value was taken for the original purchase, that
value becomes the basis for the annual or periodic depletion charge. There
is, of course, a large element of speculation in some estimates of this kind.
In the case of timber, the original amount purchased is easily determinable
with fair accuracy by cruising; the amount cut each period is a matter of
record. The ratio of the amount cut to the original amount is the portion of
the original value or cost of the timber tract to be written off periodically. In
the case of a mine or pit, the estimate cannot be made with an equal degree
of accuracy. Competent engineers do make calculations of the amounts of
available ores with sufficient certainty to warrant the expenditures of vast
sums in the purchase of properties. If their estimate avails for this purpose,
it can with equal certainty be made the basis for the periodic depletion
charge. Nice questions arise in this connection when the property is being
operated under a lease or on a royalty basis.
Application of Income Tax to Wasting Assets
Under the 1916 income tax law specific provision was made for
allowing depletion and the manner of handling it is prescribed. First, for
such a charge to be allowed as a deduction, it must be recorded on the
books. Secondly, as soon as the depletion reserve equals the capital
investment no further deduction can be made—all else is pure income. If,
however, it is desirable to carry on the books as an asset the estimated
amount of product still remaining in addition to that written off, it may be
done, the offsetting credit being to income, which must be shown as income
on the tax return for the year in which it was brought onto the books. This
new value may be depleted until wiped off the books.
The law as now operated bases value of the asset subject to depletion on
the value existing as on March 1, 1913, or at cost or purchase price if
acquired subsequent to that date. Because the book values on March 1,
1913 seldom agreed with the estimated values, it was necessary to adjust
these by charging the asset, plant, or mining property and crediting an
account called “Property Surplus” with the amount of the adjustment where
the estimate showed more than the book value. When dividends are paid, if
The amount of the period’s depletion charge is reckoned by comparing
the amount of product worked during the period with the total estimated
amount owned. Whatever value was taken for the original purchase, that
value becomes the basis for the annual or periodic depletion charge. There
is, of course, a large element of speculation in some estimates of this kind.
In the case of timber, the original amount purchased is easily determinable
with fair accuracy by cruising; the amount cut each period is a matter of
record. The ratio of the amount cut to the original amount is the portion of
the original value or cost of the timber tract to be written off periodically. In
the case of a mine or pit, the estimate cannot be made with an equal degree
of accuracy. Competent engineers do make calculations of the amounts of
available ores with sufficient certainty to warrant the expenditures of vast
sums in the purchase of properties. If their estimate avails for this purpose,
it can with equal certainty be made the basis for the periodic depletion
charge. Nice questions arise in this connection when the property is being
operated under a lease or on a royalty basis.
Application of Income Tax to Wasting Assets
Under the 1916 income tax law specific provision was made for
allowing depletion and the manner of handling it is prescribed. First, for
such a charge to be allowed as a deduction, it must be recorded on the
books. Secondly, as soon as the depletion reserve equals the capital
investment no further deduction can be made—all else is pure income. If,
however, it is desirable to carry on the books as an asset the estimated
amount of product still remaining in addition to that written off, it may be
done, the offsetting credit being to income, which must be shown as income
on the tax return for the year in which it was brought onto the books. This
new value may be depleted until wiped off the books.
The law as now operated bases value of the asset subject to depletion on
the value existing as on March 1, 1913, or at cost or purchase price if
acquired subsequent to that date. Because the book values on March 1,
1913 seldom agreed with the estimated values, it was necessary to adjust
these by charging the asset, plant, or mining property and crediting an
account called “Property Surplus” with the amount of the adjustment where
the estimate showed more than the book value. When dividends are paid, if
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it is the policy to return capital as well as profits, the charge should be made
partly against operating surplus for the profits share, and partly against
property surplus for the capital share.
Depreciation on Buildings and Machinery of a Wasting Asset
In addition to the depletion charge, proper allowance should be made
for depreciation of the other fixed assets, such as buildings, machinery, and
the like. The limit of their service life is evidently the working life of the
venture, which must be estimated. If there is still operating value in the
equipment at that date, this is covered by the higher salvage value taken
into account when fixing the depreciation charge.
Unusual Risks
In connection with both the estimate for depreciation and for depletion,
the elements of unusual risks, due to fires, floods, and the like, should be
taken into account. Their effect might be to cut down the supply of
available product and so increase the periodic depletion charge. Another
factor, of great importance at times, is the available supply of any auxiliary
product needed for the treatment of the main product. Thus, large ore bodies
may remain unmined and unprofitable because of the failure of a ready
supply of auxiliary material needed in the reduction, smelting, or refining of
the ore. This applies particularly to iron ores.
Water Rights
Sometimes valuable water rights are acquired along with mining
property, and it may be profitable to utilize them for the manufacture and
sale of power long after the depletion of the mine. In that case their capital
value should be separated from that of the mining venture, and retained as
an investment; or a new company may be formed to carry on the power
project after ceasing mining operations.
Leaseholds
On the boundary line between a depreciating asset and one subject to
depletion stands a leasehold, i.e., the right of occupancy of premises for a
stated term. Thus, a building may be rented for a term of years; or a piece of
land may be leased for a long enough period to justify the erection of a
partly against operating surplus for the profits share, and partly against
property surplus for the capital share.
Depreciation on Buildings and Machinery of a Wasting Asset
In addition to the depletion charge, proper allowance should be made
for depreciation of the other fixed assets, such as buildings, machinery, and
the like. The limit of their service life is evidently the working life of the
venture, which must be estimated. If there is still operating value in the
equipment at that date, this is covered by the higher salvage value taken
into account when fixing the depreciation charge.
Unusual Risks
In connection with both the estimate for depreciation and for depletion,
the elements of unusual risks, due to fires, floods, and the like, should be
taken into account. Their effect might be to cut down the supply of
available product and so increase the periodic depletion charge. Another
factor, of great importance at times, is the available supply of any auxiliary
product needed for the treatment of the main product. Thus, large ore bodies
may remain unmined and unprofitable because of the failure of a ready
supply of auxiliary material needed in the reduction, smelting, or refining of
the ore. This applies particularly to iron ores.
Water Rights
Sometimes valuable water rights are acquired along with mining
property, and it may be profitable to utilize them for the manufacture and
sale of power long after the depletion of the mine. In that case their capital
value should be separated from that of the mining venture, and retained as
an investment; or a new company may be formed to carry on the power
project after ceasing mining operations.
Leaseholds
On the boundary line between a depreciating asset and one subject to
depletion stands a leasehold, i.e., the right of occupancy of premises for a
stated term. Thus, a building may be rented for a term of years; or a piece of
land may be leased for a long enough period to justify the erection of a
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building thereon, the building going to the owner of the land as a gift or at
an appraised value, or the land may revert in its original condition to the
owner upon expiration of the period of the lease, according to the contract.
The payment for the lease may be an annual sum similar to a rental charge,
or a bonus and an annual sum. In the latter case, the bonus should be treated
as a deferred charge and spread as additional rent over the period of the
lease.
Leases may run for any period up to 99 years, 63 and 84 years being
favorite terms in New York. An original lessee may sell his lease outright
for a set sum sufficient to cover the remaining period of the lease, or on an
annual rental basis. The set sum is calculated as the present worth of an
annuity of the amount of a fair annual rental.
Where property values have greatly appreciated, a leasehold on
favorable terms may have a high market value which may not appear on the
books or balance sheet. If the terms of the lease call only for a periodic
payment like rent, the value of the lease will not usually appear on the
books. If the lease is purchased outright for a lump sum or a bonus is paid,
some value for it will appear on the books. Where the balance sheet is to be
used as the basis for credit, the present appraised value of the leasehold
should appear, either in a footnote or preferably incorporated into the
balance sheet with an offsetting reserve.
If the leasehold is carried at any value on the books, this must, of
course, be depreciated or amortized by the end of the leased period. As
stated above, the periodic charge for this is to the rent account and the credit
to the leasehold account, writing it down directly instead of by means of a
reserve. The straight line method of amortization is the easiest of
application, but authorities seem to favor, on theoretical grounds, the
annuity method which brings in the element of interest. If the agreement
provides for the reversion of the building to the owner of the leased land,
then also the full cost of the building must be depreciated over the life of
the lease. Any excess of this depreciation over normal depreciation is in the
nature of a rental charge but not usually of sufficient importance to require
segregation. If the premises must be returned in original condition to the
owner, the net costs of demolishing any structures erected thereon must be
treated as expenses of the lease and provided for accordingly.
an appraised value, or the land may revert in its original condition to the
owner upon expiration of the period of the lease, according to the contract.
The payment for the lease may be an annual sum similar to a rental charge,
or a bonus and an annual sum. In the latter case, the bonus should be treated
as a deferred charge and spread as additional rent over the period of the
lease.
Leases may run for any period up to 99 years, 63 and 84 years being
favorite terms in New York. An original lessee may sell his lease outright
for a set sum sufficient to cover the remaining period of the lease, or on an
annual rental basis. The set sum is calculated as the present worth of an
annuity of the amount of a fair annual rental.
Where property values have greatly appreciated, a leasehold on
favorable terms may have a high market value which may not appear on the
books or balance sheet. If the terms of the lease call only for a periodic
payment like rent, the value of the lease will not usually appear on the
books. If the lease is purchased outright for a lump sum or a bonus is paid,
some value for it will appear on the books. Where the balance sheet is to be
used as the basis for credit, the present appraised value of the leasehold
should appear, either in a footnote or preferably incorporated into the
balance sheet with an offsetting reserve.
If the leasehold is carried at any value on the books, this must, of
course, be depreciated or amortized by the end of the leased period. As
stated above, the periodic charge for this is to the rent account and the credit
to the leasehold account, writing it down directly instead of by means of a
reserve. The straight line method of amortization is the easiest of
application, but authorities seem to favor, on theoretical grounds, the
annuity method which brings in the element of interest. If the agreement
provides for the reversion of the building to the owner of the leased land,
then also the full cost of the building must be depreciated over the life of
the lease. Any excess of this depreciation over normal depreciation is in the
nature of a rental charge but not usually of sufficient importance to require
segregation. If the premises must be returned in original condition to the
owner, the net costs of demolishing any structures erected thereon must be
treated as expenses of the lease and provided for accordingly.
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CHAPTER XVIII
INTANGIBLE ASSETS—PATENTS,
FRANCHISES, GOOD-WILL
General Considerations
The final place among the assets of the balance sheet is given to the
intangible items. Because this class of assets has so frequently been used for
doubtful or illegitimate purposes, whatever the value given to them they
should be shown boldly in a group by themselves and not merged with the
values of tangible assets. Their real value, if any, should be open to
verification. To list them with tangible items on the balance sheet is apt to
raise a suspicion as to their validity much more than if they are shown in a
group by themselves.
Because the assets of this group are intangible is no reason in itself for
the hasty judgment frequently made that therefore they are worthless. It is
true, as above stated, that the doubtful uses to which they may be put have
caused them to be viewed with suspicion. Yet they have an entirely
legitimate use and oftentimes constitute the most valuable portion of the
assets. Therefore, the values at which these intangible assets are carried on
the books should always be open to investigation and capable of
verification.
It is purposed here to lay down the principles of the legitimate use of
intangible assets, and to point out some of the wrong uses to which they
easily lend themselves. The group comprises patents, copyrights, trade-
marks, formulas, receipts, franchises, organization expense, going concern
value, and good-will.
Patents a Monopoly Grant
A patent is “a grant made by the government to an inventor conveying
and securing to him the exclusive right to make and sell his invention for a
term of years.” The purpose of the government in making such grants is to
encourage and stimulate individual ingenuity along lines that will ultimately
INTANGIBLE ASSETS—PATENTS,
FRANCHISES, GOOD-WILL
General Considerations
The final place among the assets of the balance sheet is given to the
intangible items. Because this class of assets has so frequently been used for
doubtful or illegitimate purposes, whatever the value given to them they
should be shown boldly in a group by themselves and not merged with the
values of tangible assets. Their real value, if any, should be open to
verification. To list them with tangible items on the balance sheet is apt to
raise a suspicion as to their validity much more than if they are shown in a
group by themselves.
Because the assets of this group are intangible is no reason in itself for
the hasty judgment frequently made that therefore they are worthless. It is
true, as above stated, that the doubtful uses to which they may be put have
caused them to be viewed with suspicion. Yet they have an entirely
legitimate use and oftentimes constitute the most valuable portion of the
assets. Therefore, the values at which these intangible assets are carried on
the books should always be open to investigation and capable of
verification.
It is purposed here to lay down the principles of the legitimate use of
intangible assets, and to point out some of the wrong uses to which they
easily lend themselves. The group comprises patents, copyrights, trade-
marks, formulas, receipts, franchises, organization expense, going concern
value, and good-will.
Patents a Monopoly Grant
A patent is “a grant made by the government to an inventor conveying
and securing to him the exclusive right to make and sell his invention for a
term of years.” The purpose of the government in making such grants is to
encourage and stimulate individual ingenuity along lines that will ultimately
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redound to public welfare. Letters of patent are in the nature of a monopoly
grant but, although extreme care is taken in their issuance to see that they
cover really new devices, no governmental guarantee implies that the
patentee shall have free and uncontested use of his invention. If
encroachment is made upon his rights under the patent, the courts are open
to him for protection and similar privileges are extended to all alike.
Oftentimes, until infringement proceedings have established a clear and
uncontested right and property in an invention, little commercial value
attaches to it. Patents therefore tend to create a monopoly in the marketable
product protected by them and accordingly have value so long as the right
to monopoly continues.
Purchase of Patents
The valuation of patents owned and made use of by a business should
always be on the basis of cost. If owned by purchase from the inventor, the
consideration paid for the patent constitutes cost. When the consideration is
cash, there is no question as to the valuation at cost. When payment is made
in the capital stock of the purchasing concern the problem is the same here
as in the proper valuation of other fixed assets purchased in the same way,
referred to in Chapter XVII. The federal income tax law takes cognizance
of this different basis for valuation and attempts to establish a true cash
basis by allowing depreciation on patents, when purchased by means of
stock, only on the basis of the cash value of the stock. Prevailing practice
sponsors the bringing of patents onto the books at cost, as shown either by
the cash paid for them or by the par value of the stock issued for them.
Except where deceit and fraud are the points at issue, no serious objection
can be raised to the practice, for any overvaluation thus occasioned is
absorbed in the product by means of the depreciation charge spread over the
life of the patent. Any additional costs necessary to secure the full
enjoyment of the rights granted under the patent are considered proper
charges against the patent, as giving it additional value.
Patents Developed within the Plant
When the patent is not purchased from outside but is developed within
the plant itself, only the costs of development and of securing the patent are
proper charges to the asset as constituting its value. In some concerns an
experimental laboratory is maintained for the purpose of working out
grant but, although extreme care is taken in their issuance to see that they
cover really new devices, no governmental guarantee implies that the
patentee shall have free and uncontested use of his invention. If
encroachment is made upon his rights under the patent, the courts are open
to him for protection and similar privileges are extended to all alike.
Oftentimes, until infringement proceedings have established a clear and
uncontested right and property in an invention, little commercial value
attaches to it. Patents therefore tend to create a monopoly in the marketable
product protected by them and accordingly have value so long as the right
to monopoly continues.
Purchase of Patents
The valuation of patents owned and made use of by a business should
always be on the basis of cost. If owned by purchase from the inventor, the
consideration paid for the patent constitutes cost. When the consideration is
cash, there is no question as to the valuation at cost. When payment is made
in the capital stock of the purchasing concern the problem is the same here
as in the proper valuation of other fixed assets purchased in the same way,
referred to in Chapter XVII. The federal income tax law takes cognizance
of this different basis for valuation and attempts to establish a true cash
basis by allowing depreciation on patents, when purchased by means of
stock, only on the basis of the cash value of the stock. Prevailing practice
sponsors the bringing of patents onto the books at cost, as shown either by
the cash paid for them or by the par value of the stock issued for them.
Except where deceit and fraud are the points at issue, no serious objection
can be raised to the practice, for any overvaluation thus occasioned is
absorbed in the product by means of the depreciation charge spread over the
life of the patent. Any additional costs necessary to secure the full
enjoyment of the rights granted under the patent are considered proper
charges against the patent, as giving it additional value.
Patents Developed within the Plant
When the patent is not purchased from outside but is developed within
the plant itself, only the costs of development and of securing the patent are
proper charges to the asset as constituting its value. In some concerns an
experimental laboratory is maintained for the purpose of working out
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improved methods and devices. Much of the work of such a laboratory is
often fruitless so far as patentable devices are concerned, but if the entire
effort is directed towards the development of patents, then the entire cost
becomes a proper charge to whatever patents result from the effort. More
often some portion of the laboratory organization is also used for other
purposes. However developed, whether in the formal laboratory or in any
other way, the full cost of development and of securing letters patent is the
figure for the original valuation of the patent. This cost includes the labor
and material used in the process, drawings, models—including discarded
models—attorney’s fees, government fees, etc.
As in the case of purchase, all the costs, whenever incurred, of
defending the right to the patent or of prosecuting for infringements
constitute additional elements of value, as only by such means can the real
holder be made secure in the exclusive enjoyment of his right. It is hardly
necessary to point out that if such proceedings and prosecution establish the
right of the other party to a device which practically destroys or greatly
diminishes the worth of the contested patents, not only must such costs
usually be charged against revenue but also the whole or major portion of
the value at which the patent is being carried. However, where the
development of patents is one branch of a concern’s organization, costs of
this nature may usually be absorbed by those patents which are successful.
Because inflation of values is easy at this point, a careful investigation to
establish the legitimacy of all such charges is always desirable. Each case
must be judged on its merits.
Patents Purchased and not Used
Patented devices are sometimes purchased with no intent to use them.
This may be for the purpose of eliminating competition, of forestalling
obsolescence or supersession, and so of postponing the necessity of making
expensive alterations that would be required to meet threatened
competition, even to the point of scrapping a valuable organization. The
ethics of such practice is not under review here. Correct accounting practice
justifies the addition of the purchase price of such devices to the value of
the asset, patents, and its periodic depreciation in regular course.
Elements of Depreciation on Patents
often fruitless so far as patentable devices are concerned, but if the entire
effort is directed towards the development of patents, then the entire cost
becomes a proper charge to whatever patents result from the effort. More
often some portion of the laboratory organization is also used for other
purposes. However developed, whether in the formal laboratory or in any
other way, the full cost of development and of securing letters patent is the
figure for the original valuation of the patent. This cost includes the labor
and material used in the process, drawings, models—including discarded
models—attorney’s fees, government fees, etc.
As in the case of purchase, all the costs, whenever incurred, of
defending the right to the patent or of prosecuting for infringements
constitute additional elements of value, as only by such means can the real
holder be made secure in the exclusive enjoyment of his right. It is hardly
necessary to point out that if such proceedings and prosecution establish the
right of the other party to a device which practically destroys or greatly
diminishes the worth of the contested patents, not only must such costs
usually be charged against revenue but also the whole or major portion of
the value at which the patent is being carried. However, where the
development of patents is one branch of a concern’s organization, costs of
this nature may usually be absorbed by those patents which are successful.
Because inflation of values is easy at this point, a careful investigation to
establish the legitimacy of all such charges is always desirable. Each case
must be judged on its merits.
Patents Purchased and not Used
Patented devices are sometimes purchased with no intent to use them.
This may be for the purpose of eliminating competition, of forestalling
obsolescence or supersession, and so of postponing the necessity of making
expensive alterations that would be required to meet threatened
competition, even to the point of scrapping a valuable organization. The
ethics of such practice is not under review here. Correct accounting practice
justifies the addition of the purchase price of such devices to the value of
the asset, patents, and its periodic depreciation in regular course.
Elements of Depreciation on Patents
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Patents are subject to depreciation. At the time of their purchase or
acquisition, they should be valued at full cost, as stated above. At any
subsequent time, value should be calculated on the basis of full cost less
depreciation. The elements of depreciation as applied to patents are (1) time
lapse, (2) supersession, and (3) obsolescence.
1. Time Lapse. There is no such thing as wear and tear on a patent itself,
but since the grant by the government is for a definitely prescribed term of
years, as each of those years goes by there passes with it some portion of
the value attaching to the exclusive enjoyment of the right for the
prescribed period. In this country a mechanical patent is granted for a term
of seventeen years, after which the patented device or process becomes
common or public property. The period allowed for patents covering
designs is three and one-half, seven, or fourteen years, depending on the
application. Thus, simply through the lapse of time the value of the right
diminishes.
2. Supersession. If no other causes than time lapse were operative, the
problem of depreciation would be a simple one, consisting of spreading the
value of the patent over its life. In addition to lapse of time and operating
simultaneously with it is the possibility of supersession. Supersession as an
element of depreciation is the attempt to measure the probability of the
patent’s being superseded before the expiration of its term by a better
machine, device, or method. The measure of this element of depreciation is
always speculative but should be attempted with the best judgment possible.
3. Obsolescence. Akin to the element of supersession is that of
obsolescence. Obsolescence is particularly operative in cases where the
patent covers a product the life of which depends on the whims of fashion.
Obviously, when the market for the product ceases, the value of the patent
is gone.
From the above it is seen that the three elements of depreciation are
usually operative concurrently and the rate of depreciation must take
cognizance of them all.
Service Life of Patents
While the vast majority of patents become valueless before their
expiration, some few may have a value beyond their protected term. It may
acquisition, they should be valued at full cost, as stated above. At any
subsequent time, value should be calculated on the basis of full cost less
depreciation. The elements of depreciation as applied to patents are (1) time
lapse, (2) supersession, and (3) obsolescence.
1. Time Lapse. There is no such thing as wear and tear on a patent itself,
but since the grant by the government is for a definitely prescribed term of
years, as each of those years goes by there passes with it some portion of
the value attaching to the exclusive enjoyment of the right for the
prescribed period. In this country a mechanical patent is granted for a term
of seventeen years, after which the patented device or process becomes
common or public property. The period allowed for patents covering
designs is three and one-half, seven, or fourteen years, depending on the
application. Thus, simply through the lapse of time the value of the right
diminishes.
2. Supersession. If no other causes than time lapse were operative, the
problem of depreciation would be a simple one, consisting of spreading the
value of the patent over its life. In addition to lapse of time and operating
simultaneously with it is the possibility of supersession. Supersession as an
element of depreciation is the attempt to measure the probability of the
patent’s being superseded before the expiration of its term by a better
machine, device, or method. The measure of this element of depreciation is
always speculative but should be attempted with the best judgment possible.
3. Obsolescence. Akin to the element of supersession is that of
obsolescence. Obsolescence is particularly operative in cases where the
patent covers a product the life of which depends on the whims of fashion.
Obviously, when the market for the product ceases, the value of the patent
is gone.
From the above it is seen that the three elements of depreciation are
usually operative concurrently and the rate of depreciation must take
cognizance of them all.
Service Life of Patents
While the vast majority of patents become valueless before their
expiration, some few may have a value beyond their protected term. It may
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happen that the concern using the patent has built up such an organization
that competitors cannot with profit enter the field after the patent has
expired; or it may have acquired the good-will of the purchasing public to
such a degree that buyers come to it rather than to a competitor. In these and
other ways the value of the patent may extend beyond its life. This is
exceptional, however, and cannot with conservatism form the basis for
estimating the service life of the average patent.
The prevailing practice authorizes writing off the value of a patent quite
rapidly during the early years of its life when its earning capacity should be
at a maximum, leaving only a small part of the value to be spread over its
later years. This policy applies to the possession of single or separate
patents. An effective method used for extending the life of a patent is the
securing of auxiliary patents every few years. Thus an improvement of
some part may be patented, without which the use of the original or basic
patent would not be worth while. The basic patent may thus have its
effective life—though not its legal life—extended almost indefinitely.
Where an additional cost, such as infringement costs, is incurred some
time after the grant is made, strict accuracy would demand that these costs
be spread over the remaining life of the patent. Where, however, the above
policy of securing periodic improvements is in force, sufficiently accurate
results are secured by wanting off at the end of each year—in the case of
mechanical patents—one-seventeenth of the total values to date. In this
way, by the end of the original 17-year term, there will be values left in the
account which may be looked upon as applicable to the patented
improvements. There is in these cases a constant overlapping of the grant
periods and no serious inequity results as between fiscal periods by writing
off each year one-seventeenth of the total value in the Patents account. In
the case of the one original patent or an occasional improvement, the more
accurate method is desirable because here the life of the patent is rather
definitely limited.
If the estimated life on which the depreciation estimate is based, should
prove longer than the real life, the value remaining in the asset at the end of
its real life must be absorbed by the profits; i.e., charged against surplus.
The Federal Income Tax Law allows this remaining value to be charged
against the profits of the period in which it is written off.
that competitors cannot with profit enter the field after the patent has
expired; or it may have acquired the good-will of the purchasing public to
such a degree that buyers come to it rather than to a competitor. In these and
other ways the value of the patent may extend beyond its life. This is
exceptional, however, and cannot with conservatism form the basis for
estimating the service life of the average patent.
The prevailing practice authorizes writing off the value of a patent quite
rapidly during the early years of its life when its earning capacity should be
at a maximum, leaving only a small part of the value to be spread over its
later years. This policy applies to the possession of single or separate
patents. An effective method used for extending the life of a patent is the
securing of auxiliary patents every few years. Thus an improvement of
some part may be patented, without which the use of the original or basic
patent would not be worth while. The basic patent may thus have its
effective life—though not its legal life—extended almost indefinitely.
Where an additional cost, such as infringement costs, is incurred some
time after the grant is made, strict accuracy would demand that these costs
be spread over the remaining life of the patent. Where, however, the above
policy of securing periodic improvements is in force, sufficiently accurate
results are secured by wanting off at the end of each year—in the case of
mechanical patents—one-seventeenth of the total values to date. In this
way, by the end of the original 17-year term, there will be values left in the
account which may be looked upon as applicable to the patented
improvements. There is in these cases a constant overlapping of the grant
periods and no serious inequity results as between fiscal periods by writing
off each year one-seventeenth of the total value in the Patents account. In
the case of the one original patent or an occasional improvement, the more
accurate method is desirable because here the life of the patent is rather
definitely limited.
If the estimated life on which the depreciation estimate is based, should
prove longer than the real life, the value remaining in the asset at the end of
its real life must be absorbed by the profits; i.e., charged against surplus.
The Federal Income Tax Law allows this remaining value to be charged
against the profits of the period in which it is written off.
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Booking Depreciation on Patents
In booking the depreciation of patents, the periodic charge is to the
expense account, Depreciation—or Depletion—and the credit is made
either direct to the asset account or to the corresponding Depreciation
Reserve account. It is sometimes argued that since the life of the patent is
for a definite term, its depreciation is equally definite and the value of the
asset should be written down rather than carry the estimated amount of the
periodic depreciation in a reserve account. Because of the elements of
supersession and obsolescence on which in the majority of cases the service
life of the patent depends more than on its time grant, it is evident that
determination of the amount of periodic depreciation is just as much a
speculative estimate as is the case with any other asset. Either method of
showing the periodic value of the patent may be used with equal propriety.
If an easy determination of “total value to date” is sought, as under the
policy referred to above, the information is better secured by carrying the
offsetting estimate of depreciation in a reserve account. When no such
purpose is to be served, it is a needless multiplication of accounts to use the
reserve account.
Accounting Classification of Depreciation on Patents
A problem closely related to the valuation of patents has to do with the
classification or incidence of the periodic depreciation of the patent.
According to some theorists it is stated that if the patent applies to the
process of manufacture—i.e., to any part of the manufacturing equipment
used—the periodic depreciation is a cost of manufacturing and should be
allocated to the product at that point. But if the patent covers the article
itself, its periodic depreciation expense should be treated as a selling
expense. Perhaps the point is well taken but the distinction is rather finely
drawn. Another view requires the showing of depreciation on patents
among the general administrative items, on the several grounds that there is
no logical basis or method for distributing it directly to the product; that
there is no direct connection between the product and this expense; and that
it is a general overhead item which must be cared for out of gross earnings
but cannot be applied definitely to manufacturing or selling. Failure to
establish a suitable basis on which to apply the cost in practice cannot, of
In booking the depreciation of patents, the periodic charge is to the
expense account, Depreciation—or Depletion—and the credit is made
either direct to the asset account or to the corresponding Depreciation
Reserve account. It is sometimes argued that since the life of the patent is
for a definite term, its depreciation is equally definite and the value of the
asset should be written down rather than carry the estimated amount of the
periodic depreciation in a reserve account. Because of the elements of
supersession and obsolescence on which in the majority of cases the service
life of the patent depends more than on its time grant, it is evident that
determination of the amount of periodic depreciation is just as much a
speculative estimate as is the case with any other asset. Either method of
showing the periodic value of the patent may be used with equal propriety.
If an easy determination of “total value to date” is sought, as under the
policy referred to above, the information is better secured by carrying the
offsetting estimate of depreciation in a reserve account. When no such
purpose is to be served, it is a needless multiplication of accounts to use the
reserve account.
Accounting Classification of Depreciation on Patents
A problem closely related to the valuation of patents has to do with the
classification or incidence of the periodic depreciation of the patent.
According to some theorists it is stated that if the patent applies to the
process of manufacture—i.e., to any part of the manufacturing equipment
used—the periodic depreciation is a cost of manufacturing and should be
allocated to the product at that point. But if the patent covers the article
itself, its periodic depreciation expense should be treated as a selling
expense. Perhaps the point is well taken but the distinction is rather finely
drawn. Another view requires the showing of depreciation on patents
among the general administrative items, on the several grounds that there is
no logical basis or method for distributing it directly to the product; that
there is no direct connection between the product and this expense; and that
it is a general overhead item which must be cared for out of gross earnings
but cannot be applied definitely to manufacturing or selling. Failure to
establish a suitable basis on which to apply the cost in practice cannot, of
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course, be allowed to militate against the determination of its theoretical
incidence.
Royalties
An analogous problem arises in the treatment of royalties where such
cover the cost of renting the patented devices of others for the purpose of
manufacture. Although the general practice is to treat this expense as a cost
of manufacture, it is sometimes handled as a general management expense
on the ground that it represents a policy of management which has adopted
the royalty method of production in preference to the outright purchase or
development of the patents. The point seems not well taken, however. The
value of a patent may be looked upon as a prepaid expense item which is
the equivalent of royalties expense and should therefore usually be treated
as a manufacturing cost. There may be instances, however, where such
treatment would not be advisable on practical and perhaps theoretical
grounds.
Relation of Depreciation Rate to Cost of Manufacture
Related to this problem of patent costs is the effect on manufacturing
costs of the rate of depreciation of the patent. It is evident that a too rapid
depreciation will result in an inequitable loading of the product made during
the early years of the life of the patent as compared with that of its later life.
A product made under a patent still valuable after all value has been written
off the books, bears none of the burden though enjoying the benefit
accruing from its being a patented article. On the other hand, if the rate of
depreciation is not rapid enough, the product is then underburdened. It
should constantly be borne in mind that depreciation is always an estimate.
It should be the best estimate possible and subject to periodic revision
where accurate results are desired. Slight inaccuracies and inequities are
bound to occur and must be absorbed by the future product; the record of
the past is a closed book and cannot usually be reopened.
Sale Price of Patents
The sale price of a patent, as distinguished from the value at which the
owner may carry it in his accounts, frequently is based on the estimated
savings in royalties which could be made by a purchaser. When a new
concern is organized and patents are owned by some of the incorporators,
incidence.
Royalties
An analogous problem arises in the treatment of royalties where such
cover the cost of renting the patented devices of others for the purpose of
manufacture. Although the general practice is to treat this expense as a cost
of manufacture, it is sometimes handled as a general management expense
on the ground that it represents a policy of management which has adopted
the royalty method of production in preference to the outright purchase or
development of the patents. The point seems not well taken, however. The
value of a patent may be looked upon as a prepaid expense item which is
the equivalent of royalties expense and should therefore usually be treated
as a manufacturing cost. There may be instances, however, where such
treatment would not be advisable on practical and perhaps theoretical
grounds.
Relation of Depreciation Rate to Cost of Manufacture
Related to this problem of patent costs is the effect on manufacturing
costs of the rate of depreciation of the patent. It is evident that a too rapid
depreciation will result in an inequitable loading of the product made during
the early years of the life of the patent as compared with that of its later life.
A product made under a patent still valuable after all value has been written
off the books, bears none of the burden though enjoying the benefit
accruing from its being a patented article. On the other hand, if the rate of
depreciation is not rapid enough, the product is then underburdened. It
should constantly be borne in mind that depreciation is always an estimate.
It should be the best estimate possible and subject to periodic revision
where accurate results are desired. Slight inaccuracies and inequities are
bound to occur and must be absorbed by the future product; the record of
the past is a closed book and cannot usually be reopened.
Sale Price of Patents
The sale price of a patent, as distinguished from the value at which the
owner may carry it in his accounts, frequently is based on the estimated
savings in royalties which could be made by a purchaser. When a new
concern is organized and patents are owned by some of the incorporators,
Page 280
and purchased from them, the value at which they are carried is almost
always speculative and arbitrary. A valuation based on the saving in
royalties has no place on the books of a concern unless that price were paid
in purchase. Similarly, licenses to use patents should not be carried as an
asset unless purchased by a lump sum payment even though they grant a
virtual monopoly in the product.
Copyrights
Copyrights are similar to patents in that they secure to the author or
publisher the exclusive right for a term of years to make and sell copies of
literary or artistic productions. They are thus in nature a monopoly grant.
The term for a copyright is 28 years, with a renewal privilege of 28 years if
application is made within one year prior to expiration of original
copyright.
A more rigid application of the principles of valuation enunciated for
patents must be made for copyrights. On the books of the original grantee
they should be carried at full cost which may be only the fees required in
securing the copyright. For a subsequent purchaser they should be set up at
full cost to him. A much smaller proportion of copyrights than of patents
continue valuable for their granted term. Periodic valuations, then, require a
very liberal and rapid depreciation from original value. In the accounts of
publishers who make outright purchases of copyrights, extreme care is
needed in keeping track of and valuing this asset, else a too optimistic
outlook will result in carrying false and misleading values. Oftentimes the
only satisfactory and reliable method of valuation will require an
examination of each copyright owned and an independent appraisal of its
worth.
Trade Secrets
Akin to copyrights are formulas for manufacture, receipts, and other
trade secrets. These may constitute very valuable holdings, perhaps the
most valuable of all the assets, but they are not usually carried on the books
as assets under this title. A baker with a secret economical process of
making yeast may have a marked advantage over competitors. An oil
refiner with a process which secures a larger return of gasoline has a similar
advantage over competitors without such means of refining. If costs are
always speculative and arbitrary. A valuation based on the saving in
royalties has no place on the books of a concern unless that price were paid
in purchase. Similarly, licenses to use patents should not be carried as an
asset unless purchased by a lump sum payment even though they grant a
virtual monopoly in the product.
Copyrights
Copyrights are similar to patents in that they secure to the author or
publisher the exclusive right for a term of years to make and sell copies of
literary or artistic productions. They are thus in nature a monopoly grant.
The term for a copyright is 28 years, with a renewal privilege of 28 years if
application is made within one year prior to expiration of original
copyright.
A more rigid application of the principles of valuation enunciated for
patents must be made for copyrights. On the books of the original grantee
they should be carried at full cost which may be only the fees required in
securing the copyright. For a subsequent purchaser they should be set up at
full cost to him. A much smaller proportion of copyrights than of patents
continue valuable for their granted term. Periodic valuations, then, require a
very liberal and rapid depreciation from original value. In the accounts of
publishers who make outright purchases of copyrights, extreme care is
needed in keeping track of and valuing this asset, else a too optimistic
outlook will result in carrying false and misleading values. Oftentimes the
only satisfactory and reliable method of valuation will require an
examination of each copyright owned and an independent appraisal of its
worth.
Trade Secrets
Akin to copyrights are formulas for manufacture, receipts, and other
trade secrets. These may constitute very valuable holdings, perhaps the
most valuable of all the assets, but they are not usually carried on the books
as assets under this title. A baker with a secret economical process of
making yeast may have a marked advantage over competitors. An oil
refiner with a process which secures a larger return of gasoline has a similar
advantage over competitors without such means of refining. If costs are
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incurred in developing or acquiring these formulas or processes, the same
reason exists for treating them as assets as in the case of patents or
copyrights. If not protected in any way by the government, greater need of
rapid depreciation is apparent as the discovery of the secret by others might
greatly reduce its value.
Trade-Marks
A trade-mark is an earmark of ownership for advertising and selling
purposes. Thus a firm may adopt a label for their products or a manner of
marking or displaying them which wherever used is evidence of the make,
brand, and quality of the goods. A concern enjoying a trade built up by
educating the public to recognize its trade-marks and what they represent
may possess therein a very valuable property. The courts of the country
guarantee the rightful owner in the exclusive enjoyment of any benefits
arising from the use of his trade-mark. Priority of continuous use is the
factor determining rightful ownership. Such priority is most easily
established through registration of the trade-mark with the government.
Registration is not necessary but is offered by the government as a
convenient and certain means of establishing rightful ownership.
Continuous use is necessary to retain unquestioned ownership of the right.
Trade-marks must be valued at cost. Cost to develop, cost of purchase,
cost to defend—all are legitimate charges to the asset. At times even some
portion of the advertising expense may be capitalized under the caption
“Trade-Marks.” This question and that of periodic revaluation follow so
closely the principles of revaluation of good-will and the treatment of
depreciation in relation thereto, that its consideration is deferred for
combined treatment in later pages of this chapter.
Franchises—Definition and Kinds
A franchise is an intangible asset of considerable value in most cases. Its
appearance on a balance sheet is usually limited to those of public, or quasi-
public, utility companies. There it is included as an asset of value from the
standpoint of rate-making rather than for ordinary commercial purposes.
Such companies are usually under the close supervision and regulation of
public service commissions. The latter prescribe the manner of showing the
utility company’s accounts and the basis for the valuation of its assets,
reason exists for treating them as assets as in the case of patents or
copyrights. If not protected in any way by the government, greater need of
rapid depreciation is apparent as the discovery of the secret by others might
greatly reduce its value.
Trade-Marks
A trade-mark is an earmark of ownership for advertising and selling
purposes. Thus a firm may adopt a label for their products or a manner of
marking or displaying them which wherever used is evidence of the make,
brand, and quality of the goods. A concern enjoying a trade built up by
educating the public to recognize its trade-marks and what they represent
may possess therein a very valuable property. The courts of the country
guarantee the rightful owner in the exclusive enjoyment of any benefits
arising from the use of his trade-mark. Priority of continuous use is the
factor determining rightful ownership. Such priority is most easily
established through registration of the trade-mark with the government.
Registration is not necessary but is offered by the government as a
convenient and certain means of establishing rightful ownership.
Continuous use is necessary to retain unquestioned ownership of the right.
Trade-marks must be valued at cost. Cost to develop, cost of purchase,
cost to defend—all are legitimate charges to the asset. At times even some
portion of the advertising expense may be capitalized under the caption
“Trade-Marks.” This question and that of periodic revaluation follow so
closely the principles of revaluation of good-will and the treatment of
depreciation in relation thereto, that its consideration is deferred for
combined treatment in later pages of this chapter.
Franchises—Definition and Kinds
A franchise is an intangible asset of considerable value in most cases. Its
appearance on a balance sheet is usually limited to those of public, or quasi-
public, utility companies. There it is included as an asset of value from the
standpoint of rate-making rather than for ordinary commercial purposes.
Such companies are usually under the close supervision and regulation of
public service commissions. The latter prescribe the manner of showing the
utility company’s accounts and the basis for the valuation of its assets,
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chiefly from the point of view of an adequate protection of the interests of
the public. It is neither the purpose nor within the scope of the present
volume to raise the question of the valuation of public utility companies,
part of which problem would be concerned with the valuation of franchises.
An attempt will be made, however, to lay down some principles of
valuation from the commercial standpoint as distinguished from the rate-
making standpoint, applicable to a very limited number of concerns which
are not subject to state regulation, and to indicate briefly the tendency of the
rulings of the best public service commissions with regard to franchises.
A franchise is defined by H. A. Foster[45] as “a privilege given by the
community to a private person—or corporation—for use of the public
property for the benefit of the public, and only incidentally is it the
intention of the community in granting such a right, to allow the person
accepting the same enough profit to insure his willingness to take advantage
of it by investing in plant to make use of the grant.” To the same effect is
the statement of the Federal Court in the case of the Consolidated Gas Co.
of New York, 157 Fed. 373: “The franchise is but a part of the power or
privilege of sovereignty allotted to a private person for the benefit of all,
and only incidentally given for private emoluments.”
Franchises may be perpetual, where the grant is without time limit;
limited, where the term is definitely stated; and indeterminate where the
privilege granted is good “during good behavior and may be terminated by
the authorities at any time by paying the fair value of the property exclusive
of the franchise.” It may be noted that in Massachusetts no provision is
made for buying the property of the utility company in case of revocation of
the franchise. Manifestly the contract entered into with the state will
influence very largely the manner of handling and the valuation of all the
assets. Without regard to such contract and on the general principles of
valuation as laid down for fixed assets, a franchise should be taken onto the
books at full cost to acquire. Proper charges to the account would cover:
1. Lump sum payments to the state or some division
thereof, applicable to the life of the franchise as
distinguished from regular annual payments which
are in the nature of a license or rental charge and
are therefore an operating expense.
the public. It is neither the purpose nor within the scope of the present
volume to raise the question of the valuation of public utility companies,
part of which problem would be concerned with the valuation of franchises.
An attempt will be made, however, to lay down some principles of
valuation from the commercial standpoint as distinguished from the rate-
making standpoint, applicable to a very limited number of concerns which
are not subject to state regulation, and to indicate briefly the tendency of the
rulings of the best public service commissions with regard to franchises.
A franchise is defined by H. A. Foster[45] as “a privilege given by the
community to a private person—or corporation—for use of the public
property for the benefit of the public, and only incidentally is it the
intention of the community in granting such a right, to allow the person
accepting the same enough profit to insure his willingness to take advantage
of it by investing in plant to make use of the grant.” To the same effect is
the statement of the Federal Court in the case of the Consolidated Gas Co.
of New York, 157 Fed. 373: “The franchise is but a part of the power or
privilege of sovereignty allotted to a private person for the benefit of all,
and only incidentally given for private emoluments.”
Franchises may be perpetual, where the grant is without time limit;
limited, where the term is definitely stated; and indeterminate where the
privilege granted is good “during good behavior and may be terminated by
the authorities at any time by paying the fair value of the property exclusive
of the franchise.” It may be noted that in Massachusetts no provision is
made for buying the property of the utility company in case of revocation of
the franchise. Manifestly the contract entered into with the state will
influence very largely the manner of handling and the valuation of all the
assets. Without regard to such contract and on the general principles of
valuation as laid down for fixed assets, a franchise should be taken onto the
books at full cost to acquire. Proper charges to the account would cover:
1. Lump sum payments to the state or some division
thereof, applicable to the life of the franchise as
distinguished from regular annual payments which
are in the nature of a license or rental charge and
are therefore an operating expense.
Page 283
2. The full purchase price paid another company for
the assignment of its rights and privileges under a
franchise owned by it.
3. Legal and other fees in connection with securing the
grant.
4. Any other legitimate expenses, such as the cost of
securing the consent of affected property owners
or of the whole community where such cost is to
be borne by the petitioning company.
All of these are costs which from the standpoint of good business
practice may be capitalized under the caption “Franchises.”
Depreciation on Franchises
For periodic revaluations, depreciation should be in accordance with the
terms of the grant. If the grant is perpetual, no depreciation need be taken
account of; if it is for a limited term, the cost of the franchise should be
prorated over that term; if the grant is indeterminate, as defined above, not
only should a very liberal depreciation policy be pursued with regard to the
franchise but, in the case of the type of franchise granted by Massachusetts,
a liberal provision for writing off all the assets should be made, unless in
the execution of the law a policy of non-revocability of franchises has
become fairly well fixed.
In contrast with the above, note the ruling of the Public Service
Commission for the First District of the State of New York. “To this account
—Franchises (Gas)—shall be charged ‘the amount (exclusive of any tax or
annual charge) actually paid to the state or to a political subdivision thereof
as the consideration for the grant of such franchise or right’ (Section 69 of
the Public Service Commissions Law) as is necessary to the conduct of the
corporation’s gas operations. If any such franchise is acquired by means of
assignment, the charge to this account in respect thereof must not exceed
the amount actually paid therefor by the corporation to its assignor, nor
shall it exceed the amount specified in the statute above quoted. Any excess
of the amount actually paid by the corporation over the amount specified in
the statute shall be charged to the account ‘Other Intangible Gas Capital.’ If
any such franchise has a life of not more than one year after the date when
the assignment of its rights and privileges under a
franchise owned by it.
3. Legal and other fees in connection with securing the
grant.
4. Any other legitimate expenses, such as the cost of
securing the consent of affected property owners
or of the whole community where such cost is to
be borne by the petitioning company.
All of these are costs which from the standpoint of good business
practice may be capitalized under the caption “Franchises.”
Depreciation on Franchises
For periodic revaluations, depreciation should be in accordance with the
terms of the grant. If the grant is perpetual, no depreciation need be taken
account of; if it is for a limited term, the cost of the franchise should be
prorated over that term; if the grant is indeterminate, as defined above, not
only should a very liberal depreciation policy be pursued with regard to the
franchise but, in the case of the type of franchise granted by Massachusetts,
a liberal provision for writing off all the assets should be made, unless in
the execution of the law a policy of non-revocability of franchises has
become fairly well fixed.
In contrast with the above, note the ruling of the Public Service
Commission for the First District of the State of New York. “To this account
—Franchises (Gas)—shall be charged ‘the amount (exclusive of any tax or
annual charge) actually paid to the state or to a political subdivision thereof
as the consideration for the grant of such franchise or right’ (Section 69 of
the Public Service Commissions Law) as is necessary to the conduct of the
corporation’s gas operations. If any such franchise is acquired by means of
assignment, the charge to this account in respect thereof must not exceed
the amount actually paid therefor by the corporation to its assignor, nor
shall it exceed the amount specified in the statute above quoted. Any excess
of the amount actually paid by the corporation over the amount specified in
the statute shall be charged to the account ‘Other Intangible Gas Capital.’ If
any such franchise has a life of not more than one year after the date when
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it is placed in service, it shall not be charged to this account but to the
appropriate accounts in ‘Operating Expenses,’ and in ‘Prepayments’ if
extending beyond the fiscal year.” To a depreciation account called
“General Amortization” is to be charged, besides depreciation of tangible
fixed capital, “such portion of the life of intangible fixed capital as has
expired or been consumed during the month.”
Such careful regulations as to the content of intangible asset accounts
are not always nor everywhere imposed at the present time. It is not putting
the case too strongly to say that the reader of a balance sheet containing
items about which practice is not standardized should always be on his
guard to assure himself as to the content of such items in order to establish
the legitimacy of their use and value.
Organization Expenses
Organization expenses are those costs necessarily incurred for the
purpose of getting an enterprise under way, i.e., of putting it in readiness to
do business and produce income. These expenses usually comprise such
costs as state incorporation fees, attorney’s fees for drawing up the
application and other papers, the cost of prospectuses, soliciting costs for
stock subscriptions, fees paid promoters and organizers, cost of printing and
issuing certificates of stock, cost of capital stock records, and similar items.
These are necessary and unavoidable expenses without which the company
cannot come into being. A company organized and ready to commence
business is in a better position than one whose elements have not been
brought into harmonious working. In the same way that the costs of
installing machinery in position and ready for use are capitalized by being
added to the value of the equipment, so may the organization expenses of a
corporation be legitimately capitalized as being the measure of the amount
of the greater value which these organized business elements have over the
same elements unorganized. Capital has been brought together and set to
work, management and plan of operation have been secured, and business is
ready to begin.
Organization expenses are therefore, from the standpoint of
classification, best treated as an intangible asset rather than as a deferred or
prepaid expense. In strict theory the value of these costs will last as long as
the corporate existence. In Italy where corporate life is limited to fifty
appropriate accounts in ‘Operating Expenses,’ and in ‘Prepayments’ if
extending beyond the fiscal year.” To a depreciation account called
“General Amortization” is to be charged, besides depreciation of tangible
fixed capital, “such portion of the life of intangible fixed capital as has
expired or been consumed during the month.”
Such careful regulations as to the content of intangible asset accounts
are not always nor everywhere imposed at the present time. It is not putting
the case too strongly to say that the reader of a balance sheet containing
items about which practice is not standardized should always be on his
guard to assure himself as to the content of such items in order to establish
the legitimacy of their use and value.
Organization Expenses
Organization expenses are those costs necessarily incurred for the
purpose of getting an enterprise under way, i.e., of putting it in readiness to
do business and produce income. These expenses usually comprise such
costs as state incorporation fees, attorney’s fees for drawing up the
application and other papers, the cost of prospectuses, soliciting costs for
stock subscriptions, fees paid promoters and organizers, cost of printing and
issuing certificates of stock, cost of capital stock records, and similar items.
These are necessary and unavoidable expenses without which the company
cannot come into being. A company organized and ready to commence
business is in a better position than one whose elements have not been
brought into harmonious working. In the same way that the costs of
installing machinery in position and ready for use are capitalized by being
added to the value of the equipment, so may the organization expenses of a
corporation be legitimately capitalized as being the measure of the amount
of the greater value which these organized business elements have over the
same elements unorganized. Capital has been brought together and set to
work, management and plan of operation have been secured, and business is
ready to begin.
Organization expenses are therefore, from the standpoint of
classification, best treated as an intangible asset rather than as a deferred or
prepaid expense. In strict theory the value of these costs will last as long as
the corporate existence. In Italy where corporate life is limited to fifty
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years, it is prescribed that organization costs be prorated over the full life of
the corporation. The best practice in this country requires a much more
rapid writing off of these items; R. H. Montgomery[46] advocating writing
them off as they occur or at most over the first two years’ operation. To one
not cognizant of the many abuses which have crept in—and even frauds
perpetrated—through this channel, the treatment advocated may seem harsh
and severe. Perhaps no harm is done in pursuing a more liberal policy, if
such expenses are carried under a proper title, if they are not used to inflate
the value of the tangible assets, and if the caution stated above is observed
as to the need for investigating the values of all intangible asset items.
Certainly organization expense should never be used as a cloak for discount
on stocks or other securities marketed.
Good-Will—Definition and Nature
The last of the intangible assets to be treated is good-will. Lord Justice
Lindley, in an English case, says: “Good-will regarded as property has no
meaning except in connection with some trade, business, or calling. In that
connection I understand the word to include whatever adds value to a
business by reason of situation, name and reputation, connection,
introduction to old customers, and agreed absence from competition, or any
of these things, and there may be others which do not occur to me.” The
definition by George Lisle[47] is to the same general effect: “Good-will is
the monetary value placed upon the connection and reputation of a
mercantile or manufacturing concern, and discounts the value of the
turnover of a business in consequence of the probabilities of the old
customers continuing.” Good-will therefore includes every advantage
connected with location, premises, reputation, personality, name, etc. That
all these are elements of good-will cannot be gainsaid, but unless an earning
power larger than that of a newly established competing concern goes along
with these elements, no one would be willing to pay anything for the good-
will of the old concern.
It sometimes happens in the case of a merger, that because of the
dormant or latent good-will of the various units—or some of them—to be
merged, a promoter may be willing to pay something more than the value of
the tangible assets in order to acquire the various properties. Dormant or
latent good-will signifies the excess earning power that would exist if it
the corporation. The best practice in this country requires a much more
rapid writing off of these items; R. H. Montgomery[46] advocating writing
them off as they occur or at most over the first two years’ operation. To one
not cognizant of the many abuses which have crept in—and even frauds
perpetrated—through this channel, the treatment advocated may seem harsh
and severe. Perhaps no harm is done in pursuing a more liberal policy, if
such expenses are carried under a proper title, if they are not used to inflate
the value of the tangible assets, and if the caution stated above is observed
as to the need for investigating the values of all intangible asset items.
Certainly organization expense should never be used as a cloak for discount
on stocks or other securities marketed.
Good-Will—Definition and Nature
The last of the intangible assets to be treated is good-will. Lord Justice
Lindley, in an English case, says: “Good-will regarded as property has no
meaning except in connection with some trade, business, or calling. In that
connection I understand the word to include whatever adds value to a
business by reason of situation, name and reputation, connection,
introduction to old customers, and agreed absence from competition, or any
of these things, and there may be others which do not occur to me.” The
definition by George Lisle[47] is to the same general effect: “Good-will is
the monetary value placed upon the connection and reputation of a
mercantile or manufacturing concern, and discounts the value of the
turnover of a business in consequence of the probabilities of the old
customers continuing.” Good-will therefore includes every advantage
connected with location, premises, reputation, personality, name, etc. That
all these are elements of good-will cannot be gainsaid, but unless an earning
power larger than that of a newly established competing concern goes along
with these elements, no one would be willing to pay anything for the good-
will of the old concern.
It sometimes happens in the case of a merger, that because of the
dormant or latent good-will of the various units—or some of them—to be
merged, a promoter may be willing to pay something more than the value of
the tangible assets in order to acquire the various properties. Dormant or
latent good-will signifies the excess earning power that would exist if it
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were not for poor management, an inharmonious working together of the
various parts of the organization, and other similar handicaps which the new
management will remove. It may be objected that until such handicaps have
been removed there is no good-will; that any good-will brought into
evidence through the removal of these handicaps is the good-will built up
by the new concern and not the old. It cannot be denied, however, that all
the other elements of good-will may have been acquired and built up by the
old company and that without them the new concern would be unable to
bring good-will into evidence simply by a change of management. It is true
that the merger may be able to build up quickly a good-will of its own
through the elimination of competition, and through the full utilization of
all the advantages of the different units—such as access to supplies of raw
material, favorable trade agreements of various sorts, and the like.
While there is a sense in which expected future performance as
indicated above, may be an element in the determination of good-will and
may be legitimately paid for as such, as a usual thing the essence of good-
will lies in the ability to make a profit in excess of the normal. Past
performance must be reviewed by which to judge the normality of the
present profits and the probability of their continuance in the future.
Local and Personal Character of Good-Will
It should be pointed out, as a corollary to the above statement that only
those elements which are transferable and are transferred can be disposed of
for a price. Thus, when a business goes to the new owner, if there is apt to
be a very appreciable shrinking in profits—as is the case in the transfer of
some professional businesses—or if the favorable location on which in
some cases depends the ability to earn excess profits cannot be turned over
to the purchaser because of the expiration of the lease or other reason,
good-will may not be worth much to a prospective purchaser. There is thus
a local and personal character to good-will which cannot be ignored.
Difficulty of Valuing Good-Will
The valuation of good-will presents at times many complexities. The
general principle of valuation at cost—and not market—may be said to
apply here, too. What constitutes cost is sometimes difficult to determine. A
corporation which buys out an existing business, paying an agreed sum for
various parts of the organization, and other similar handicaps which the new
management will remove. It may be objected that until such handicaps have
been removed there is no good-will; that any good-will brought into
evidence through the removal of these handicaps is the good-will built up
by the new concern and not the old. It cannot be denied, however, that all
the other elements of good-will may have been acquired and built up by the
old company and that without them the new concern would be unable to
bring good-will into evidence simply by a change of management. It is true
that the merger may be able to build up quickly a good-will of its own
through the elimination of competition, and through the full utilization of
all the advantages of the different units—such as access to supplies of raw
material, favorable trade agreements of various sorts, and the like.
While there is a sense in which expected future performance as
indicated above, may be an element in the determination of good-will and
may be legitimately paid for as such, as a usual thing the essence of good-
will lies in the ability to make a profit in excess of the normal. Past
performance must be reviewed by which to judge the normality of the
present profits and the probability of their continuance in the future.
Local and Personal Character of Good-Will
It should be pointed out, as a corollary to the above statement that only
those elements which are transferable and are transferred can be disposed of
for a price. Thus, when a business goes to the new owner, if there is apt to
be a very appreciable shrinking in profits—as is the case in the transfer of
some professional businesses—or if the favorable location on which in
some cases depends the ability to earn excess profits cannot be turned over
to the purchaser because of the expiration of the lease or other reason,
good-will may not be worth much to a prospective purchaser. There is thus
a local and personal character to good-will which cannot be ignored.
Difficulty of Valuing Good-Will
The valuation of good-will presents at times many complexities. The
general principle of valuation at cost—and not market—may be said to
apply here, too. What constitutes cost is sometimes difficult to determine. A
corporation which buys out an existing business, paying an agreed sum for
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the good-will, should set up on the books that sum as the value of good-
will. The vendor concern during the years of the establishment of its good-
will, unless specific expenditures were made for that purpose, should not
show any value for it on its books. In an English case, Stewart v. Gladstone,
1879, the court said: “Is it reasonable ... that a changing thing like good-
will, the value of which would vary year by year according to the state of
the trade ... and to the reputation which the house had acquired or had lost
for integrity, punctuality, solvency, and mercantile prudence, was to be
valued from year to year,” and the increase or decrease was to be treated as
profit or loss for the year and distributed?
The impropriety of bringing good-will on the books unless paid for by
purchase or otherwise, is established and rests on principles of sound
business.
Creation of Good-Will by Advertising
There is perhaps only one case in which a concern which has not
acquired good-will by purchase but has built it up for itself may with
propriety set up its value on the books. Creating a demand for a product by
means of extensive advertising is one of the quickest ways of building up
good-will. The difference between the cost of the advertising necessary to
retain a given volume of trade—which we may call the normal advertising
expenditure—and the cost of the publicity required to secure that trade may
be treated, in theory at least, as an expenditure on account of good-will and
be so shown on the books. This is usually a difficult matter to determine at
the close of the publicity campaign and before the cost of normal
advertising is known, and the valuation at best is somewhat speculative. But
where handled carefully and with conservatism there seems no serious
objection to bringing good-will on the books at a value calculated in this
way.
Unless it is possible to treat some expenditures of this sort as the direct
cause of good-will, the evidence of the possession of good-will must be
sought in the profit and loss record rather than in the balance sheet, as its
existence would be indicated only by above-normal profits.
Valuation of Good-Will Based on Normal Profits
will. The vendor concern during the years of the establishment of its good-
will, unless specific expenditures were made for that purpose, should not
show any value for it on its books. In an English case, Stewart v. Gladstone,
1879, the court said: “Is it reasonable ... that a changing thing like good-
will, the value of which would vary year by year according to the state of
the trade ... and to the reputation which the house had acquired or had lost
for integrity, punctuality, solvency, and mercantile prudence, was to be
valued from year to year,” and the increase or decrease was to be treated as
profit or loss for the year and distributed?
The impropriety of bringing good-will on the books unless paid for by
purchase or otherwise, is established and rests on principles of sound
business.
Creation of Good-Will by Advertising
There is perhaps only one case in which a concern which has not
acquired good-will by purchase but has built it up for itself may with
propriety set up its value on the books. Creating a demand for a product by
means of extensive advertising is one of the quickest ways of building up
good-will. The difference between the cost of the advertising necessary to
retain a given volume of trade—which we may call the normal advertising
expenditure—and the cost of the publicity required to secure that trade may
be treated, in theory at least, as an expenditure on account of good-will and
be so shown on the books. This is usually a difficult matter to determine at
the close of the publicity campaign and before the cost of normal
advertising is known, and the valuation at best is somewhat speculative. But
where handled carefully and with conservatism there seems no serious
objection to bringing good-will on the books at a value calculated in this
way.
Unless it is possible to treat some expenditures of this sort as the direct
cause of good-will, the evidence of the possession of good-will must be
sought in the profit and loss record rather than in the balance sheet, as its
existence would be indicated only by above-normal profits.
Valuation of Good-Will Based on Normal Profits
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Valuing good-will for a purchaser is not so difficult. Two standard
methods are in use, the one based on profits, the other on excess profits.
According to the first, the value of the good-will is estimated as so many
years’ purchase price of the net profits of the last year; or, better, the
average of the last three or five years. This simply means multiplying the
profits by the number of years’ purchase. The number of years to be used as
a multiplier varies from one to fifteen, or twenty in some instances. Thus, if
the agreement is to pay three years’ purchase of the average profit for the
past five years and this average is $50,000, the price paid will be $150,000
and at that value good-will should be shown on the purchaser’s books.
Valuation of Good-Will Based on Excess Profits
The other method determines first the excess profits, i.e., the amount by
which the profits of a particular business exceed the normal or average
figures for that line of business. Thus, if the profits are $75,000 and normal
profits are $50,000, the excess earning capacity per period is $25,000. This
amount is then capitalized on some arbitrary basis, ranging in practice from
the prevailing interest rate, say 5%, to 20% or even 50%. The effect of such
capitalization is to apply a multiplier, as in the first method, ranging from
20 to 5 or less. Thus, if 20% is the agreed rate, the excess, $25,000
multiplied by 5 gives $125,000 as the value.
It is, of course, apparent that the valuation of good-will for prospective
purchase is largely dependent upon the individual judgment of the buyer
and that seldom will any two men arrive at the same valuation. As a matter
of prudence, under either method the average profits for the past few years
should be used rather than those of the last year. The latter may be sporadic
and under conditions such as not to warrant their continuance. An average
figure gives a better indication of what the business may be expected to do
under normal conditions. Inasmuch as the value of good-will depends on
excess earning capacity, the second method of valuation rests on better
theoretical grounds than the first. Practically there is no preference, since
valuation is largely a matter of personal judgment under either method.
Valuation of Good-Will Based on Capitalization of Profits
A slight variation of the second method is sometimes used. Under it the
average net profits are capitalized at some agreed rate, giving the amount of
methods are in use, the one based on profits, the other on excess profits.
According to the first, the value of the good-will is estimated as so many
years’ purchase price of the net profits of the last year; or, better, the
average of the last three or five years. This simply means multiplying the
profits by the number of years’ purchase. The number of years to be used as
a multiplier varies from one to fifteen, or twenty in some instances. Thus, if
the agreement is to pay three years’ purchase of the average profit for the
past five years and this average is $50,000, the price paid will be $150,000
and at that value good-will should be shown on the purchaser’s books.
Valuation of Good-Will Based on Excess Profits
The other method determines first the excess profits, i.e., the amount by
which the profits of a particular business exceed the normal or average
figures for that line of business. Thus, if the profits are $75,000 and normal
profits are $50,000, the excess earning capacity per period is $25,000. This
amount is then capitalized on some arbitrary basis, ranging in practice from
the prevailing interest rate, say 5%, to 20% or even 50%. The effect of such
capitalization is to apply a multiplier, as in the first method, ranging from
20 to 5 or less. Thus, if 20% is the agreed rate, the excess, $25,000
multiplied by 5 gives $125,000 as the value.
It is, of course, apparent that the valuation of good-will for prospective
purchase is largely dependent upon the individual judgment of the buyer
and that seldom will any two men arrive at the same valuation. As a matter
of prudence, under either method the average profits for the past few years
should be used rather than those of the last year. The latter may be sporadic
and under conditions such as not to warrant their continuance. An average
figure gives a better indication of what the business may be expected to do
under normal conditions. Inasmuch as the value of good-will depends on
excess earning capacity, the second method of valuation rests on better
theoretical grounds than the first. Practically there is no preference, since
valuation is largely a matter of personal judgment under either method.
Valuation of Good-Will Based on Capitalization of Profits
A slight variation of the second method is sometimes used. Under it the
average net profits are capitalized at some agreed rate, giving the amount of
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money on which the average profits could be earned at the rate used. The
difference between this amount and the amount of capital actually invested
gives the value of the good-will. Thus, if on an investment of $250,000 net
average profits are $60,000 and the normal rate for this business is 15%,
$60,000 would represent a 15% income on $400,000. Good-will must
therefore represent the difference between $400,000 and $250,000, or
$150,000. This must evidently work out in exactly the same way as the
second method if the rate used is the same. Therefore it constitutes not a
distinct method, but only a variation. In the one case the difference between
the average and normal profits is capitalized; in the other both are
capitalized and the difference of their capitalizations is taken.
False Good-Will to Cover Capital Deficiency
A method of valuing good-will which makes it represent the difference
between the value of tangible assets contributed or purchased and the par
value of the stock issued cannot be countenanced at all. This use of good-
will to cover up a capital deficiency is not only improper and misleading
but often fraudulent. It is the favorite means by which “water” is injected
into corporations. Thus, a concern desiring to capitalize at $500,000 and
unable to sell its stock for more than $300,000, might carry an asset, good-
will, to take care of the $200,000 discount on stock. A partnership desiring
to incorporate might issue for the partnership assets stock with a par value
much more than the assets taken over, and either inflate the asset values or
set up a good-will account to care for the difference. This practice cannot be
too severely criticized. In connection with this it should always be kept in
mind that a newly organized company can never include good-will among
its assets except by purchase.
Somewhat analogous to the above practice is that of increasing the
capitalization of a company and issuing new shares in exchange for the old.
Thus a company capitalized at $1,000,000 might increase its capital to
$2,000,000, issuing two shares of the new for each share of the old. This
will necessitate bringing onto the books an intangible asset, usually good-
will, to cover the additional $1,000,000 of stock issued. Sometimes a real
good-will may be existent as shown by the abnormal profits. In such cases,
the effect of an increase of capital stock will be to keep down the rate of
profit on the capital stock and so decrease the market value of each share,
difference between this amount and the amount of capital actually invested
gives the value of the good-will. Thus, if on an investment of $250,000 net
average profits are $60,000 and the normal rate for this business is 15%,
$60,000 would represent a 15% income on $400,000. Good-will must
therefore represent the difference between $400,000 and $250,000, or
$150,000. This must evidently work out in exactly the same way as the
second method if the rate used is the same. Therefore it constitutes not a
distinct method, but only a variation. In the one case the difference between
the average and normal profits is capitalized; in the other both are
capitalized and the difference of their capitalizations is taken.
False Good-Will to Cover Capital Deficiency
A method of valuing good-will which makes it represent the difference
between the value of tangible assets contributed or purchased and the par
value of the stock issued cannot be countenanced at all. This use of good-
will to cover up a capital deficiency is not only improper and misleading
but often fraudulent. It is the favorite means by which “water” is injected
into corporations. Thus, a concern desiring to capitalize at $500,000 and
unable to sell its stock for more than $300,000, might carry an asset, good-
will, to take care of the $200,000 discount on stock. A partnership desiring
to incorporate might issue for the partnership assets stock with a par value
much more than the assets taken over, and either inflate the asset values or
set up a good-will account to care for the difference. This practice cannot be
too severely criticized. In connection with this it should always be kept in
mind that a newly organized company can never include good-will among
its assets except by purchase.
Somewhat analogous to the above practice is that of increasing the
capitalization of a company and issuing new shares in exchange for the old.
Thus a company capitalized at $1,000,000 might increase its capital to
$2,000,000, issuing two shares of the new for each share of the old. This
will necessitate bringing onto the books an intangible asset, usually good-
will, to cover the additional $1,000,000 of stock issued. Sometimes a real
good-will may be existent as shown by the abnormal profits. In such cases,
the effect of an increase of capital stock will be to keep down the rate of
profit on the capital stock and so decrease the market value of each share,
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but not the real value of the total shares nor the amount of profit
distributable to each of the holders of shares of the original issue. The
purpose in such an increase of capital stock is usually an ulterior one, such
as the desire to cover up real earnings in order to prevent a reduction of
rates, as in the case of a public utility company. The purpose may
sometimes seemingly justify the practice. The problem is mainly an ethical
one and it is not proposed to discuss it here further than to say that the
practice is usually to be condemned.
Periodic Revaluation of Good-Will
Periodic revaluation of good-will must next be considered. This
involves a determination as to whether it is subject to depreciation. From
what has been established as the essence of good-will, viz., the ability to
earn excess profits, it is apparent, as stated in the case Stewart v. Gladstone
on page 333, that its value must fluctuate from time to time with the
earnings of the business. Because of this changing and at times doubtful
value, some authorities advocate its being written off the books periodically,
and a good many concerns do so write it off. The effect of this, so long as
there is any value remaining in good-will, is to create a secret reserve and
this is justified on the ground of conservatism. The practice is not
reprehensible, though usually to be discouraged.
The weight of authority is to the effect that all purposes are best served
by allowing it to remain always on the books at cost. There is no logical
reason for writing it off. When profits are large, good-will is a very real
asset. To write it off then is not logically consistent. When profits are small
and good-will is accordingly of less value than before, it would hardly be
logical to write off any amount less than its decreased value, yet the profits
at such a time are rarely sufficient to stand so heroic a treatment.
As was stated above on page 330, all intangible assets should be
examined carefully by a prospective purchaser as to the values at which
they are being carried.
Good-will, because of the improper and misleading uses to which it has
so often been put, is never above suspicion and its value should not be taken
without close investigation. If it really exists, the profit and loss record will
show it. That should guide as to its valuation and not the value carried on
the balance sheet. Accordingly, since the asset does not depreciate but only
distributable to each of the holders of shares of the original issue. The
purpose in such an increase of capital stock is usually an ulterior one, such
as the desire to cover up real earnings in order to prevent a reduction of
rates, as in the case of a public utility company. The purpose may
sometimes seemingly justify the practice. The problem is mainly an ethical
one and it is not proposed to discuss it here further than to say that the
practice is usually to be condemned.
Periodic Revaluation of Good-Will
Periodic revaluation of good-will must next be considered. This
involves a determination as to whether it is subject to depreciation. From
what has been established as the essence of good-will, viz., the ability to
earn excess profits, it is apparent, as stated in the case Stewart v. Gladstone
on page 333, that its value must fluctuate from time to time with the
earnings of the business. Because of this changing and at times doubtful
value, some authorities advocate its being written off the books periodically,
and a good many concerns do so write it off. The effect of this, so long as
there is any value remaining in good-will, is to create a secret reserve and
this is justified on the ground of conservatism. The practice is not
reprehensible, though usually to be discouraged.
The weight of authority is to the effect that all purposes are best served
by allowing it to remain always on the books at cost. There is no logical
reason for writing it off. When profits are large, good-will is a very real
asset. To write it off then is not logically consistent. When profits are small
and good-will is accordingly of less value than before, it would hardly be
logical to write off any amount less than its decreased value, yet the profits
at such a time are rarely sufficient to stand so heroic a treatment.
As was stated above on page 330, all intangible assets should be
examined carefully by a prospective purchaser as to the values at which
they are being carried.
Good-will, because of the improper and misleading uses to which it has
so often been put, is never above suspicion and its value should not be taken
without close investigation. If it really exists, the profit and loss record will
show it. That should guide as to its valuation and not the value carried on
the balance sheet. Accordingly, since the asset does not depreciate but only
Page 291
fluctuates in value, and since it is neither prudent nor consistently possible
to take these changing values onto the books, the best course for all
purposes seems to be to retain good-will in the accounts always at its cost
figure.
The above considerations as to the depreciation of good-will apply with
almost equal weight to the depreciation of trade-marks.
In closing this chapter attention should be called to the fact that the term
“going value” is used in the case of public utility companies in much the
same way as good-will.
to take these changing values onto the books, the best course for all
purposes seems to be to retain good-will in the accounts always at its cost
figure.
The above considerations as to the depreciation of good-will apply with
almost equal weight to the depreciation of trade-marks.
In closing this chapter attention should be called to the fact that the term
“going value” is used in the case of public utility companies in much the
same way as good-will.
Page 292
CHAPTER XIX
LIABILITIES ON THE BALANCE SHEET;
CURRENT AND CONTINGENT LIABILITIES
Form and Valuation
The problem of handling liabilities on the balance sheet is usually not so
complicated as that of assets. The questions of arrangement, form, groups,
and suitable nomenclature have in the case of liabilities an equal or even
greater importance than that of the assets, the governing principle being
clearness and fullness in the information given, with due regard to the
purpose and intended use of the balance sheet.
The problem of valuation, which assumes great importance in the
treatment of the assets, has normally little or no significance in the
consideration of liabilities. This is due to several causes. In the first place,
human nature being what it is, there is normally little danger of an
overstatement of liabilities; they are usually sufficiently large, and no desire
exists to make them appear more than they really are. Secondly, and
likewise based on human frailty, while a concern may desire to undervalue
its liabilities, the other party to the liability, the person holding the claim,
can usually be depended upon to press his claim with sufficient insistence
as to make the concern aware at all times of the amount of its liabilities.
From the viewpoint of a going concern, while all business experience
points to a decrease and a necessary diminution in the values at which
certain assets may appear on the books, no such diminution in the value of
liabilities can be looked for; as legitimate claims must be met if a business
is to exist as a going concern. Similarly, there is normally no tendency to
inflate the liabilities by the inclusion of items which do not rank fully in this
class—intangible liabilities seldom find place in any balance sheet.
On the other hand, there is frequently a very real hesitancy about the
inclusion of some liability items until their claim becomes urgent or their
full liability status becomes determined. Occasionally, and usually with
LIABILITIES ON THE BALANCE SHEET;
CURRENT AND CONTINGENT LIABILITIES
Form and Valuation
The problem of handling liabilities on the balance sheet is usually not so
complicated as that of assets. The questions of arrangement, form, groups,
and suitable nomenclature have in the case of liabilities an equal or even
greater importance than that of the assets, the governing principle being
clearness and fullness in the information given, with due regard to the
purpose and intended use of the balance sheet.
The problem of valuation, which assumes great importance in the
treatment of the assets, has normally little or no significance in the
consideration of liabilities. This is due to several causes. In the first place,
human nature being what it is, there is normally little danger of an
overstatement of liabilities; they are usually sufficiently large, and no desire
exists to make them appear more than they really are. Secondly, and
likewise based on human frailty, while a concern may desire to undervalue
its liabilities, the other party to the liability, the person holding the claim,
can usually be depended upon to press his claim with sufficient insistence
as to make the concern aware at all times of the amount of its liabilities.
From the viewpoint of a going concern, while all business experience
points to a decrease and a necessary diminution in the values at which
certain assets may appear on the books, no such diminution in the value of
liabilities can be looked for; as legitimate claims must be met if a business
is to exist as a going concern. Similarly, there is normally no tendency to
inflate the liabilities by the inclusion of items which do not rank fully in this
class—intangible liabilities seldom find place in any balance sheet.
On the other hand, there is frequently a very real hesitancy about the
inclusion of some liability items until their claim becomes urgent or their
full liability status becomes determined. Occasionally, and usually with
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ulterior intent, the liabilities may be inflated in value and items included
therein which are fictitious; but our present concern is not with such
conditions.
The one principle underlying the showing of both assets and liabilities is
that their true status should be indicated. As applied to liabilities this means
that they should be shown not only in correct amount but also in their true
light, viz.: that all facts bearing on their relation to the business which ought
to be known properly to judge conditions must be stated. The chief problem
in handling liabilities is, therefore, how to show and list them so as to
accomplish this purpose of truth and usually the further purpose of full
truth. In a consideration of this problem, the auxiliary one of the inclusion
of doubtful items among the liabilities will also receive consideration.
Arrangement on Balance Sheet
As to the classification and arrangement of liabilities on the balance
sheet, it may be stated in a general way that whatever classification and
arrangement are adopted for the assets, the liabilities should be shown
similarly. For most purposes a standard grouping under the captions,
Current, Deferred Income, Fixed or Funded, will suffice. The order of the
groups as given here follows the order given for the assets. This is desirable
for purposes of easy comparison, because in this way current liabilities are
brought into juxtaposition with the group of assets to which current
creditors must look for payment of their claims; and fixed liabilities and
capital are opposed to the assets in which for the most part they have been
invested.
Items within Groups
Arrangement within the group may be attempted on the basis of relative
degree of liquidity of the items. This, however, is not always determinable
nor is it an end to be sought; the chief desideratum is to show items in the
main group to which they properly belong.
The manner of listing the items within the group is not a question of
relative order so much as it is of nomenclature and clearness of expression.
Thus, desirable and valuable information would be given by a separation of
the items to show (1) those past due; (2) those due but not payable because
of their credit term; (3) those neither due nor payable, such as accruing
therein which are fictitious; but our present concern is not with such
conditions.
The one principle underlying the showing of both assets and liabilities is
that their true status should be indicated. As applied to liabilities this means
that they should be shown not only in correct amount but also in their true
light, viz.: that all facts bearing on their relation to the business which ought
to be known properly to judge conditions must be stated. The chief problem
in handling liabilities is, therefore, how to show and list them so as to
accomplish this purpose of truth and usually the further purpose of full
truth. In a consideration of this problem, the auxiliary one of the inclusion
of doubtful items among the liabilities will also receive consideration.
Arrangement on Balance Sheet
As to the classification and arrangement of liabilities on the balance
sheet, it may be stated in a general way that whatever classification and
arrangement are adopted for the assets, the liabilities should be shown
similarly. For most purposes a standard grouping under the captions,
Current, Deferred Income, Fixed or Funded, will suffice. The order of the
groups as given here follows the order given for the assets. This is desirable
for purposes of easy comparison, because in this way current liabilities are
brought into juxtaposition with the group of assets to which current
creditors must look for payment of their claims; and fixed liabilities and
capital are opposed to the assets in which for the most part they have been
invested.
Items within Groups
Arrangement within the group may be attempted on the basis of relative
degree of liquidity of the items. This, however, is not always determinable
nor is it an end to be sought; the chief desideratum is to show items in the
main group to which they properly belong.
The manner of listing the items within the group is not a question of
relative order so much as it is of nomenclature and clearness of expression.
Thus, desirable and valuable information would be given by a separation of
the items to show (1) those past due; (2) those due but not payable because
of their credit term; (3) those neither due nor payable, such as accruing
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items; and (4) contingent liabilities.[48] It may be remarked that such an
analysis is seldom seen on the ordinary balance sheet. Corporations which
have to report to a regulating body may be required to give more
information concerning their business than those not so regulated. For
internal use the suggested analysis has undoubted merit. For public use, it is
neither necessary nor usually desirable that the information be given in that
form; a showing of the items under the usual titles within the group to
which they properly belong being here deemed sufficient.
Cancellation of Liabilities against Assets
Occasionally the practice is met of cancelling the liabilities, or some
group of them, against corresponding assets, showing only the net assets
remaining. Thus, Current Assets less Current Claims might appear as an
item among the assets. Even for publication purposes this would not be
deemed sufficient; for the outsider as a prospective creditor or investor has
a right to judge for himself the relative sufficiency of the assets to meet the
claims of creditors. No basis for such judgment is offered by a cancellation
of the one against the other with a showing of the net amount only. A
somewhat analogous situation arises in the double-account form of
statement used by some English companies. Here, the capital assets are
canceled against the capital and fixed liabilities and only the net surplus—
usually of capital—appears in the balance sheet proper. The criticism is not
so pertinent here, however, because almost invariably the balance sheet is
accompanied by the so-called capital account which shows the full detail of
the net item in the balance sheet. So also, the practice is often condoned
wherever an accompanying schedule shows the full facts as to assets and
liabilities. As a matter of principle, it should be condemned because
accompanying schedules do not always “accompany.”
Inventory of Liabilities
The principle of showing the full truth as to the liabilities raises the
problem of the complete inclusion or inventory of the liabilities. Under this
will be considered any adjustments that must be made in the book record in
order to show the true state of the liabilities, and also the proper treatment
of contingent liabilities so as to show their relation to the state of the
business.
analysis is seldom seen on the ordinary balance sheet. Corporations which
have to report to a regulating body may be required to give more
information concerning their business than those not so regulated. For
internal use the suggested analysis has undoubted merit. For public use, it is
neither necessary nor usually desirable that the information be given in that
form; a showing of the items under the usual titles within the group to
which they properly belong being here deemed sufficient.
Cancellation of Liabilities against Assets
Occasionally the practice is met of cancelling the liabilities, or some
group of them, against corresponding assets, showing only the net assets
remaining. Thus, Current Assets less Current Claims might appear as an
item among the assets. Even for publication purposes this would not be
deemed sufficient; for the outsider as a prospective creditor or investor has
a right to judge for himself the relative sufficiency of the assets to meet the
claims of creditors. No basis for such judgment is offered by a cancellation
of the one against the other with a showing of the net amount only. A
somewhat analogous situation arises in the double-account form of
statement used by some English companies. Here, the capital assets are
canceled against the capital and fixed liabilities and only the net surplus—
usually of capital—appears in the balance sheet proper. The criticism is not
so pertinent here, however, because almost invariably the balance sheet is
accompanied by the so-called capital account which shows the full detail of
the net item in the balance sheet. So also, the practice is often condoned
wherever an accompanying schedule shows the full facts as to assets and
liabilities. As a matter of principle, it should be condemned because
accompanying schedules do not always “accompany.”
Inventory of Liabilities
The principle of showing the full truth as to the liabilities raises the
problem of the complete inclusion or inventory of the liabilities. Under this
will be considered any adjustments that must be made in the book record in
order to show the true state of the liabilities, and also the proper treatment
of contingent liabilities so as to show their relation to the state of the
business.
Page 295
The adjustment of the book record is not usually complicated. The
necessary data are for the most part available. All that is required is an
analysis of each item to determine what, if any, adjustment is needed to
bring the books to a true statement of conditions as on the date of the
balance sheet. These adjustments fall into six main groups, only two of
which appear among the liabilities, while one of the others is often based on
information obtainable only from an analysis of the liabilities. These groups
are:
1. Accrued Expenses
2. Deferred Income
3. Deferred Expenses
4. Accrued Income
5. Valuation Reserves
6. Merchandise Inventory
The first three groups are discussed below, as well as another analogous
group.
Accrued Expenses. These expenses comprise the liability existing at the
close of a fiscal period because of expenses incurred but not settled for and
oftentimes not yet due. Information as to these may be gathered—not in
completeness however—from an examination of the various expense
accounts and a somewhat intimate knowledge of the operations of the
business. Unless a record is kept of all services being rendered to the
business, it is very easy to omit some items of this kind. These will be
discussed in detail under “Current Liabilities,” page 350.
Deferred Income. This income comprises the items of income received
in advance of the full performance of the service required to earn it. In cases
of this kind there are in the possession of the business certain assets which
must be used to perform the service not yet completed in order to entitle the
business to the full enjoyment of the income. That is, the property of the
owners is liable for the service not yet rendered. Also, in order to make a
correct showing of results as between the current fiscal period and the next,
this unearned income must be carried forward for credit in the period in
which the service is performed.
necessary data are for the most part available. All that is required is an
analysis of each item to determine what, if any, adjustment is needed to
bring the books to a true statement of conditions as on the date of the
balance sheet. These adjustments fall into six main groups, only two of
which appear among the liabilities, while one of the others is often based on
information obtainable only from an analysis of the liabilities. These groups
are:
1. Accrued Expenses
2. Deferred Income
3. Deferred Expenses
4. Accrued Income
5. Valuation Reserves
6. Merchandise Inventory
The first three groups are discussed below, as well as another analogous
group.
Accrued Expenses. These expenses comprise the liability existing at the
close of a fiscal period because of expenses incurred but not settled for and
oftentimes not yet due. Information as to these may be gathered—not in
completeness however—from an examination of the various expense
accounts and a somewhat intimate knowledge of the operations of the
business. Unless a record is kept of all services being rendered to the
business, it is very easy to omit some items of this kind. These will be
discussed in detail under “Current Liabilities,” page 350.
Deferred Income. This income comprises the items of income received
in advance of the full performance of the service required to earn it. In cases
of this kind there are in the possession of the business certain assets which
must be used to perform the service not yet completed in order to entitle the
business to the full enjoyment of the income. That is, the property of the
owners is liable for the service not yet rendered. Also, in order to make a
correct showing of results as between the current fiscal period and the next,
this unearned income must be carried forward for credit in the period in
which the service is performed.
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Premium on Bonds. Somewhat analogous to deferred income is the item
of premium on bonds. As indicated in Chapter XV this is preferably treated
as a direct deduction from the periodic interest payments on the bonds,
because the bonds were marketed at a rate higher than the interest rate
prevailing at the time of their flotation. Inasmuch as the premium must be
spread over the life of the bonds, its unexpired portion will appear as of the
nature of deferred income at all intermediate stages. A more detailed
showing of this is given in Chapter XX, in the discussion of the liability,
bonds.
Deferred Expenses. These expenses have been explained in detail in
Chapter XIV. Here it is to be noted that, while this group of adjustment
items is always an asset, for the proper determination of deferred interest an
examination of the liability, notes payable, is often necessary. Notes payable
given for a loan at the bank, or given to a creditor, with prepaid interest
added to the principal of the debt as a part of the face amount of the note,
will give the data for calculation of the amount of interest or discount to be
deferred to later periods.
Contingent Liabilities
As stated above, the second group of items under the head of inventory
of the liabilities is that of contingent liabilities. It is taken for granted that
all items which on the date of the balance sheet have assumed a status of
full and direct liability will, of course, appear as such on the books. Here,
all that can be said without trespassing on the distinctive field of auditing, is
that all such items must appear. For the method of detecting their omission,
whether omitted with fraudulent intent or through carelessness and
inaccuracy, the student is referred to a standard work on auditing.
We have here to consider, however, a group of items the status of which
is one of suspended or indeterminate liability. Expressed otherwise, they are
items concerning which it is hoped—it may be even expected—that the
business will never incur liability but for which in the event of certain
happenings liability must be assumed. There are, of course, degrees of
contingency, ranging from almost certainty to negligible remoteness. It
would seem that no business man would omit the almost certain type from
his books, and in case of doubt prudence demands that decision be rendered
in favor of at least the greater probability.
of premium on bonds. As indicated in Chapter XV this is preferably treated
as a direct deduction from the periodic interest payments on the bonds,
because the bonds were marketed at a rate higher than the interest rate
prevailing at the time of their flotation. Inasmuch as the premium must be
spread over the life of the bonds, its unexpired portion will appear as of the
nature of deferred income at all intermediate stages. A more detailed
showing of this is given in Chapter XX, in the discussion of the liability,
bonds.
Deferred Expenses. These expenses have been explained in detail in
Chapter XIV. Here it is to be noted that, while this group of adjustment
items is always an asset, for the proper determination of deferred interest an
examination of the liability, notes payable, is often necessary. Notes payable
given for a loan at the bank, or given to a creditor, with prepaid interest
added to the principal of the debt as a part of the face amount of the note,
will give the data for calculation of the amount of interest or discount to be
deferred to later periods.
Contingent Liabilities
As stated above, the second group of items under the head of inventory
of the liabilities is that of contingent liabilities. It is taken for granted that
all items which on the date of the balance sheet have assumed a status of
full and direct liability will, of course, appear as such on the books. Here,
all that can be said without trespassing on the distinctive field of auditing, is
that all such items must appear. For the method of detecting their omission,
whether omitted with fraudulent intent or through carelessness and
inaccuracy, the student is referred to a standard work on auditing.
We have here to consider, however, a group of items the status of which
is one of suspended or indeterminate liability. Expressed otherwise, they are
items concerning which it is hoped—it may be even expected—that the
business will never incur liability but for which in the event of certain
happenings liability must be assumed. There are, of course, degrees of
contingency, ranging from almost certainty to negligible remoteness. It
would seem that no business man would omit the almost certain type from
his books, and in case of doubt prudence demands that decision be rendered
in favor of at least the greater probability.
Page 297
Yet there is often seen a failure to book even the liability on account of
goods purchased and shipped, but not received. If it is argued that the
liability is not fully established until receipt and acceptance of the goods,
every manager knows that non-acceptance of purchases is the exception,
not the rule. On the other hand, upon receipt of consigned goods to be sold
on account of a principal, no liability except to exercise ordinary care
usually attaches to a broker until some part of the goods has been sold by
him. Between these two extremes are many shades and degrees of
probability, all of which in some cases are recorded as liabilities; in others
none are so recorded. The importance of the information as to contingent
liability on account of notes receivable discounted and discounted
acceptances is now accorded general recognition. As to liability under court
judgments awaiting appeal, guarantees of work and product, deposits made
on contracts or bids—these and other similar matters will be treated fully in
following pages.
These, then, constitute the main problems in connection with liabilities
on the balance sheet. The group of current liabilities will now be
considered, followed by a discussion of the nature of contingent liabilities.
Current Liabilities
Notes and accounts payable, using the terms broadly, constitute
practically all of the current liabilities. Not all notes nor all accounts
payable are, however, current items. The term “current” cannot be
standardized; it varies and will perhaps always vary according to customs
and practices in any particular trade. In the main, the 90-day period may be
taken as the average. That is, on the given date of the balance sheet a
knowledge of the debts that must be met within the next 90 days is a
minimum of necessary information for the purpose of judging business
condition, particularly so far as concerns the credit extended to it. When a
balance sheet is submitted to the bank as the basis for credit, other data
concerning notes payable are usually called for—such as notes given for
merchandise, notes negotiated to own banks, notes otherwise disposed of.
The Federal Reserve Bulletin for April, 1917, under the title “Uniform
Accounting a Tentative Proposal” suggests for balance sheet presentation a
list of notes analyzed as to acceptances made for merchandise or raw
goods purchased and shipped, but not received. If it is argued that the
liability is not fully established until receipt and acceptance of the goods,
every manager knows that non-acceptance of purchases is the exception,
not the rule. On the other hand, upon receipt of consigned goods to be sold
on account of a principal, no liability except to exercise ordinary care
usually attaches to a broker until some part of the goods has been sold by
him. Between these two extremes are many shades and degrees of
probability, all of which in some cases are recorded as liabilities; in others
none are so recorded. The importance of the information as to contingent
liability on account of notes receivable discounted and discounted
acceptances is now accorded general recognition. As to liability under court
judgments awaiting appeal, guarantees of work and product, deposits made
on contracts or bids—these and other similar matters will be treated fully in
following pages.
These, then, constitute the main problems in connection with liabilities
on the balance sheet. The group of current liabilities will now be
considered, followed by a discussion of the nature of contingent liabilities.
Current Liabilities
Notes and accounts payable, using the terms broadly, constitute
practically all of the current liabilities. Not all notes nor all accounts
payable are, however, current items. The term “current” cannot be
standardized; it varies and will perhaps always vary according to customs
and practices in any particular trade. In the main, the 90-day period may be
taken as the average. That is, on the given date of the balance sheet a
knowledge of the debts that must be met within the next 90 days is a
minimum of necessary information for the purpose of judging business
condition, particularly so far as concerns the credit extended to it. When a
balance sheet is submitted to the bank as the basis for credit, other data
concerning notes payable are usually called for—such as notes given for
merchandise, notes negotiated to own banks, notes otherwise disposed of.
The Federal Reserve Bulletin for April, 1917, under the title “Uniform
Accounting a Tentative Proposal” suggests for balance sheet presentation a
list of notes analyzed as to acceptances made for merchandise or raw
Page 298
material purchased; notes given for merchandise or raw material purchased;
notes given to banks for money borrowed; notes sold through brokers; notes
given for machinery, additions to plant, etc.; notes due to stockholders,
officers, or employees. R. H. Montgomery[49] suggests a division of notes
into the groups: notes issued for merchandise; notes discounted by own
banks; notes sold through brokers; and demand loans. He suggests further
that an additional separation into notes accompanied by collateral and notes
with which no collateral is given would be desirable.
From the above it is seen that the present tendency of bankers is to insist
on a full statement of essential facts needed to pass intelligent judgment as
to the exact status of affairs. Even in the case of balance sheets, the
accuracy of which has been certified by someone, some bankers require a
certificate as to the character of the certifier unless he is well known. More
and more is the fact being recognized that legitimate business has nothing
to fear and much to gain by making a full and free statement of exact
condition, and that the sooner business supported by fraudulent statement is
eliminated, the better will it be for legitimate enterprises. In certain cases,
however, the interests or purpose of a business would not be well served by
the detailed information demanded by the banker and, here as elsewhere, no
specific rule can be laid down other than that the purpose should in all cases
govern the form and particularly the amount of detail.
Loans from Bank
In connection with advances from the bank it should be noted that the
banker does not expect to become a permanent partner in the business, but
that one of his legitimate functions is to furnish funds for seasonal
fluctuations. Oftentimes a concern does not start with enough capital to
carry its load of maximum trade, from the fear that advantageous
investment of surplus funds during the dull season will not be possible. It
may rightly expect its bank to furnish funds for this purpose when expenses
are heaviest, and to await repayment of the loan out of the income, as
accounts are collected after the peak of the seasonal trade is passed. This is
one of the fields of legitimate banking and the banker has a right to
whatever information is necessary to assure himself that his aid is being put
to proper use.
General Classification of Notes
notes given to banks for money borrowed; notes sold through brokers; notes
given for machinery, additions to plant, etc.; notes due to stockholders,
officers, or employees. R. H. Montgomery[49] suggests a division of notes
into the groups: notes issued for merchandise; notes discounted by own
banks; notes sold through brokers; and demand loans. He suggests further
that an additional separation into notes accompanied by collateral and notes
with which no collateral is given would be desirable.
From the above it is seen that the present tendency of bankers is to insist
on a full statement of essential facts needed to pass intelligent judgment as
to the exact status of affairs. Even in the case of balance sheets, the
accuracy of which has been certified by someone, some bankers require a
certificate as to the character of the certifier unless he is well known. More
and more is the fact being recognized that legitimate business has nothing
to fear and much to gain by making a full and free statement of exact
condition, and that the sooner business supported by fraudulent statement is
eliminated, the better will it be for legitimate enterprises. In certain cases,
however, the interests or purpose of a business would not be well served by
the detailed information demanded by the banker and, here as elsewhere, no
specific rule can be laid down other than that the purpose should in all cases
govern the form and particularly the amount of detail.
Loans from Bank
In connection with advances from the bank it should be noted that the
banker does not expect to become a permanent partner in the business, but
that one of his legitimate functions is to furnish funds for seasonal
fluctuations. Oftentimes a concern does not start with enough capital to
carry its load of maximum trade, from the fear that advantageous
investment of surplus funds during the dull season will not be possible. It
may rightly expect its bank to furnish funds for this purpose when expenses
are heaviest, and to await repayment of the loan out of the income, as
accounts are collected after the peak of the seasonal trade is passed. This is
one of the fields of legitimate banking and the banker has a right to
whatever information is necessary to assure himself that his aid is being put
to proper use.
General Classification of Notes
Page 299
For general purposes, a separation of notes into notes for trade purposes
and notes for other purposes is desirable. Trade purposes would be limited
to merchandise purchases and loans for working capital. Other purposes
would be long-time loans, purchase money notes often secured by mortgage
on equipment, and notes of officers and employees. These last would best
be classified by their showing as fixed rather than current liabilities.
Accounts Payable
The use of the term, accounts payable, to cover only creditors for stock-
in-trade and other trade purposes is too indefinite and inaccurate, the term
being too comprehensive and inclusive. The considerations applying to
trade debtors have equal weight in requiring the use of the term trade
creditors for the purposes mentioned above. Accounts payable to trade
creditors are usually the current items, whereas those payable to
stockholders, officers, etc., and those due to a parent or holding company
are more or less fixed, as there is usually no particular urgency as to the
time of their payment. An analysis of trade creditors into “not due” and
“past due” will at least bring out the information as to neglected discounts
and some idea as to the amount of cash needed to pay off debts and to
secure their discount.
There is no necessary relationship between accounts and notes payable,
nor any significance in their relative amounts. In some trades notes are
given in order to obtain the discounts; in others notes are given at the date
of purchase of the commodities.
Deposits. Another group of accounts payable of a more or less current
type consists of deposits of various sorts. The business may accept deposits
from customers or employees for various purposes. Consumers’ deposits
with gas and electric light companies as guarantee to cover payment of bills
and possible damage to meters or other company property; deposits
covering locker privileges, breakage of materials, keys issued, and the like,
are examples of this kind. These deposits are seldom all claimed at any one
time; experience only can indicate the necessary financial provisions to be
made currently for them. In some instances there is an accruing liability on
account of interest on these deposits which must also be cared for.
Guarantees. Sometimes goods are purchased and only partly paid for, a
portion of the purchase price being retained as a guarantee of quality until
and notes for other purposes is desirable. Trade purposes would be limited
to merchandise purchases and loans for working capital. Other purposes
would be long-time loans, purchase money notes often secured by mortgage
on equipment, and notes of officers and employees. These last would best
be classified by their showing as fixed rather than current liabilities.
Accounts Payable
The use of the term, accounts payable, to cover only creditors for stock-
in-trade and other trade purposes is too indefinite and inaccurate, the term
being too comprehensive and inclusive. The considerations applying to
trade debtors have equal weight in requiring the use of the term trade
creditors for the purposes mentioned above. Accounts payable to trade
creditors are usually the current items, whereas those payable to
stockholders, officers, etc., and those due to a parent or holding company
are more or less fixed, as there is usually no particular urgency as to the
time of their payment. An analysis of trade creditors into “not due” and
“past due” will at least bring out the information as to neglected discounts
and some idea as to the amount of cash needed to pay off debts and to
secure their discount.
There is no necessary relationship between accounts and notes payable,
nor any significance in their relative amounts. In some trades notes are
given in order to obtain the discounts; in others notes are given at the date
of purchase of the commodities.
Deposits. Another group of accounts payable of a more or less current
type consists of deposits of various sorts. The business may accept deposits
from customers or employees for various purposes. Consumers’ deposits
with gas and electric light companies as guarantee to cover payment of bills
and possible damage to meters or other company property; deposits
covering locker privileges, breakage of materials, keys issued, and the like,
are examples of this kind. These deposits are seldom all claimed at any one
time; experience only can indicate the necessary financial provisions to be
made currently for them. In some instances there is an accruing liability on
account of interest on these deposits which must also be cared for.
Guarantees. Sometimes goods are purchased and only partly paid for, a
portion of the purchase price being retained as a guarantee of quality until
Page 300
opportunity is given for adequate examination and acceptance or rejection.
Similarly, in the case of construction work done by contract or subcontract,
the owner—or, if a subcontract, the general contractor—retains a certain
percentage of the contract price as a guarantee of performance of the whole
according to contract agreement. This liability for the portion retained is a
current liability, as a usual thing, and is to be listed under accounts payable
with suitable subtitle.
Long-Term Notes. Long-term notes and accounts, bonds, and other fixed
liabilities become current as their maturity closely approaches and provision
for payment must be made.
Future Deliveries. On the border lines between contingent and full
liabilities may be classed the liability because of goods purchased with long
future dating. This is sometimes allowed by a seller to secure warehouse
room for new product. It is undoubtedly best to set up both the asset and the
liability, even where the goods have not yet been received.
Consigned Goods Sold. The factor’s real liability on account of
consigned goods sold should, of course, be shown as a current liability,
offset by any claims for expenses incurred on account of the consignor and
any accrued commissions earned on sales to date.
Dividends Not Yet Paid. Another item belonging to accounts payable is
dividends declared but not yet paid. Though it may be the custom of a
company always to declare a dividend on a given date, no liability is
incurred on account of dividends until they are actually declared. Upon
declaration of a dividend the company makes itself liable to stockholders
for the amount of the dividend. This liability ranks as an unsecured debt on
the same footing as unsecured liabilities to other creditors. The dividend
liability in large part is usually soon liquidated. Any unclaimed dividends
constitute a liability until claimed or authority is given for other disposition.
The item is usually small and is best shown as a current liability even
though the chance of its being claimed may be remote. The method of
handling and safeguarding the dividend transaction is treated in Chapter
XXIV.
Accrued Expenses
Similarly, in the case of construction work done by contract or subcontract,
the owner—or, if a subcontract, the general contractor—retains a certain
percentage of the contract price as a guarantee of performance of the whole
according to contract agreement. This liability for the portion retained is a
current liability, as a usual thing, and is to be listed under accounts payable
with suitable subtitle.
Long-Term Notes. Long-term notes and accounts, bonds, and other fixed
liabilities become current as their maturity closely approaches and provision
for payment must be made.
Future Deliveries. On the border lines between contingent and full
liabilities may be classed the liability because of goods purchased with long
future dating. This is sometimes allowed by a seller to secure warehouse
room for new product. It is undoubtedly best to set up both the asset and the
liability, even where the goods have not yet been received.
Consigned Goods Sold. The factor’s real liability on account of
consigned goods sold should, of course, be shown as a current liability,
offset by any claims for expenses incurred on account of the consignor and
any accrued commissions earned on sales to date.
Dividends Not Yet Paid. Another item belonging to accounts payable is
dividends declared but not yet paid. Though it may be the custom of a
company always to declare a dividend on a given date, no liability is
incurred on account of dividends until they are actually declared. Upon
declaration of a dividend the company makes itself liable to stockholders
for the amount of the dividend. This liability ranks as an unsecured debt on
the same footing as unsecured liabilities to other creditors. The dividend
liability in large part is usually soon liquidated. Any unclaimed dividends
constitute a liability until claimed or authority is given for other disposition.
The item is usually small and is best shown as a current liability even
though the chance of its being claimed may be remote. The method of
handling and safeguarding the dividend transaction is treated in Chapter
XXIV.
Accrued Expenses
Page 301
The final item to be considered among the current liabilities is the group
of accrued expenses. These constitute such items as wages, salaries, rents,
royalties, expense supplies purchased but unpaid for, interest, advertising,
sales commissions, traveling expenses, freights, water and other taxes, etc.
—in fact, all services which have been rendered the business previous to the
date of the balance sheet but which on that date are unpaid. These usually
comprise the most urgent of the liability items and so are properly classed
as current. There is seldom any business in which items of this kind are not
encountered and, as stated on page 343, a careful examination of the
records and familiarity with the business is needed to secure a full statement
of them.
With regard to some of these items, difference of opinion exists. It is
argued that until the amount of the liability is known, no real liability can be
said to exist. Thus, taxes for the current year may not be known until the
following year. Proverbially taxes are as certain as death, and there would
seem to be no unreality or contingency about their incidence. As the current
year passes by, the accounts should include a charge for taxes. Since the
real amount is not known, it must be carefully estimated; for any difference
must be taken up when the real amount becomes known, and so may disturb
and somewhat invalidate the results for comparative purposes. Because of
the fact that the current amount is an estimate, the title given the liability
thereunder is sometimes called “Reserve for Taxes” rather than “Accrued
Taxes.” No matter what the caption may be, it should usually be listed as a
current liability.
Booking of Accrued Expenses
As in the case of deferred expenses, so in the booking of accrued
expenses, in some quarters it is thought highly unscientific to record both
the expense and liability elements in the same account at the time of
adjusting the books. Use is made of a separate liability account entitled
“Interest Accrued,” for example. When so used immediately at the opening
of the new period, this account is either transferred to the expense account
where it will act as an offsetting credit to the expense when paid, so
automatically reducing the amount to the part properly applicable to the
new period; or the account may be allowed to stand untouched (and
therefore having no real significance) till the end of the next period when
of accrued expenses. These constitute such items as wages, salaries, rents,
royalties, expense supplies purchased but unpaid for, interest, advertising,
sales commissions, traveling expenses, freights, water and other taxes, etc.
—in fact, all services which have been rendered the business previous to the
date of the balance sheet but which on that date are unpaid. These usually
comprise the most urgent of the liability items and so are properly classed
as current. There is seldom any business in which items of this kind are not
encountered and, as stated on page 343, a careful examination of the
records and familiarity with the business is needed to secure a full statement
of them.
With regard to some of these items, difference of opinion exists. It is
argued that until the amount of the liability is known, no real liability can be
said to exist. Thus, taxes for the current year may not be known until the
following year. Proverbially taxes are as certain as death, and there would
seem to be no unreality or contingency about their incidence. As the current
year passes by, the accounts should include a charge for taxes. Since the
real amount is not known, it must be carefully estimated; for any difference
must be taken up when the real amount becomes known, and so may disturb
and somewhat invalidate the results for comparative purposes. Because of
the fact that the current amount is an estimate, the title given the liability
thereunder is sometimes called “Reserve for Taxes” rather than “Accrued
Taxes.” No matter what the caption may be, it should usually be listed as a
current liability.
Booking of Accrued Expenses
As in the case of deferred expenses, so in the booking of accrued
expenses, in some quarters it is thought highly unscientific to record both
the expense and liability elements in the same account at the time of
adjusting the books. Use is made of a separate liability account entitled
“Interest Accrued,” for example. When so used immediately at the opening
of the new period, this account is either transferred to the expense account
where it will act as an offsetting credit to the expense when paid, so
automatically reducing the amount to the part properly applicable to the
new period; or the account may be allowed to stand untouched (and
therefore having no real significance) till the end of the next period when
Page 302
only the difference between it and the new amount accrued is made the
basis of the new adjusting entry. Both these methods, while securing a more
evident separation of the expense and liability elements, do so only at the
cost of a needless multiplication of accounts and work. To one acquainted
with the significance of bookkeeping methods, the old way of treating the
liability element as an inventory in the expense account makes a definite
allocation of the two elements, and does so with less burden on the
bookkeeper and is to be preferred in most cases.
Deferred Credits
Deferred credits, as already explained, are analogous to current
liabilities in that they represent unearned income. The enjoyment or earning
of this income requires the rendering of certain services which are a claim
on the current assets. In this sense, then, they belong to the current liability
group, for the payment of which the current assets must be available.
Nature of Contingent Liabilities
Statement of Contingent Liabilities
As stated on page 345, contingent liabilities range from those almost
certain to materialize to those extremely remote. For some purposes a full
statement of all such liabilities is needed to give an adequate view of
conditions within the business. For other purposes, so detailed a statement
may not be necessary although usually desirable. The Federal Reserve
Board requires on a balance sheet submitted as the basis for credit a full
statement of contingent liability as follows:
Kind of Contingent Liability Amount
Upon customers’ notes discounted, sold,
or otherwise transferred $ ......
Upon drafts negotiated ......
For accommodation indorsements ......
For guarantees ......
Upon leases ......
basis of the new adjusting entry. Both these methods, while securing a more
evident separation of the expense and liability elements, do so only at the
cost of a needless multiplication of accounts and work. To one acquainted
with the significance of bookkeeping methods, the old way of treating the
liability element as an inventory in the expense account makes a definite
allocation of the two elements, and does so with less burden on the
bookkeeper and is to be preferred in most cases.
Deferred Credits
Deferred credits, as already explained, are analogous to current
liabilities in that they represent unearned income. The enjoyment or earning
of this income requires the rendering of certain services which are a claim
on the current assets. In this sense, then, they belong to the current liability
group, for the payment of which the current assets must be available.
Nature of Contingent Liabilities
Statement of Contingent Liabilities
As stated on page 345, contingent liabilities range from those almost
certain to materialize to those extremely remote. For some purposes a full
statement of all such liabilities is needed to give an adequate view of
conditions within the business. For other purposes, so detailed a statement
may not be necessary although usually desirable. The Federal Reserve
Board requires on a balance sheet submitted as the basis for credit a full
statement of contingent liability as follows:
Kind of Contingent Liability Amount
Upon customers’ notes discounted, sold,
or otherwise transferred $ ......
Upon drafts negotiated ......
For accommodation indorsements ......
For guarantees ......
Upon leases ......
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Upon bonds or other obligations of ......
subsidiary companies ......
Under contracts or purchase arrangements ......
Under agreements ......
Under pending lawsuits ......
This company is not a guarantor or indorser of any liabilities or
obligations of any individual, firm, or corporation, and it is not
liable under any contracts, bonds, or profit-sharing arrangements, or
any other agreements, and there are no lawsuits pending except as set
forth above.
Sign Company’s name here ..........................................................
By ..........................
N. B. It is most essential that each question be fully answered.
Full answers to the above inquisition would often prove embarrassing
but very enlightening. Two additional kinds of contingent liability not listed
above sometimes exist, viz.: that arising out of a call for the unpaid portion
of stocks owned but not fully paid for; and in the case of a corporation,
unpaid accumulated dividends on preferred stocks. Some of these
contingent liabilities require detailed consideration.
Notes and Drafts Transferred
The proper method of handling notes discounted, sold, or otherwise
transferred, and negotiated drafts is given in Volume I and will not be
repeated here. The showing of these items on the balance sheet is by
inclusion among both the assets and liabilities, or preferably by inclusion
among the assets with the liability element shown deducted. When a person
or firm lends its credit by means of an accommodation indorsement, the
transaction should be recorded as a charge to the accommodated party and a
credit to Notes Payable if the liability is primary; or to Indorser’s Liability,
if secondary. In case of primary liability, liability is full and must be listed
on the balance sheet as a note payable. In case of secondary liability,
liability is contingent, as in the case of discounted notes, and should be so
subsidiary companies ......
Under contracts or purchase arrangements ......
Under agreements ......
Under pending lawsuits ......
This company is not a guarantor or indorser of any liabilities or
obligations of any individual, firm, or corporation, and it is not
liable under any contracts, bonds, or profit-sharing arrangements, or
any other agreements, and there are no lawsuits pending except as set
forth above.
Sign Company’s name here ..........................................................
By ..........................
N. B. It is most essential that each question be fully answered.
Full answers to the above inquisition would often prove embarrassing
but very enlightening. Two additional kinds of contingent liability not listed
above sometimes exist, viz.: that arising out of a call for the unpaid portion
of stocks owned but not fully paid for; and in the case of a corporation,
unpaid accumulated dividends on preferred stocks. Some of these
contingent liabilities require detailed consideration.
Notes and Drafts Transferred
The proper method of handling notes discounted, sold, or otherwise
transferred, and negotiated drafts is given in Volume I and will not be
repeated here. The showing of these items on the balance sheet is by
inclusion among both the assets and liabilities, or preferably by inclusion
among the assets with the liability element shown deducted. When a person
or firm lends its credit by means of an accommodation indorsement, the
transaction should be recorded as a charge to the accommodated party and a
credit to Notes Payable if the liability is primary; or to Indorser’s Liability,
if secondary. In case of primary liability, liability is full and must be listed
on the balance sheet as a note payable. In case of secondary liability,
liability is contingent, as in the case of discounted notes, and should be so
Page 304
shown on the balance sheet. In either of these cases, the practice of
cancelling the liability against the corresponding asset and by a feat of
mental dexterity persuading oneself that there is therefore no need to show
the item on the balance sheet, is a practice to be universally condemned.
Guarantees as a Contingent Liability
Guarantees are of many sorts—guarantees of product sold or work
performed, guarantees of the good faith of others in meeting their
obligations, etc. The transferred note is one kind of guarantee. Oftentimes, a
parent company may guarantee the principal and interest or the interest only
of the bond or note obligations of a subsidiary. While the expectation is
usually that the contingent liability will not become real, yet experience
shows the need of making adequate provision against it. The recent example
of the Denver & Rio Grande as guarantor of the bond interest of Western
Pacific bonds drives home that necessity. In a case of this sort provision is
best made in the creation of a contingency reserve, for there is no
experience on which to base a better estimate. In the case of a policy of
guaranteeing the quality of a product or its workmanship, after a few years’
experience very accurate estimates can be made of the loss to be expected
therefrom, and at the end of a fiscal period the books can be adjusted on
that basis just as they are for taxes. A charge to a suitable expense account
and a credit to a reserve or accrued account comprises the book entry, with
a listing of the reserve as a real liability.
Long-Term Leases
Contingent liability brought about by a lease covering a long period
may be disregarded if the lease has a marketable value sufficient to cover
the liability. Otherwise a contingent reserve should be set up. Liability
under the subletting of a lease is best handled by means of a reserve.
Purchases for Future Delivery
Purchase contracts for future delivery, if made at a fixed price, may be
disregarded unless at the date of the balance sheet market value is lower
than cost, when a reserve should be set up. A fuller statement of the facts
shows the transaction among both assets and liabilities. If the contract,
being speculative, is not at a named price, the showing of the reserve is
prudent and conservative.
cancelling the liability against the corresponding asset and by a feat of
mental dexterity persuading oneself that there is therefore no need to show
the item on the balance sheet, is a practice to be universally condemned.
Guarantees as a Contingent Liability
Guarantees are of many sorts—guarantees of product sold or work
performed, guarantees of the good faith of others in meeting their
obligations, etc. The transferred note is one kind of guarantee. Oftentimes, a
parent company may guarantee the principal and interest or the interest only
of the bond or note obligations of a subsidiary. While the expectation is
usually that the contingent liability will not become real, yet experience
shows the need of making adequate provision against it. The recent example
of the Denver & Rio Grande as guarantor of the bond interest of Western
Pacific bonds drives home that necessity. In a case of this sort provision is
best made in the creation of a contingency reserve, for there is no
experience on which to base a better estimate. In the case of a policy of
guaranteeing the quality of a product or its workmanship, after a few years’
experience very accurate estimates can be made of the loss to be expected
therefrom, and at the end of a fiscal period the books can be adjusted on
that basis just as they are for taxes. A charge to a suitable expense account
and a credit to a reserve or accrued account comprises the book entry, with
a listing of the reserve as a real liability.
Long-Term Leases
Contingent liability brought about by a lease covering a long period
may be disregarded if the lease has a marketable value sufficient to cover
the liability. Otherwise a contingent reserve should be set up. Liability
under the subletting of a lease is best handled by means of a reserve.
Purchases for Future Delivery
Purchase contracts for future delivery, if made at a fixed price, may be
disregarded unless at the date of the balance sheet market value is lower
than cost, when a reserve should be set up. A fuller statement of the facts
shows the transaction among both assets and liabilities. If the contract,
being speculative, is not at a named price, the showing of the reserve is
prudent and conservative.
Page 305
Pending Lawsuits
In the case of pending lawsuits, the contingent reserve is usually all that
is necessary. If the case is on appeal, it might in addition be wise to create a
fund which would provide funds for settlement if the decision is
unfavorable. Here the item of costs, fees, and accruing interest is usually
large and liberal provision must be made.
Stock not fully Paid
Where shares of stock are held which are not fully paid, a liability
attaches for the unpaid portion contingent upon call being made for it.
Showing the stocks at subscribed price with the offsetting liability for the
unpaid amount as a deduction, is perhaps the best method, though there is
no serious objection to omit mention of it if the stock has increased in
value, or of using the method of a reserve. Where a double liability attaches
to stock ownership in case of bankruptcy, no notice need be taken of the
contingent liability so long as the business whose stock is held shows an
entirely solvent condition. When such is not the case, whatever provision
seems necessary should be made, even to the extent of liability to the full
value of the stock held.
Accumulated Dividends on Preferred Stock
There is no liability on account of accumulated dividends on preferred
stock until profits have been made out of which they may be paid. If the
policy of management does not allow their declaration at the present time,
although sufficient profits have been made, the accumulation of dividends
should be shown as a liability. Where the company is unable to declare
dividends because of insufficient profits, mention of the accumulating
dividends should be made in a footnote as a possible future liability.
Signature to Surety Bond
The liability arising through signature to a surety bond is a contingent
liability resting upon the good faith and honor of the bonded party. The
practice of personal bondsmen is not so prevalent as formerly. Experience
shows that the liability of the bondsmen may become very real, and not
only should suitable provision be made for it but its existence should be
shown on the balance sheet.
In the case of pending lawsuits, the contingent reserve is usually all that
is necessary. If the case is on appeal, it might in addition be wise to create a
fund which would provide funds for settlement if the decision is
unfavorable. Here the item of costs, fees, and accruing interest is usually
large and liberal provision must be made.
Stock not fully Paid
Where shares of stock are held which are not fully paid, a liability
attaches for the unpaid portion contingent upon call being made for it.
Showing the stocks at subscribed price with the offsetting liability for the
unpaid amount as a deduction, is perhaps the best method, though there is
no serious objection to omit mention of it if the stock has increased in
value, or of using the method of a reserve. Where a double liability attaches
to stock ownership in case of bankruptcy, no notice need be taken of the
contingent liability so long as the business whose stock is held shows an
entirely solvent condition. When such is not the case, whatever provision
seems necessary should be made, even to the extent of liability to the full
value of the stock held.
Accumulated Dividends on Preferred Stock
There is no liability on account of accumulated dividends on preferred
stock until profits have been made out of which they may be paid. If the
policy of management does not allow their declaration at the present time,
although sufficient profits have been made, the accumulation of dividends
should be shown as a liability. Where the company is unable to declare
dividends because of insufficient profits, mention of the accumulating
dividends should be made in a footnote as a possible future liability.
Signature to Surety Bond
The liability arising through signature to a surety bond is a contingent
liability resting upon the good faith and honor of the bonded party. The
practice of personal bondsmen is not so prevalent as formerly. Experience
shows that the liability of the bondsmen may become very real, and not
only should suitable provision be made for it but its existence should be
shown on the balance sheet.
Page 306
CHAPTER XX
FIXED LIABILITIES—BONDS
AND MORTGAGES
Nature of Fixed Liabilities
Fixed liabilities, called also capital, bonded, long-term, and funded liabilities or
debts, comprise all debts of which the date of maturity is some distance ahead and
considerably longer than that of current liabilities. Government regulating boards, for
purposes of standardization, may set a minimum life-period for this group of liabilities
and any kind of debt falling within the period is so classified. Thus, the Public Service
Commission for the First District of the State of New York says: “Funded debt
comprises all debt which by the terms of its creation does not mature until more than
one year after date of creation.” Private undertakings do not need such exact uniformity.
Any debt the maturity of which extends beyond the period adopted within that business
for current liabilities will usually be grouped with the fixed liabilities, there seldom
being an intermediate group.
Purpose of Fixed Liabilities
Fixed liabilities, as distinguished from current, are those issued distinctively for the
purpose of raising capital. Due to insufficient original capitalization, funds may be
needed for one or more of many purposes. Working capital may be required; extensions
of plant and market may be desirable; additional equipment and improvement within the
plant itself may be advisable; the control of the plant of a competitor may prove
advantageous; it may be deemed wise to fund floating liabilities; the refunding of
liabilities soon to mature may become necessary; the financial policy may dictate the
unification of several diverse forms of debt—these and other purposes may be served by
the assumption of long-term debts.
Corporation Bonds
The most common type of fixed liability is the bond. As an instrument of credit the
bond is limited almost exclusively to corporations. The purchasing public, interested in
securities of this kind, looks with suspicion on a long-term promise to pay issued by
either a single proprietor or by a partnership. Such businesses are almost wholly
dependent on the health and ability of individual owners. During a long period of years
so many contingencies may arise and seriously cripple the business that the long-term
debts of a partnership or sole ownership have no market, although isolated instances of
such issues exist. The corporation, however, has continuity of life, is not so dependent
FIXED LIABILITIES—BONDS
AND MORTGAGES
Nature of Fixed Liabilities
Fixed liabilities, called also capital, bonded, long-term, and funded liabilities or
debts, comprise all debts of which the date of maturity is some distance ahead and
considerably longer than that of current liabilities. Government regulating boards, for
purposes of standardization, may set a minimum life-period for this group of liabilities
and any kind of debt falling within the period is so classified. Thus, the Public Service
Commission for the First District of the State of New York says: “Funded debt
comprises all debt which by the terms of its creation does not mature until more than
one year after date of creation.” Private undertakings do not need such exact uniformity.
Any debt the maturity of which extends beyond the period adopted within that business
for current liabilities will usually be grouped with the fixed liabilities, there seldom
being an intermediate group.
Purpose of Fixed Liabilities
Fixed liabilities, as distinguished from current, are those issued distinctively for the
purpose of raising capital. Due to insufficient original capitalization, funds may be
needed for one or more of many purposes. Working capital may be required; extensions
of plant and market may be desirable; additional equipment and improvement within the
plant itself may be advisable; the control of the plant of a competitor may prove
advantageous; it may be deemed wise to fund floating liabilities; the refunding of
liabilities soon to mature may become necessary; the financial policy may dictate the
unification of several diverse forms of debt—these and other purposes may be served by
the assumption of long-term debts.
Corporation Bonds
The most common type of fixed liability is the bond. As an instrument of credit the
bond is limited almost exclusively to corporations. The purchasing public, interested in
securities of this kind, looks with suspicion on a long-term promise to pay issued by
either a single proprietor or by a partnership. Such businesses are almost wholly
dependent on the health and ability of individual owners. During a long period of years
so many contingencies may arise and seriously cripple the business that the long-term
debts of a partnership or sole ownership have no market, although isolated instances of
such issues exist. The corporation, however, has continuity of life, is not so dependent
Page 307
on individuals, and therefore has avenues for the raising of funds open to it which are
closed to other types of organization.
Nature of Bonds
A bond may be defined as an instrument under seal promising to pay a certain
amount of money at a definite or determinable future time. From a legal standpoint, a
bond is a contract setting forth the terms and conditions under which the obligation is
assumed. Furthermore, it is a negotiable contract transferable from hand to hand, though
in some cases registration is necessary to prove ownership in the eyes of the issuing
corporation. From a financial standpoint, a bond is essentially a long-term promissory
note. Bonds, as here used, are to be distinguished from the old real estate bond and
mortgage. Bonds are usually secured by a lien on some definite property or prospect of
property, just as the real estate bond and mortgage. The corporation bond, however, is a
separate instrument, divisible into small parts, whereas the bond and mortgage is not
usually an instrument of that type.
Corporation bonds are also to be distinguished from the surety bonds mentioned in
the preceding chapter. These latter, as already noted, are instruments whereby
individuals, firms, or corporations bind themselves as guarantors for the conduct of
others or for the payment of sums of money for which the guarantor is not directly
liable.
Difference between Bond and Real Estate Mortgages
With regard to the mortgage covering the bond issue, points of difference from the
ordinary real estate mortgage are to be noted. To the ordinary mortgage there are two
parties, viz., the party obligated and the party accommodated, the obligor and obligee.
To the bond mortgage, the obligee is a trustee standing in the stead of the numerous
bondholders who could not conveniently act individually. In this trustee the title to the
property liened is vested for the benefit of the bondholders. The mortgage instrument
itself is often a model of completeness and comprehensiveness, defining with minute
care the relations, duties, rights, interests, and status of the issuing corporation, the
bondholders, and the trustee under present circumstances and all possible future
contingencies.
Kinds of Corporation Bonds
Since bonds were first issued, perhaps one hundred different kinds have been placed
on the market. They all have the same fundamental characteristics but differ in minor
particulars. No universally recognized basis exists for their classification, nor is such a
basis possible, the use which they are to serve determining always the basis of analysis
into classes. Thus, in the opinion of a leading authority[50] on the subject bonds may be
classified under the following heads, according to:
1. The character of the issuing corporation under
closed to other types of organization.
Nature of Bonds
A bond may be defined as an instrument under seal promising to pay a certain
amount of money at a definite or determinable future time. From a legal standpoint, a
bond is a contract setting forth the terms and conditions under which the obligation is
assumed. Furthermore, it is a negotiable contract transferable from hand to hand, though
in some cases registration is necessary to prove ownership in the eyes of the issuing
corporation. From a financial standpoint, a bond is essentially a long-term promissory
note. Bonds, as here used, are to be distinguished from the old real estate bond and
mortgage. Bonds are usually secured by a lien on some definite property or prospect of
property, just as the real estate bond and mortgage. The corporation bond, however, is a
separate instrument, divisible into small parts, whereas the bond and mortgage is not
usually an instrument of that type.
Corporation bonds are also to be distinguished from the surety bonds mentioned in
the preceding chapter. These latter, as already noted, are instruments whereby
individuals, firms, or corporations bind themselves as guarantors for the conduct of
others or for the payment of sums of money for which the guarantor is not directly
liable.
Difference between Bond and Real Estate Mortgages
With regard to the mortgage covering the bond issue, points of difference from the
ordinary real estate mortgage are to be noted. To the ordinary mortgage there are two
parties, viz., the party obligated and the party accommodated, the obligor and obligee.
To the bond mortgage, the obligee is a trustee standing in the stead of the numerous
bondholders who could not conveniently act individually. In this trustee the title to the
property liened is vested for the benefit of the bondholders. The mortgage instrument
itself is often a model of completeness and comprehensiveness, defining with minute
care the relations, duties, rights, interests, and status of the issuing corporation, the
bondholders, and the trustee under present circumstances and all possible future
contingencies.
Kinds of Corporation Bonds
Since bonds were first issued, perhaps one hundred different kinds have been placed
on the market. They all have the same fundamental characteristics but differ in minor
particulars. No universally recognized basis exists for their classification, nor is such a
basis possible, the use which they are to serve determining always the basis of analysis
into classes. Thus, in the opinion of a leading authority[50] on the subject bonds may be
classified under the following heads, according to:
1. The character of the issuing corporation under
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which are treated:
(a) Civil Loans
(b) Corporation loans
2. The security of the bonds under which come:
(a) First mortgage (second, third, etc.)
(b) General mortgage
(c) Divisional
(d) Guaranteed
(e) Collateral trust
(f) Debenture
(g) Income
(h) Land grant
(i) Real estate
(j) Prior lien
(k) Consolidated (consols)
Etc., etc., there seemingly being no limit to
the descriptive titles that may be used in
order to indicate some feature of the security.
3. The purpose of the issue, as:
(a) Improvement
(b) Construction
(c) Refunding
(d) Purchase money
(e) Unified
(f) Subsidy
Etc.
4. The conditions incident upon payment of principal
and interest, as:
For the payment of interest—
(a) Income
(b) Participating
(c) Unconditional
(d) Registered
(e) Registered coupon
(f) Coupon
(g) Interchangeable
Etc.
(a) Civil Loans
(b) Corporation loans
2. The security of the bonds under which come:
(a) First mortgage (second, third, etc.)
(b) General mortgage
(c) Divisional
(d) Guaranteed
(e) Collateral trust
(f) Debenture
(g) Income
(h) Land grant
(i) Real estate
(j) Prior lien
(k) Consolidated (consols)
Etc., etc., there seemingly being no limit to
the descriptive titles that may be used in
order to indicate some feature of the security.
3. The purpose of the issue, as:
(a) Improvement
(b) Construction
(c) Refunding
(d) Purchase money
(e) Unified
(f) Subsidy
Etc.
4. The conditions incident upon payment of principal
and interest, as:
For the payment of interest—
(a) Income
(b) Participating
(c) Unconditional
(d) Registered
(e) Registered coupon
(f) Coupon
(g) Interchangeable
Etc.
Page 309
For the payment of the principal—
(a) Premium
(b) Gold
(c) Silver
(d) Straight
(e) Serial
(f) Extended
(g) Callable
(h) Optional
(i) Convertible
Etc.
The issuing corporation often distinguishes its bonds by means of some descriptive
adjectives purporting to classify them or indicate their nature. Thus, consolidated first
and improvement, general and refunding mortgage, first mortgage extension, general
lien railway and land grant, are titles sometimes met, though a simpler title carrying also
the interest rate is more common, as general mortgage 4’s of 1965, C. & A. 5’s, Toledo
Light & Power 4’s, etc. As listed on the exchange the title usually gives the name of the
issuing corporation (i.e., the obligor), the distinctive name of the bond, and its interest
rate.
Bonds rank very much as mortgages do in the priority of their liens. A first mortgage
bond has a first lien on the property securing it; a second mortgage bond has a second
lien and its claim is said to be junior to that of the first. No attempt can here be made to
explain the distinguishing features of the above-named issues. Attention is called to
them only because the reader of a balance sheet—an investor or prospective creditor—
often must have a knowledge of the various classes of bonds and a detailed knowledge
of the conditions of particular issues. It is obvious that the accountant should have a
knowledge of the particular issues of a business in order intelligently to draw up a
balance sheet and make a report thereon.
Authority for the Issue of Bonds
A corporation has generally a charter right to issue bonds for the purpose of securing
money, acquiring property, or in payment for labor or financial services rendered. The
exercise of this right may be curtailed by, or be dependent upon, authority from a
regulating body. Within the corporation itself, the right to issue vests in the stockholders.
In some cases a majority vote suffices; in others as many as three-quarters of the votes
may be required to authorize the issue. The directors themselves may, upon proper
authorization from the stockholders, make the actual issue, and usually the initiative for
a bond issue comes from them because they have intimate knowledge of the business
and its needs.
(a) Premium
(b) Gold
(c) Silver
(d) Straight
(e) Serial
(f) Extended
(g) Callable
(h) Optional
(i) Convertible
Etc.
The issuing corporation often distinguishes its bonds by means of some descriptive
adjectives purporting to classify them or indicate their nature. Thus, consolidated first
and improvement, general and refunding mortgage, first mortgage extension, general
lien railway and land grant, are titles sometimes met, though a simpler title carrying also
the interest rate is more common, as general mortgage 4’s of 1965, C. & A. 5’s, Toledo
Light & Power 4’s, etc. As listed on the exchange the title usually gives the name of the
issuing corporation (i.e., the obligor), the distinctive name of the bond, and its interest
rate.
Bonds rank very much as mortgages do in the priority of their liens. A first mortgage
bond has a first lien on the property securing it; a second mortgage bond has a second
lien and its claim is said to be junior to that of the first. No attempt can here be made to
explain the distinguishing features of the above-named issues. Attention is called to
them only because the reader of a balance sheet—an investor or prospective creditor—
often must have a knowledge of the various classes of bonds and a detailed knowledge
of the conditions of particular issues. It is obvious that the accountant should have a
knowledge of the particular issues of a business in order intelligently to draw up a
balance sheet and make a report thereon.
Authority for the Issue of Bonds
A corporation has generally a charter right to issue bonds for the purpose of securing
money, acquiring property, or in payment for labor or financial services rendered. The
exercise of this right may be curtailed by, or be dependent upon, authority from a
regulating body. Within the corporation itself, the right to issue vests in the stockholders.
In some cases a majority vote suffices; in others as many as three-quarters of the votes
may be required to authorize the issue. The directors themselves may, upon proper
authorization from the stockholders, make the actual issue, and usually the initiative for
a bond issue comes from them because they have intimate knowledge of the business
and its needs.
Page 310
Financial Considerations Involved in Issue
Financial considerations involved in the determination to issue bonds may be
reviewed briefly. It is interesting to note that the bond has been used very extensively as
a means of securing capital. There is, however, no necessary relationship between the
amount of capital raised by stock issues and that raised by bond issues. The sale of
additional stock or of bonds or other similar securities is the main source of corporation
funds for capital purposes. Some concerns have obtained approximately one-half of
their capital through the issue of bonds. Percentages of capital so raised ranging from
15% to 40% are not uncommon.
The manner of raising capital is largely a matter of credit, expediency, and the
question of fixed operating expenses. It rarely happens that bonds carry with them the
privilege of voice in the management of the corporation’s affairs; that is usually limited
strictly to the shareholders. Accordingly, the issue of bonds instead of additional stock
does not interfere with the management or control of the concern—so long as the
contract requirements of the bond issue are adhered to.
Because of the definiteness of the income on bonds and usually the greater security
of the principal, bonds may often find a market where stocks would not. On the other
hand, if the stock can be marketed as advantageously as the bonds, no definite dividend
rate is necessarily attached to them. The price at which stocks may be marketed, aside
from the features of extra inducement which might influence the market, depends
largely upon the prospective income rate judged mostly by what the company has been
able to do in the past and any features of present condition or expected future condition
which might influence the earning capacity of the corporation. Therefore, unless a
dividend rate a little higher than the current interest rate is in prospect, the company
usually finds it difficult to market its stock advantageously.
Bonds versus Stock Issues
The bond market furnishes opportunity for investment to quite a different class of
people from those interested in stocks. Security, conservatism, and a definite income are
the main elements desired. Thus conditions may oftentimes be such that one market or
another may be more favorable for absorbing an issue of securities, dependent on
conditions in that market as much as on the credit and standing of the issuing
corporation.
Aside from these points which are usually given consideration, is the question of
how heavy are the fixed charges the corporation can carry. While from the investor’s
viewpoint an income at a fixed rate is highly desirable, from the corporation’s point of
view it may impose so great a burden as to eat up all the profits. The bond interest
constitutes a fixed charge deductible before the determination of profits. In case of
failure to meet the bond interest, the mortgage covering the bonds is subject to
foreclosure. Upon foreclosure at forced sale values always shrink greatly, oftentimes the
shareholders lose their entire interest in the company, and all the net assets may be taken
Financial considerations involved in the determination to issue bonds may be
reviewed briefly. It is interesting to note that the bond has been used very extensively as
a means of securing capital. There is, however, no necessary relationship between the
amount of capital raised by stock issues and that raised by bond issues. The sale of
additional stock or of bonds or other similar securities is the main source of corporation
funds for capital purposes. Some concerns have obtained approximately one-half of
their capital through the issue of bonds. Percentages of capital so raised ranging from
15% to 40% are not uncommon.
The manner of raising capital is largely a matter of credit, expediency, and the
question of fixed operating expenses. It rarely happens that bonds carry with them the
privilege of voice in the management of the corporation’s affairs; that is usually limited
strictly to the shareholders. Accordingly, the issue of bonds instead of additional stock
does not interfere with the management or control of the concern—so long as the
contract requirements of the bond issue are adhered to.
Because of the definiteness of the income on bonds and usually the greater security
of the principal, bonds may often find a market where stocks would not. On the other
hand, if the stock can be marketed as advantageously as the bonds, no definite dividend
rate is necessarily attached to them. The price at which stocks may be marketed, aside
from the features of extra inducement which might influence the market, depends
largely upon the prospective income rate judged mostly by what the company has been
able to do in the past and any features of present condition or expected future condition
which might influence the earning capacity of the corporation. Therefore, unless a
dividend rate a little higher than the current interest rate is in prospect, the company
usually finds it difficult to market its stock advantageously.
Bonds versus Stock Issues
The bond market furnishes opportunity for investment to quite a different class of
people from those interested in stocks. Security, conservatism, and a definite income are
the main elements desired. Thus conditions may oftentimes be such that one market or
another may be more favorable for absorbing an issue of securities, dependent on
conditions in that market as much as on the credit and standing of the issuing
corporation.
Aside from these points which are usually given consideration, is the question of
how heavy are the fixed charges the corporation can carry. While from the investor’s
viewpoint an income at a fixed rate is highly desirable, from the corporation’s point of
view it may impose so great a burden as to eat up all the profits. The bond interest
constitutes a fixed charge deductible before the determination of profits. In case of
failure to meet the bond interest, the mortgage covering the bonds is subject to
foreclosure. Upon foreclosure at forced sale values always shrink greatly, oftentimes the
shareholders lose their entire interest in the company, and all the net assets may be taken
Page 311
to satisfy the claims of the bondholders. As compared with an additional issue of stock
—common or preference shares, as may best meet the situation—a bond issue may thus
be of doubtful value. One of the knotty problems upon a reorganization following
insolvency is that of lowering the fixed charges by converting some of the bond issues
into preferred stocks in order to prevent the recurrence of operation at a loss and so of
inability to meet bond interest.
Accounting for Bond Issue
Accounting for the bond issue presents much the same problems as those connected
with an issue of stock. Inasmuch as most corporation issues are sold in block to a banker
who in turn markets them to the investing public, often through a syndicate (or the
process may be one of under-writing), there is usually no need for detailed subscription
records and accounts. In the case of coupon bonds no record of individual ownership is
required because the bonds pass by delivery, possession evidencing ownership and the
interest coupon being payable to bearer. In the case of registered bonds, a record of
individual holdings must be kept similar to the record of stockholders. The party in
whose name the bond is registered on the company’s records is the prima facie owner to
whom the periodic interest check is also sent. If the bond is registered as to principal but
bears coupons for the interest, records of individual ownership are also required here.
Entry of Issue on Books
Placing the bond issue on the books is accomplished by either of two methods.
Assuming an issue of $500,000 of first mortgage 5% bonds of which $350,000 are sold
at par for cash, the balance remaining unissued for the present, the entries would be:
First Method
(1) Unissued First Mortgage Bonds $500,000.00
First Mortgage Bonds Payable $500,000.00
(2) Cash 350,000.00
Unissued First Mortgage Bonds 350,000.00
Entry (1) is used to make a memorandum entry of the authorized issue. Entry (2)
shows the amount sold for cash. The balance in the Unissued Bond account is treated as
an offset to the Bonds Payable account. Sometimes the title “Treasury Bonds” is used
instead of “Unissued,” but the term is apt to be misleading because of the restricted
meaning given the word in connection with treasury stock.
Second Method
(3) Cash $350,000.00
First Mortgage Bonds Payable $350,000.00
—common or preference shares, as may best meet the situation—a bond issue may thus
be of doubtful value. One of the knotty problems upon a reorganization following
insolvency is that of lowering the fixed charges by converting some of the bond issues
into preferred stocks in order to prevent the recurrence of operation at a loss and so of
inability to meet bond interest.
Accounting for Bond Issue
Accounting for the bond issue presents much the same problems as those connected
with an issue of stock. Inasmuch as most corporation issues are sold in block to a banker
who in turn markets them to the investing public, often through a syndicate (or the
process may be one of under-writing), there is usually no need for detailed subscription
records and accounts. In the case of coupon bonds no record of individual ownership is
required because the bonds pass by delivery, possession evidencing ownership and the
interest coupon being payable to bearer. In the case of registered bonds, a record of
individual holdings must be kept similar to the record of stockholders. The party in
whose name the bond is registered on the company’s records is the prima facie owner to
whom the periodic interest check is also sent. If the bond is registered as to principal but
bears coupons for the interest, records of individual ownership are also required here.
Entry of Issue on Books
Placing the bond issue on the books is accomplished by either of two methods.
Assuming an issue of $500,000 of first mortgage 5% bonds of which $350,000 are sold
at par for cash, the balance remaining unissued for the present, the entries would be:
First Method
(1) Unissued First Mortgage Bonds $500,000.00
First Mortgage Bonds Payable $500,000.00
(2) Cash 350,000.00
Unissued First Mortgage Bonds 350,000.00
Entry (1) is used to make a memorandum entry of the authorized issue. Entry (2)
shows the amount sold for cash. The balance in the Unissued Bond account is treated as
an offset to the Bonds Payable account. Sometimes the title “Treasury Bonds” is used
instead of “Unissued,” but the term is apt to be misleading because of the restricted
meaning given the word in connection with treasury stock.
Second Method
(3) Cash $350,000.00
First Mortgage Bonds Payable $350,000.00
Page 312
Under the second method, the desired information as to authorized issue would be
carried parenthetically in the account title. At the present time the tendency is to
deprecate an unnecessary multiplication of accounts as is brought about through the use
of memorandum accounts. The second method is therefore the preferred method and in
its operation brings onto the books the same information as the first method.
Entry of Premium or Discount on Books
Bringing the bond premium or discount onto the books is accomplished in the same
manner as for stock. Thus, using the above data and assuming $100,000 of the bonds
sold at 101 and the remaining $50,000 at 99¾, the entries would be, illustrating only the
second method:
(4) Cash $101,000.00
First Mortgage Bonds Payable $100,000.00
(5) Cash 99,750.00
Discount on First Mortgage Bonds Payable 250.00
First Mortgage Bonds Payable 100,000.00
Subsequent handling of the premium and discount accounts will be shown on page
368.
Bonds may be issued for cash or property, as in the case of stock. Unless there is
evidence to the contrary, when bonds are issued for property they are brought onto the
books at par value, the courts holding here as with stock that the parties to the
transaction (usually the corporation’s directors) are in a better position to judge the
value of the property taken over than anyone else. This oftentimes results in an inflation
of property values—an injection of water—and should not be countenanced where a
true basis for determining the value of the bond is offered. Thus, if almost
simultaneously with the issue of the bonds for property, some are sold for cash, the cash
price received would usually be a fair basis for booking the premium or discount on
those issued for property. The sale for cash must be a bona fide sale in the open market
if it is to represent the market’s judgment of the offering. Sometimes an objection is
raised to a Bond Discount account appearing on the books; hence the practice, wherever
possible, of charging the discount against some asset account as a part of the cost of that
asset. When the true nature of bond discount or premium in its relation to the periodic
interest charge is appreciated, the objection has no weight.
Entry of Interest Payments on Books
Booking the payment of the periodic interest is accomplished by a charge to Bond
Interest and a credit to Cash. This interest should never be entered in the regular Interest
and Discount account. If the bonds are coupon bonds with the coupons redeemable
through a designated trust company, a check for the full amount of the interest on the
carried parenthetically in the account title. At the present time the tendency is to
deprecate an unnecessary multiplication of accounts as is brought about through the use
of memorandum accounts. The second method is therefore the preferred method and in
its operation brings onto the books the same information as the first method.
Entry of Premium or Discount on Books
Bringing the bond premium or discount onto the books is accomplished in the same
manner as for stock. Thus, using the above data and assuming $100,000 of the bonds
sold at 101 and the remaining $50,000 at 99¾, the entries would be, illustrating only the
second method:
(4) Cash $101,000.00
First Mortgage Bonds Payable $100,000.00
(5) Cash 99,750.00
Discount on First Mortgage Bonds Payable 250.00
First Mortgage Bonds Payable 100,000.00
Subsequent handling of the premium and discount accounts will be shown on page
368.
Bonds may be issued for cash or property, as in the case of stock. Unless there is
evidence to the contrary, when bonds are issued for property they are brought onto the
books at par value, the courts holding here as with stock that the parties to the
transaction (usually the corporation’s directors) are in a better position to judge the
value of the property taken over than anyone else. This oftentimes results in an inflation
of property values—an injection of water—and should not be countenanced where a
true basis for determining the value of the bond is offered. Thus, if almost
simultaneously with the issue of the bonds for property, some are sold for cash, the cash
price received would usually be a fair basis for booking the premium or discount on
those issued for property. The sale for cash must be a bona fide sale in the open market
if it is to represent the market’s judgment of the offering. Sometimes an objection is
raised to a Bond Discount account appearing on the books; hence the practice, wherever
possible, of charging the discount against some asset account as a part of the cost of that
asset. When the true nature of bond discount or premium in its relation to the periodic
interest charge is appreciated, the objection has no weight.
Entry of Interest Payments on Books
Booking the payment of the periodic interest is accomplished by a charge to Bond
Interest and a credit to Cash. This interest should never be entered in the regular Interest
and Discount account. If the bonds are coupon bonds with the coupons redeemable
through a designated trust company, a check for the full amount of the interest on the
Page 313
outstanding bonds should be issued and booked as above. If the coupons are redeemable
at the company’s office, an entry debiting Bond Interest and crediting Coupons Payable
should be made, to record the interest charge and the liability therefor. As the coupons
are redeemed, Coupons Payable is charged and Cash credited, any balance remaining in
Coupons Payable account representing the liability existing because of coupons not yet
presented for redemption. In the case of bonds registered both as to principal and
interest, the interest checks made payable to the registered parties constitute a charge to
Bond Interest and a credit to Cash. It is sometimes advisable to transfer by one check
the total bond interest payable to a special bank account and issue the individual interest
checks against this fund. Whenever the books are closed it is always necessary, unless
the end of the fiscal period coincides with the bond interest date, to take account of the
accrued bond interest as on that date. The adjusting entry here is similar to that for any
accrued expense.
Relation of Bond Interest to Premium or Discount
The main problem in connection with accounting for bond interest is that of the
relation between bond premium or discount and the periodic bond interest. At
practically any time in the market there is a rate at which the bonds could be sold at par.
This rate is known as the effective rate. If a company puts an issue of bonds on the
market at a higher rate than this, the market will offer a premium for them. The amount
of the premium will be, theoretically, the present value of the periodic sum represented
by the difference between the stated bond interest and the effective interest, these
periodic payments extending over the life of the bond. In other words, the premium
represents the price paid to buy the additional interest, dollar for dollar, on a compound
interest basis. The premium is therefore not an earning, an item of income, but is an
offset to the excess bond interest. The portion of it applicable to each period represents
the excess interest which deducted from the bond interest shows the real or effective
cost of the money borrowed and to be paid back. Thus, the bond interest rate based on
the money actually received, i.e., par plus premium, is exactly the same as the market or
effective rate on par. In other words, the corporation is paying for its actual borrowings
simply the current market rate of interest.
It is therefore incorrect to show on the books the cost of the loan at any other figure
than the effective interest. The actual periodic payment of interest is, however, at the
bond interest rate. This must be brought down to the effective rate by application to it of
a portion of the premium which represents the sum paid for the privilege of receiving
the higher rate of interest. Similarly, bonds are marketed at a discount when the bond
interest rate is lower than the market rate prevailing on similar security at the time the
bonds are floated. This may be looked upon as a payment by the company in lump sum
to compensate a purchaser for the difference in the income on the bond and what he
might obtain on the open market. The discount should be applied, therefore, periodically
to bring the cost of the loan up to its true figure, viz., the market or effective rate. An
illustration will clarify the points of the above discussion.
at the company’s office, an entry debiting Bond Interest and crediting Coupons Payable
should be made, to record the interest charge and the liability therefor. As the coupons
are redeemed, Coupons Payable is charged and Cash credited, any balance remaining in
Coupons Payable account representing the liability existing because of coupons not yet
presented for redemption. In the case of bonds registered both as to principal and
interest, the interest checks made payable to the registered parties constitute a charge to
Bond Interest and a credit to Cash. It is sometimes advisable to transfer by one check
the total bond interest payable to a special bank account and issue the individual interest
checks against this fund. Whenever the books are closed it is always necessary, unless
the end of the fiscal period coincides with the bond interest date, to take account of the
accrued bond interest as on that date. The adjusting entry here is similar to that for any
accrued expense.
Relation of Bond Interest to Premium or Discount
The main problem in connection with accounting for bond interest is that of the
relation between bond premium or discount and the periodic bond interest. At
practically any time in the market there is a rate at which the bonds could be sold at par.
This rate is known as the effective rate. If a company puts an issue of bonds on the
market at a higher rate than this, the market will offer a premium for them. The amount
of the premium will be, theoretically, the present value of the periodic sum represented
by the difference between the stated bond interest and the effective interest, these
periodic payments extending over the life of the bond. In other words, the premium
represents the price paid to buy the additional interest, dollar for dollar, on a compound
interest basis. The premium is therefore not an earning, an item of income, but is an
offset to the excess bond interest. The portion of it applicable to each period represents
the excess interest which deducted from the bond interest shows the real or effective
cost of the money borrowed and to be paid back. Thus, the bond interest rate based on
the money actually received, i.e., par plus premium, is exactly the same as the market or
effective rate on par. In other words, the corporation is paying for its actual borrowings
simply the current market rate of interest.
It is therefore incorrect to show on the books the cost of the loan at any other figure
than the effective interest. The actual periodic payment of interest is, however, at the
bond interest rate. This must be brought down to the effective rate by application to it of
a portion of the premium which represents the sum paid for the privilege of receiving
the higher rate of interest. Similarly, bonds are marketed at a discount when the bond
interest rate is lower than the market rate prevailing on similar security at the time the
bonds are floated. This may be looked upon as a payment by the company in lump sum
to compensate a purchaser for the difference in the income on the bond and what he
might obtain on the open market. The discount should be applied, therefore, periodically
to bring the cost of the loan up to its true figure, viz., the market or effective rate. An
illustration will clarify the points of the above discussion.
Page 314
Example of True Interest Cost
Assume a 7% bond, interest every six months, payable in 25 years (50 periods), par
$1,000, sold in a market whose prevailing interest rate is 6%. By the method developed
on page 273, the value of such a bond is found to be $1,128.6488, the premium being
$128.6488. At the effective rate the real cost to the issuing company is 3% on
$1,128.6488, or $33.8595. The actual sum paid as interest is $35, i.e., 3½% on $1,000.
The difference between the effective and actual bond interest, or $1.1405, is the portion
of the premium to be used that period in order to reduce the amount of actual interest
paid to the real or effective cost of the loan. The bookkeeping entries are:
(6) Bond Interest $35.00
Cash $35.00
(7) Premium on Bonds 1.14
Bond Interest 1.14
Similar calculations and entries for each of the succeeding 49 periods would be
made, the application of the effective rate always being, of course, to the amortized
value of the bond as on that date. This process is called scientific amortization of the
premium (or discount) of the bond. Its effect is readily seen to be to spread over the life
of the bond the premium (or discount) and so not to take credit for it in a lump sum
during the period in which the bond is matured. There are four cases to which this
principle of showing the true interest cost is applicable, as follows:
1. A bond sold at a premium to be redeemed at par on maturity.
2. A bond sold at a discount to be redeemed at par on maturity.
3. A bond sold at a discount to be redeemed at a premium on maturity.
4. A bond sold at par to be redeemed at a premium on maturity.
At the close of a fiscal period which does not coincide with the bond interest period,
not only must the bond interest accrued to date be shown as an accrued expense, but
also there must be so shown the portion of the premium (or discount) accrued to that
date required to bring the bond interest cost down to the effective basis.
Presentation on Balance Sheet
The final problem in connection with bonds concerns the manner of their showing
on the balance sheet. That has perhaps been sufficiently indicated. The amount of the
authorized issue should be short-extended, and the amount unissued subtracted
therefrom with the net amount outstanding full-extended as the significant figure in the
balance sheet.
Other Fixed Liabilities
Assume a 7% bond, interest every six months, payable in 25 years (50 periods), par
$1,000, sold in a market whose prevailing interest rate is 6%. By the method developed
on page 273, the value of such a bond is found to be $1,128.6488, the premium being
$128.6488. At the effective rate the real cost to the issuing company is 3% on
$1,128.6488, or $33.8595. The actual sum paid as interest is $35, i.e., 3½% on $1,000.
The difference between the effective and actual bond interest, or $1.1405, is the portion
of the premium to be used that period in order to reduce the amount of actual interest
paid to the real or effective cost of the loan. The bookkeeping entries are:
(6) Bond Interest $35.00
Cash $35.00
(7) Premium on Bonds 1.14
Bond Interest 1.14
Similar calculations and entries for each of the succeeding 49 periods would be
made, the application of the effective rate always being, of course, to the amortized
value of the bond as on that date. This process is called scientific amortization of the
premium (or discount) of the bond. Its effect is readily seen to be to spread over the life
of the bond the premium (or discount) and so not to take credit for it in a lump sum
during the period in which the bond is matured. There are four cases to which this
principle of showing the true interest cost is applicable, as follows:
1. A bond sold at a premium to be redeemed at par on maturity.
2. A bond sold at a discount to be redeemed at par on maturity.
3. A bond sold at a discount to be redeemed at a premium on maturity.
4. A bond sold at par to be redeemed at a premium on maturity.
At the close of a fiscal period which does not coincide with the bond interest period,
not only must the bond interest accrued to date be shown as an accrued expense, but
also there must be so shown the portion of the premium (or discount) accrued to that
date required to bring the bond interest cost down to the effective basis.
Presentation on Balance Sheet
The final problem in connection with bonds concerns the manner of their showing
on the balance sheet. That has perhaps been sufficiently indicated. The amount of the
authorized issue should be short-extended, and the amount unissued subtracted
therefrom with the net amount outstanding full-extended as the significant figure in the
balance sheet.
Other Fixed Liabilities
Page 315
Real Estate Mortgages. Another item among the fixed liabilities is the simple real
estate mortgage. This is usually called a bond and mortgage, the bond being simply the
promise to pay and the mortgage being the security for the amount of money borrowed.
In some states the more formal document called the bond is used as a contract according
to which a named sum is to be paid in case the amount borrowed on the mortgage is not
paid. This named sum is usually the amount borrowed, although in some states it is
twice this amount. In booking a note or bond supported by a mortgage, the customary
title is “Mortgage Payable” rather than “Notes Payable” which is generally understood
to be applicable in the main to current liabilities. In case the double amount is named in
the bond, it is not customary to take cognizance of the contingent liability thereunder.
Loans on Collateral. Short-time loans are frequently made on collateral security.
Stocks and bonds, particularly of the borrowing company or its subsidiaries, may also
be made the basis of a long-time loan. This may take the form of a bond issue,
promissory notes, or other similar obligations. Accounting for the loan and its showing
on the balance sheet follow the principles already laid down. The title of the loan
account should carry the word “Collateral” or other similar term to show its nature.
Accounting for the collateral is usually accomplished by a memorandum in the stocks,
bonds, or investments account to show exactly what securities have been withdrawn for
deposit as collateral. No further record is needed other than a complete list of such
securities; the securities are still owned by the company, though deposited under a
conditional contract with someone else. If the loan is dishonored at maturity and the
securities are sold in satisfaction thereof, the necessary entries must be made to show
the sale of the securities, the profit or loss attendant thereupon, and the repayment of the
loan. In showing the pledged securities on the balance sheet, it is well to present the
securities in two groups or classes, viz., those pledged as collateral for the loan shown
contra and those not so pledged.
Short-Term Securities. When the market is not favorable to the issue of long-term
securities, because of the high rate of return demanded by investors, corporations often
have recourse in their borrowings to short-term securities—usually note issues with
maturities ranging from one to five years, two- and three-year terms being the
commonest. The financial consideration in their issue is merely a speculation that by the
time of their maturity the market will be more favorable for the flotation of long-term
securities. Thus the company hopes at the maturity of the notes to free itself from the
need of paying so high an interest rate as it is required to pay now for the short-term
securities. These notes may be in different denominations and are accounted for just as
other notes. On the balance sheet they are grouped with the fixed liabilities until within
a short time of maturity, when they must be shown with the other current items.
estate mortgage. This is usually called a bond and mortgage, the bond being simply the
promise to pay and the mortgage being the security for the amount of money borrowed.
In some states the more formal document called the bond is used as a contract according
to which a named sum is to be paid in case the amount borrowed on the mortgage is not
paid. This named sum is usually the amount borrowed, although in some states it is
twice this amount. In booking a note or bond supported by a mortgage, the customary
title is “Mortgage Payable” rather than “Notes Payable” which is generally understood
to be applicable in the main to current liabilities. In case the double amount is named in
the bond, it is not customary to take cognizance of the contingent liability thereunder.
Loans on Collateral. Short-time loans are frequently made on collateral security.
Stocks and bonds, particularly of the borrowing company or its subsidiaries, may also
be made the basis of a long-time loan. This may take the form of a bond issue,
promissory notes, or other similar obligations. Accounting for the loan and its showing
on the balance sheet follow the principles already laid down. The title of the loan
account should carry the word “Collateral” or other similar term to show its nature.
Accounting for the collateral is usually accomplished by a memorandum in the stocks,
bonds, or investments account to show exactly what securities have been withdrawn for
deposit as collateral. No further record is needed other than a complete list of such
securities; the securities are still owned by the company, though deposited under a
conditional contract with someone else. If the loan is dishonored at maturity and the
securities are sold in satisfaction thereof, the necessary entries must be made to show
the sale of the securities, the profit or loss attendant thereupon, and the repayment of the
loan. In showing the pledged securities on the balance sheet, it is well to present the
securities in two groups or classes, viz., those pledged as collateral for the loan shown
contra and those not so pledged.
Short-Term Securities. When the market is not favorable to the issue of long-term
securities, because of the high rate of return demanded by investors, corporations often
have recourse in their borrowings to short-term securities—usually note issues with
maturities ranging from one to five years, two- and three-year terms being the
commonest. The financial consideration in their issue is merely a speculation that by the
time of their maturity the market will be more favorable for the flotation of long-term
securities. Thus the company hopes at the maturity of the notes to free itself from the
need of paying so high an interest rate as it is required to pay now for the short-term
securities. These notes may be in different denominations and are accounted for just as
other notes. On the balance sheet they are grouped with the fixed liabilities until within
a short time of maturity, when they must be shown with the other current items.
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CHAPTER XXI
CAPITAL STOCK AND ITS VALUATION
Problems in Valuation
The problems in connection with the valuation of the assets and the
liabilities and the manner of showing them on the balance sheet—and in
some cases the manner of booking them—have been treated in some detail
in the preceding chapters. It might seem that, inasmuch as proprietorship or
net worth is determined always by the excess of assets over liabilities, no
question would arise concerning the valuation of net worth, its value being
automatically determined by whatever values are placed on assets and
liabilities. That its value is so determined, that every change in net worth
must be reflected in the assets and liabilities, does not admit of argument.
There are, however, certain phases of the question of valuation and certain
problems connected with it, that, because of their close connection with net
worth or their direct effect upon it, are best treated under this head rather
than under the head of each particular asset that may be affected. Thus, if
treated among the assets, the valuation of properties purchased with stock
would require, under the head of each asset which might be so acquired, an
almost identical statement of principle. For this reason, some problems in
valuation have been reserved for treatment here in connection with capital
stock.
In addition, there are related problems which concern the surplus and
reserves. It is true, these all have their origin in the general considerations
of valuation as given for the assets and liabilities. But questions as to what
constitutes a profit, whether all profits are applicable to dividends, the
proper treatment of capital profits, the relation of capital losses to profits
and dividends, the differentiation of the classes of reserves, and finally the
manner of showing and explaining the periodic changes in net worth by
means of the supplementary statement of profit and loss—all these and
other similar questions are closely related to the problem of valuation and,
as indicative of the financial policy of a business, may directly affect all
going concern values. On this account they require separate treatment from
CAPITAL STOCK AND ITS VALUATION
Problems in Valuation
The problems in connection with the valuation of the assets and the
liabilities and the manner of showing them on the balance sheet—and in
some cases the manner of booking them—have been treated in some detail
in the preceding chapters. It might seem that, inasmuch as proprietorship or
net worth is determined always by the excess of assets over liabilities, no
question would arise concerning the valuation of net worth, its value being
automatically determined by whatever values are placed on assets and
liabilities. That its value is so determined, that every change in net worth
must be reflected in the assets and liabilities, does not admit of argument.
There are, however, certain phases of the question of valuation and certain
problems connected with it, that, because of their close connection with net
worth or their direct effect upon it, are best treated under this head rather
than under the head of each particular asset that may be affected. Thus, if
treated among the assets, the valuation of properties purchased with stock
would require, under the head of each asset which might be so acquired, an
almost identical statement of principle. For this reason, some problems in
valuation have been reserved for treatment here in connection with capital
stock.
In addition, there are related problems which concern the surplus and
reserves. It is true, these all have their origin in the general considerations
of valuation as given for the assets and liabilities. But questions as to what
constitutes a profit, whether all profits are applicable to dividends, the
proper treatment of capital profits, the relation of capital losses to profits
and dividends, the differentiation of the classes of reserves, and finally the
manner of showing and explaining the periodic changes in net worth by
means of the supplementary statement of profit and loss—all these and
other similar questions are closely related to the problem of valuation and,
as indicative of the financial policy of a business, may directly affect all
going concern values. On this account they require separate treatment from
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that of any individual assets and liabilities or group of assets and liabilities.
Accordingly, the next few chapters will be concerned with these problems
and any others which are relevant thereto.
Kinds of Stock
Capital stock is of various kinds—that with a stated par value and that
without, common stock, various kinds of preference shares, debenture
stock, guaranteed stock, founders’ stock, convertible stock, and redeemable
stock. The student is referred to Chapter I where these various kinds of
stock are discussed.
Par, Real, and Market Values
Capital stock may have several kinds of value, as the term value is used.
All stock is expressed as so much per share. The value mentioned as the
stated value of a share of stock in the contract of issue is known as the par,
face, or nominal value.
The book value of stock is the value of the stock, as shown by the books
—not the amount carried in the stock accounts, but the entire net worth of
the corporation divided by the number of shares outstanding. Thus, if the
assets minus the liabilities—the net assets—of a corporation amount to
$1,500,000, of which $1,000,000 represents 10,000 shares of stock of par
value $100, and the $500,000 is surplus, the book value of the stock is said
to be $150 per share. From the standpoint of a going concern, this value is
also spoken of as the real value in the sense that it is represented, dollar for
dollar, by actual assets held by the corporation. Real value is also used to
mean liquidation value, the value which the net assets upon forced or
voluntary sale would realize for distribution to each shareholder.
Finally, there is the market value of stock by which is meant the value
placed on it in the stock market or wherever stocks are dealt in. This value
depends primarily upon the dividend-earning capacity of the stock,
although many side issues of fact and opinion affect it. Thus, not only
present, but past as well as prospective future dividends influence the
market. At times, particularly in a declining market, the financial needs of
the holders of the stock may affect prices more than the dividend rate of the
stock.
Accordingly, the next few chapters will be concerned with these problems
and any others which are relevant thereto.
Kinds of Stock
Capital stock is of various kinds—that with a stated par value and that
without, common stock, various kinds of preference shares, debenture
stock, guaranteed stock, founders’ stock, convertible stock, and redeemable
stock. The student is referred to Chapter I where these various kinds of
stock are discussed.
Par, Real, and Market Values
Capital stock may have several kinds of value, as the term value is used.
All stock is expressed as so much per share. The value mentioned as the
stated value of a share of stock in the contract of issue is known as the par,
face, or nominal value.
The book value of stock is the value of the stock, as shown by the books
—not the amount carried in the stock accounts, but the entire net worth of
the corporation divided by the number of shares outstanding. Thus, if the
assets minus the liabilities—the net assets—of a corporation amount to
$1,500,000, of which $1,000,000 represents 10,000 shares of stock of par
value $100, and the $500,000 is surplus, the book value of the stock is said
to be $150 per share. From the standpoint of a going concern, this value is
also spoken of as the real value in the sense that it is represented, dollar for
dollar, by actual assets held by the corporation. Real value is also used to
mean liquidation value, the value which the net assets upon forced or
voluntary sale would realize for distribution to each shareholder.
Finally, there is the market value of stock by which is meant the value
placed on it in the stock market or wherever stocks are dealt in. This value
depends primarily upon the dividend-earning capacity of the stock,
although many side issues of fact and opinion affect it. Thus, not only
present, but past as well as prospective future dividends influence the
market. At times, particularly in a declining market, the financial needs of
the holders of the stock may affect prices more than the dividend rate of the
stock.
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The problem of stock valuation as related to the commercial balance
sheet takes cognizance of only one of these values, viz., par value, though
each of the others is related to and measured by the showing of values on
the balance sheet. That par value is not always the true value cannot be
controverted. As already shown, the inclusion on the balance sheet of assets
of doubtful value is allowed when the doubtfulness of their value is
generally recognized and no one is thereby misled. Some problems in
connection with stock values and their inflation on the books will now be
discussed.
Value Dependent upon Earning Capacity
Upon the inception of an enterprise the problem of stock valuation is
always bound up with the question of valuation of the assets and liabilities,
as pointed out above. When the asset to be valued is only cash, the problem
is not usually difficult, as where the capital stock is sold for cash. Where,
however, the sale is for a property taken over, the valuation of the stock is
related to the larger problems of capitalization, with which in turn the
valuation of the assets is bound up. It seems best, therefore, for an
intelligent understanding of the question to review briefly some of the bases
of capitalization.
As indicated above, the market value of any stock is dependent in the
long run more on the factor of its earning capacity than anything else. If
investment in a stock nets the prevailing income rate on money, that stock
will approximate its par value. So when determining the capitalization of a
company which expects to be taken over as a going concern, the main
consideration is not so much its true valuation as it is its earning capacity
and its ability to pay dividends. Thus, if on a cost basis the net values taken
over amount to $250,000, but past performance and future expectation
reasonably indicate a capacity to earn a normal dividend on $1,000,000, it is
very probable that the new company will capitalize at $1,000,000. If this
sum is actually and in good faith paid, little or no exception can be taken to
recording the value of the plant taken over at $1,000,000. The transaction is
the result of a bargain. The additional value over cost may, in the estimate
of the purchaser, represent the true value of the good-will or other
intangible assets acquired but not included in the $250,000 referred to
above. In a bargain transaction such as the foregoing, judgment of value is
sheet takes cognizance of only one of these values, viz., par value, though
each of the others is related to and measured by the showing of values on
the balance sheet. That par value is not always the true value cannot be
controverted. As already shown, the inclusion on the balance sheet of assets
of doubtful value is allowed when the doubtfulness of their value is
generally recognized and no one is thereby misled. Some problems in
connection with stock values and their inflation on the books will now be
discussed.
Value Dependent upon Earning Capacity
Upon the inception of an enterprise the problem of stock valuation is
always bound up with the question of valuation of the assets and liabilities,
as pointed out above. When the asset to be valued is only cash, the problem
is not usually difficult, as where the capital stock is sold for cash. Where,
however, the sale is for a property taken over, the valuation of the stock is
related to the larger problems of capitalization, with which in turn the
valuation of the assets is bound up. It seems best, therefore, for an
intelligent understanding of the question to review briefly some of the bases
of capitalization.
As indicated above, the market value of any stock is dependent in the
long run more on the factor of its earning capacity than anything else. If
investment in a stock nets the prevailing income rate on money, that stock
will approximate its par value. So when determining the capitalization of a
company which expects to be taken over as a going concern, the main
consideration is not so much its true valuation as it is its earning capacity
and its ability to pay dividends. Thus, if on a cost basis the net values taken
over amount to $250,000, but past performance and future expectation
reasonably indicate a capacity to earn a normal dividend on $1,000,000, it is
very probable that the new company will capitalize at $1,000,000. If this
sum is actually and in good faith paid, little or no exception can be taken to
recording the value of the plant taken over at $1,000,000. The transaction is
the result of a bargain. The additional value over cost may, in the estimate
of the purchaser, represent the true value of the good-will or other
intangible assets acquired but not included in the $250,000 referred to
above. In a bargain transaction such as the foregoing, judgment of value is
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sometimes wrong; but the buyer can only show the property bought at what
it cost him at the date of the purchase—whether the payment is in cash,
stock of a stated par value, or other assets.
Increase of Book Capitalization
If, however, the transaction is merely a reorganization of the old
company by its owners solely for the purpose of increasing its book
capitalization by bringing onto the books an existent good-will or by other
means of inflation of assets, the result is a so-called watering of the stock.
The propriety or impropriety of this is chiefly a question of business ethics,
and its discussion is beyond the limits and the purpose of this volume. It
may be said here, in passing, that under certain conditions the practice may
be entirely proper and no inequities may result. On the other hand, the
purpose of such a reorganization may be fraudulent, in which case it
frequently works hardship and injustice. The main accounting problem
involved when the book capitalization of a concern is increased is the
method of recording the transaction, so that the true status of affairs will
appear unmistakably and any attempted fraud will be shown.
Capitalization on Cost
Opposed to the basis of capitalization on earning power is that of
capitalization on cost. In a case of capitalization it is very difficult to know
exactly what is meant by cost, as there are so many kinds of cost. There is
original cost; original cost less depreciation; present cost new of an
identical property, i.e., reproduction new cost; reproduction cost less
depreciation, etc. In this discussion original cost is taken as the basis, less
depreciation, or such cost plus a bona fide payment for good-will or for the
privilege of securing an established business. All these other factors may
and frequently do enter into the determination of a bargain and sale price
and therefore affect capitalization.
The regulation of the Public Service Commission of the First District,
State of New York, concerning the manner of keeping the capital stock
accounts of public service corporations, is as follows: “To the account for
any class of stocks shall be credited when issued the par value of the
amount of stock of that class issued. If such issue is for money, that fact
shall be stated; and if for any other consideration than money, the person to
it cost him at the date of the purchase—whether the payment is in cash,
stock of a stated par value, or other assets.
Increase of Book Capitalization
If, however, the transaction is merely a reorganization of the old
company by its owners solely for the purpose of increasing its book
capitalization by bringing onto the books an existent good-will or by other
means of inflation of assets, the result is a so-called watering of the stock.
The propriety or impropriety of this is chiefly a question of business ethics,
and its discussion is beyond the limits and the purpose of this volume. It
may be said here, in passing, that under certain conditions the practice may
be entirely proper and no inequities may result. On the other hand, the
purpose of such a reorganization may be fraudulent, in which case it
frequently works hardship and injustice. The main accounting problem
involved when the book capitalization of a concern is increased is the
method of recording the transaction, so that the true status of affairs will
appear unmistakably and any attempted fraud will be shown.
Capitalization on Cost
Opposed to the basis of capitalization on earning power is that of
capitalization on cost. In a case of capitalization it is very difficult to know
exactly what is meant by cost, as there are so many kinds of cost. There is
original cost; original cost less depreciation; present cost new of an
identical property, i.e., reproduction new cost; reproduction cost less
depreciation, etc. In this discussion original cost is taken as the basis, less
depreciation, or such cost plus a bona fide payment for good-will or for the
privilege of securing an established business. All these other factors may
and frequently do enter into the determination of a bargain and sale price
and therefore affect capitalization.
The regulation of the Public Service Commission of the First District,
State of New York, concerning the manner of keeping the capital stock
accounts of public service corporations, is as follows: “To the account for
any class of stocks shall be credited when issued the par value of the
amount of stock of that class issued. If such issue is for money, that fact
shall be stated; and if for any other consideration than money, the person to
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whom issued shall be designated and the consideration for which issued
shall be described with sufficient particularity to identify it; if such issue is
to the treasurer, or other agent of the corporation, to be by him disposed of
for the benefit of the corporation, that fact and the name of such agent shall
be shown; and such agent shall in his account of the disposition thereof
show the like details concerning the consideration realized thereon, which
account when accepted by the corporation shall be preserved as a corporate
record. If the fair cash value of the consideration realized upon the issue of
any amount of stock is greater than the par value of such stock, the excess
shall be credited to the account ‘Premiums on Stocks’ and the
corresponding reference thereto shall be contained in the entry relating to
such stock in the stock account.”
The Law and Stock Issues
Thus, it is seen that the state takes cognizance of financial arrangements
and methods of accounting in some of those particulars wherein the state is
vitally interested. These regulatory provisions are usually found in the
corporation laws of the state or amendments thereto. At the present time
there are at least three types of such laws:
Under one type it is provided that, when property is taken by the
corporation in payment of its shares, the incorporators alone are the judges
of the values of such property and that the state’s only duty is to prevent
fraud. Fraud must be shown by the injured party and usually the facts by
which this might be established are hidden in records to which a
stockholder has no access. The remedy is against the directors personally.
This type of corporation law is found in most of the states.
Under the second type active control of the issue of stock is undertaken
by the state. This requires an independent appraisal and valuation by the
state’s experts. This type of law is found frequently governing the
incorporation of public utility companies. It is based on a paternalistic
theory of state functions not yet recognized as applicable to private
undertakings.
Under the third type, we find the law authorizing the capitalization of
any and all kinds of property—in the absence of fraud, of course—provided
that a full statement is put on record showing the amount of stock and the
exact manner in which it is paid for. The amount of cash received must be
shall be described with sufficient particularity to identify it; if such issue is
to the treasurer, or other agent of the corporation, to be by him disposed of
for the benefit of the corporation, that fact and the name of such agent shall
be shown; and such agent shall in his account of the disposition thereof
show the like details concerning the consideration realized thereon, which
account when accepted by the corporation shall be preserved as a corporate
record. If the fair cash value of the consideration realized upon the issue of
any amount of stock is greater than the par value of such stock, the excess
shall be credited to the account ‘Premiums on Stocks’ and the
corresponding reference thereto shall be contained in the entry relating to
such stock in the stock account.”
The Law and Stock Issues
Thus, it is seen that the state takes cognizance of financial arrangements
and methods of accounting in some of those particulars wherein the state is
vitally interested. These regulatory provisions are usually found in the
corporation laws of the state or amendments thereto. At the present time
there are at least three types of such laws:
Under one type it is provided that, when property is taken by the
corporation in payment of its shares, the incorporators alone are the judges
of the values of such property and that the state’s only duty is to prevent
fraud. Fraud must be shown by the injured party and usually the facts by
which this might be established are hidden in records to which a
stockholder has no access. The remedy is against the directors personally.
This type of corporation law is found in most of the states.
Under the second type active control of the issue of stock is undertaken
by the state. This requires an independent appraisal and valuation by the
state’s experts. This type of law is found frequently governing the
incorporation of public utility companies. It is based on a paternalistic
theory of state functions not yet recognized as applicable to private
undertakings.
Under the third type, we find the law authorizing the capitalization of
any and all kinds of property—in the absence of fraud, of course—provided
that a full statement is put on record showing the amount of stock and the
exact manner in which it is paid for. The amount of cash received must be
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shown; the property acquired so labeled as to render identification possible;
and any payments for services or other expenses must be shown. The
attitude taken is that a prospective investor, provided with these facts about
the company, can make his own judgment as to stock values.
Thus, we find that practice is not uniform in these regards. From the
viewpoint of theory, any accounting treatment of the issue of stock which
shows the full facts with regard thereto may be considered as meeting all
reasonable requirements.
Treatment of Discount or Premium
Valuing capital stock when issued for cash presents no problem in itself,
but the treatment of the discount or premium incident thereto requires
consideration. In most of the states and in Great Britain stock cannot be
issued below par. The manner of nullifying this provision has already been
referred to in Chapter I. There it was shown how the issue of fully paid
stock is made for property and how treasury stock is created by donation,
which may then be disposed of for any price obtainable, without any
additional liability attaching to it. In most of the states and in Great Britain,
however, a sales commission is allowed which has, in some instances, been
used as a cloak for sales at a discount. The booking of the discount or
premium presents no difficulties, but the manner of handling it on the
balance sheet is not uniform. Premium or discount on stock should be
recorded as such on the books, under titles of definite meaning.
One occasionally hears the argument that the discount on stock is a
necessary expense incident to financing the company, a sort of “cost of
getting started,” an expense without which the enterprise could not be
launched; accordingly the discount should be properly capitalized as a part
of the property costs. The argument is plausible but not convincing. The
information as to the discount on stock is very necessary to the prospective
creditor or investor and should always appear as a separate item on the
books. To the same effect is the ruling of the Interstate Commerce
Commission that premiums on capital stock must be carried on the book
permanently unless offset by discounts later allowed. Discounts may be
extinguished by premiums, assessments, surplus, or by the retirement of an
equivalent amount of stock.
and any payments for services or other expenses must be shown. The
attitude taken is that a prospective investor, provided with these facts about
the company, can make his own judgment as to stock values.
Thus, we find that practice is not uniform in these regards. From the
viewpoint of theory, any accounting treatment of the issue of stock which
shows the full facts with regard thereto may be considered as meeting all
reasonable requirements.
Treatment of Discount or Premium
Valuing capital stock when issued for cash presents no problem in itself,
but the treatment of the discount or premium incident thereto requires
consideration. In most of the states and in Great Britain stock cannot be
issued below par. The manner of nullifying this provision has already been
referred to in Chapter I. There it was shown how the issue of fully paid
stock is made for property and how treasury stock is created by donation,
which may then be disposed of for any price obtainable, without any
additional liability attaching to it. In most of the states and in Great Britain,
however, a sales commission is allowed which has, in some instances, been
used as a cloak for sales at a discount. The booking of the discount or
premium presents no difficulties, but the manner of handling it on the
balance sheet is not uniform. Premium or discount on stock should be
recorded as such on the books, under titles of definite meaning.
One occasionally hears the argument that the discount on stock is a
necessary expense incident to financing the company, a sort of “cost of
getting started,” an expense without which the enterprise could not be
launched; accordingly the discount should be properly capitalized as a part
of the property costs. The argument is plausible but not convincing. The
information as to the discount on stock is very necessary to the prospective
creditor or investor and should always appear as a separate item on the
books. To the same effect is the ruling of the Interstate Commerce
Commission that premiums on capital stock must be carried on the book
permanently unless offset by discounts later allowed. Discounts may be
extinguished by premiums, assessments, surplus, or by the retirement of an
equivalent amount of stock.
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A premium on stock may be looked upon as similar to a capital surplus.
It represents a fund of capital originating upon the inception of an
enterprise, and is in no sense an increase of capital, i.e., of net worth, due to
operation. So far as the law is concerned, there is nothing to prevent the
return of this surplus to the shareholders in the form of a dividend. To treat
it as available for ordinary dividends, however, would seem not to be in
keeping with the manner of its origin. Rather should it be set aside as a
permanent surplus. One requirement in the case of national banks is the
creation of a permanent surplus equal to 20% of the capital, and so,
frequently the original subscribers agree to take their stock at a 20%
premium, this premium providing the legal surplus required. In the case of
discounts no accounting principles are violated if they are allowed to
remain on the books. If there is a surplus from premiums, that should be
used to wipe off any discounts. In the absence of premium or other capital
surplus, conservatism usually sanctions the use of operating surplus for this
purpose, thus bringing the value of the net properties owned at least into
equivalence with the par value of the stock.
Valuation of Stock Issued for Property
The difficulty of valuing stock when issued for property has already
been stated and the attitude of the laws towards any valuation placed on the
properties taken over has been shown. Nothing further here need be said
except to state that where also a bona fide sale of a portion of the stock
takes place for cash at the same time, a fairly reliable basis for valuing the
stock given for the property is offered. It is not the usual practice to show
the probable discount on the stock, although such treatment would be
logical and consistent with the facts. A similar valuation of the stock might
be secured by an independent appraisal of the properties taken over, but
this, if done, is not often made the basis for entry on the books. If all the
facts are fully recorded, that probably is as much as can be hoped for under
the conditions now prevailing. Undoubtedly the use of no par value stock
for incorporations of this kind offers the best solution of the problem. With
regard to booking the properties acquired by a stock issue, attention is here
called to the method of valuation of the individual units by an appraisal
committee usually appointed from among the directors and the use of their
findings as the basis for the book entries of the transaction.
It represents a fund of capital originating upon the inception of an
enterprise, and is in no sense an increase of capital, i.e., of net worth, due to
operation. So far as the law is concerned, there is nothing to prevent the
return of this surplus to the shareholders in the form of a dividend. To treat
it as available for ordinary dividends, however, would seem not to be in
keeping with the manner of its origin. Rather should it be set aside as a
permanent surplus. One requirement in the case of national banks is the
creation of a permanent surplus equal to 20% of the capital, and so,
frequently the original subscribers agree to take their stock at a 20%
premium, this premium providing the legal surplus required. In the case of
discounts no accounting principles are violated if they are allowed to
remain on the books. If there is a surplus from premiums, that should be
used to wipe off any discounts. In the absence of premium or other capital
surplus, conservatism usually sanctions the use of operating surplus for this
purpose, thus bringing the value of the net properties owned at least into
equivalence with the par value of the stock.
Valuation of Stock Issued for Property
The difficulty of valuing stock when issued for property has already
been stated and the attitude of the laws towards any valuation placed on the
properties taken over has been shown. Nothing further here need be said
except to state that where also a bona fide sale of a portion of the stock
takes place for cash at the same time, a fairly reliable basis for valuing the
stock given for the property is offered. It is not the usual practice to show
the probable discount on the stock, although such treatment would be
logical and consistent with the facts. A similar valuation of the stock might
be secured by an independent appraisal of the properties taken over, but
this, if done, is not often made the basis for entry on the books. If all the
facts are fully recorded, that probably is as much as can be hoped for under
the conditions now prevailing. Undoubtedly the use of no par value stock
for incorporations of this kind offers the best solution of the problem. With
regard to booking the properties acquired by a stock issue, attention is here
called to the method of valuation of the individual units by an appraisal
committee usually appointed from among the directors and the use of their
findings as the basis for the book entries of the transaction.
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Valuation of Treasury Stock
In connection with the purchase of properties by stock, there often
arises the need of working capital. This is frequently furnished by the pro
rata donation or return of some of the stock to the corporation, the sale of
which furnishes the necessary working funds. As illustrated in an earlier
chapter this donation is booked at the par value of the stock, the charge
being to Treasury Stock and the credit to Donated Surplus, Donated
Working Capital, or other similar account. Being true treasury stock, it can
be sold at any price without liability. It is usually disposed of at a discount
which must be recorded on the books either as a charge to Discount on
Treasury Stock account which will later be closed against Donated Surplus
or as a charge direct to Donated Surplus. Thus when the treasury stock is all
disposed of, the net credit balance in Donated Surplus shows the real
amount of working capital obtained through the donation. If not entirely
sold, the portion sold gives a fair basis for the valuation of the unsold
portion, although this value is seldom brought onto the books, it being used
as a guide to financing rather than as an item to be regarded in accounting
valuation.
Redemption and Reduction of Capital Stock
The redemption and reduction of capital stock presents a problem of
surplus adjustment requiring careful treatment. If a corporation has
accumulated no surplus of any sort and redemption of the stock is at par, no
difficulty is met in making the entry. If, however, a surplus has been
accumulated and redemption is either above or below par, care must be
exercised to record the transaction properly. Redemption at a stated price is
sometimes one feature of a preferred stock issue. Again the stock may be
bought in the open market for the purpose of cancellation. Reduction of
capital, except when made a condition of the original issue, cannot usually
be accomplished without the consent of at least a majority of the
shareholders and authorization from the state. For the sake of simplicity,
assume just one class of stock and a surplus in which each share has an
equal interest. If redemption is at par, the surplus is evidently not affected
but each share of stock remaining outstanding has a larger share in the
surplus and so acquires a higher book value.
In connection with the purchase of properties by stock, there often
arises the need of working capital. This is frequently furnished by the pro
rata donation or return of some of the stock to the corporation, the sale of
which furnishes the necessary working funds. As illustrated in an earlier
chapter this donation is booked at the par value of the stock, the charge
being to Treasury Stock and the credit to Donated Surplus, Donated
Working Capital, or other similar account. Being true treasury stock, it can
be sold at any price without liability. It is usually disposed of at a discount
which must be recorded on the books either as a charge to Discount on
Treasury Stock account which will later be closed against Donated Surplus
or as a charge direct to Donated Surplus. Thus when the treasury stock is all
disposed of, the net credit balance in Donated Surplus shows the real
amount of working capital obtained through the donation. If not entirely
sold, the portion sold gives a fair basis for the valuation of the unsold
portion, although this value is seldom brought onto the books, it being used
as a guide to financing rather than as an item to be regarded in accounting
valuation.
Redemption and Reduction of Capital Stock
The redemption and reduction of capital stock presents a problem of
surplus adjustment requiring careful treatment. If a corporation has
accumulated no surplus of any sort and redemption of the stock is at par, no
difficulty is met in making the entry. If, however, a surplus has been
accumulated and redemption is either above or below par, care must be
exercised to record the transaction properly. Redemption at a stated price is
sometimes one feature of a preferred stock issue. Again the stock may be
bought in the open market for the purpose of cancellation. Reduction of
capital, except when made a condition of the original issue, cannot usually
be accomplished without the consent of at least a majority of the
shareholders and authorization from the state. For the sake of simplicity,
assume just one class of stock and a surplus in which each share has an
equal interest. If redemption is at par, the surplus is evidently not affected
but each share of stock remaining outstanding has a larger share in the
surplus and so acquires a higher book value.
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Redemption of a stock at its book value is accomplished by charging
capital stock for its par value and surplus for its pro rata share in the
surplus, the offsetting credit to both these being to cash. The value of the
remaining shares of stock has not been affected in the least. If redemption is
at any other figure than book value, not only is surplus affected, being
increased if the redemption price is below par and decreased if above par,
but also the value of the remaining shares. In the case of different classes of
stocks, a careful determination of their respectively equitable shares in
surplus would have to be made before the effect on the remaining shares
could be calculated.
In passing from the question of stock values, it should be pointed out
that an undervaluation of stock when issued for property, though seldom
seen in practice, has the refreshing effect of creating a secret reserve. That
is, property values are carried on the books below their actual values and a
secret reserve is thereby created. A further discussion of secret reserves will
follow in a later chapter.
Dividend Stock
Stock is sometimes issued for dividend purposes. In such cases, it is
always issued as of par value. If profits have been earned or a surplus
accumulated out of which a dividend may be declared, that dividend may be
paid in any way the corporation sees fit. Payment may be made in cash,
scrip, or in the shares of the company. If the corporation has neither
unissued stock nor stock in the treasury, permission to increase its
capitalization must be secured before a stock dividend can be paid. Some
corporations, notably financial institutions, often make it a matter of policy
to accumulate a large surplus and then distribute it by means of a stock
dividend. Declaration of the dividend is made and recorded as usual.
Record of the payment in stock is made as a debit to Dividends account and
a credit to Capital Stock.
The effect of a stock dividend is twofold. From the point of view of the
management of the surplus it has the effect of a permanent investment of
the surplus in the business. Thus it places the accumulated profits beyond
the control of any future board of directors. If left in surplus, a cash
dividend might have been declared and the asset dissipated to that extent.
The stock dividend, however, keeps the profits invested in the business in
capital stock for its par value and surplus for its pro rata share in the
surplus, the offsetting credit to both these being to cash. The value of the
remaining shares of stock has not been affected in the least. If redemption is
at any other figure than book value, not only is surplus affected, being
increased if the redemption price is below par and decreased if above par,
but also the value of the remaining shares. In the case of different classes of
stocks, a careful determination of their respectively equitable shares in
surplus would have to be made before the effect on the remaining shares
could be calculated.
In passing from the question of stock values, it should be pointed out
that an undervaluation of stock when issued for property, though seldom
seen in practice, has the refreshing effect of creating a secret reserve. That
is, property values are carried on the books below their actual values and a
secret reserve is thereby created. A further discussion of secret reserves will
follow in a later chapter.
Dividend Stock
Stock is sometimes issued for dividend purposes. In such cases, it is
always issued as of par value. If profits have been earned or a surplus
accumulated out of which a dividend may be declared, that dividend may be
paid in any way the corporation sees fit. Payment may be made in cash,
scrip, or in the shares of the company. If the corporation has neither
unissued stock nor stock in the treasury, permission to increase its
capitalization must be secured before a stock dividend can be paid. Some
corporations, notably financial institutions, often make it a matter of policy
to accumulate a large surplus and then distribute it by means of a stock
dividend. Declaration of the dividend is made and recorded as usual.
Record of the payment in stock is made as a debit to Dividends account and
a credit to Capital Stock.
The effect of a stock dividend is twofold. From the point of view of the
management of the surplus it has the effect of a permanent investment of
the surplus in the business. Thus it places the accumulated profits beyond
the control of any future board of directors. If left in surplus, a cash
dividend might have been declared and the asset dissipated to that extent.
The stock dividend, however, keeps the profits invested in the business in
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such a way as not hereafter to be available for dividends. From the point of
view of the stockholder, upon the declaration of a stock dividend his equity,
his proprietorship in the business, is not in the least affected excepting that
it is divided into more parts; he has more shares to represent it than he had
before. Before he possessed as a community right a pro rata share in the
surplus. Now the ownership of that share has become personal, individual.
Each share of ownership thus has a smaller book value but each
stockholder’s equity is the same as before.
Stock Issued as a Bonus
The manner of recording stock issued as a bonus with bonds or for any
other purpose has been illustrated in an earlier chapter. Here, attention is
called to the effect of such an issue in states where stock cannot be sold
below par. There is no legal bar to the sale of bonds below par. If, then, the
price received for the bond carrying a bonus of stock is at least equal to the
par value of the bonus stock, there is nothing extra legal in the transaction.
However, record must be made of the issue of the stock at par, the discount
or bonus being carried as applying to the bond.
The valuation of stock issued in effecting combinations or for labor or
services follows along the same general principles as of that issued for
property, and the same general considerations are pertinent.
Unissued and Treasury Stock on the Balance Sheet
When showing capital stock on the balance sheet, it is best to treat
unissued and treasury stock as valuation items. The reason for this was
stated and discussed in Chapter XIV. Here the relevancy of showing the
unissued stock will be considered, as a statement of the outstanding stock is
thought by some to be all that is required. It has been argued that the
unissued stock does not in any sense represent an asset nor does it show
proprietorship. Why not, therefore, leave it off the balance sheet statement
entirely? It is true that an investor, a creditor, or a stockholder is interested
in the main only in the condition of the business as shown by its present
assets and liabilities. Unissued stock has no value till placed on the market;
all that it shows is that certain legal requirements have been met authorizing
its issue and to that extent it has a contingent value which may become a
real source of capital to the corporation if additional funds become
view of the stockholder, upon the declaration of a stock dividend his equity,
his proprietorship in the business, is not in the least affected excepting that
it is divided into more parts; he has more shares to represent it than he had
before. Before he possessed as a community right a pro rata share in the
surplus. Now the ownership of that share has become personal, individual.
Each share of ownership thus has a smaller book value but each
stockholder’s equity is the same as before.
Stock Issued as a Bonus
The manner of recording stock issued as a bonus with bonds or for any
other purpose has been illustrated in an earlier chapter. Here, attention is
called to the effect of such an issue in states where stock cannot be sold
below par. There is no legal bar to the sale of bonds below par. If, then, the
price received for the bond carrying a bonus of stock is at least equal to the
par value of the bonus stock, there is nothing extra legal in the transaction.
However, record must be made of the issue of the stock at par, the discount
or bonus being carried as applying to the bond.
The valuation of stock issued in effecting combinations or for labor or
services follows along the same general principles as of that issued for
property, and the same general considerations are pertinent.
Unissued and Treasury Stock on the Balance Sheet
When showing capital stock on the balance sheet, it is best to treat
unissued and treasury stock as valuation items. The reason for this was
stated and discussed in Chapter XIV. Here the relevancy of showing the
unissued stock will be considered, as a statement of the outstanding stock is
thought by some to be all that is required. It has been argued that the
unissued stock does not in any sense represent an asset nor does it show
proprietorship. Why not, therefore, leave it off the balance sheet statement
entirely? It is true that an investor, a creditor, or a stockholder is interested
in the main only in the condition of the business as shown by its present
assets and liabilities. Unissued stock has no value till placed on the market;
all that it shows is that certain legal requirements have been met authorizing
its issue and to that extent it has a contingent value which may become a
real source of capital to the corporation if additional funds become
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necessary. While, therefore, the omission of the item entirely from the
balance sheet does not affect present conditions, it is considered best, in the
interest of full information as to the exact status of the company, to show
the amount of the authorized capital with the amount unissued extended
short on the balance sheet, the difference being the amount outstanding—
which is full-extended as the significant item, thus:
Capital Stock Authorized $1,000,000.00
Less Amount Unissued 250,000.00
Amount Outstanding $750,000.00
A similar showing of the treasury stock is also considered best, although
good authority can be found for its inclusion among the assets.
Preferred Stock Covered by Redemption Contract
On the border line between liabilities and proprietorship is preferred
stock covered by an unfulfilled redemption contract. Such stock is issued
with a definite redemption contract to become effective at stated dates, and
is manifestly different from preferred stock redeemable upon call at any
time after a named date. In the latter case the option of redemption is with
the company, whereas in the former case the company binds itself to a
contract enforceable at a definitely stated time. From the financial
standpoint the wisdom of a company binding itself to a contract enforceable
some time in the future may be open to question because of the inability at
the time of issue to foretell the company’s condition at the time of
redemption; although in this respect the condition is practically the same as
that confronting a company at the time of a bond issue. There is this marked
difference, however: A bond issue is always a liability and continues as
such after maturity; but in the case of a stock redeemable at a given date,
the point at issue is whether the failure of the company to redeem
automatically changes the status of the owner of the stock from that of a
proprietor to that of an outside creditor.
“For instance, a corporation sold $750,000 of first preferred stock, with
a provision for the retirement of $150,000 annually after a certain period
had elapsed. When the first instalment became due the corporation was
unable to meet its obligation. There was no provision in the certificate
bearing on the treatment of the overdue payment in the accounts or the
balance sheet does not affect present conditions, it is considered best, in the
interest of full information as to the exact status of the company, to show
the amount of the authorized capital with the amount unissued extended
short on the balance sheet, the difference being the amount outstanding—
which is full-extended as the significant item, thus:
Capital Stock Authorized $1,000,000.00
Less Amount Unissued 250,000.00
Amount Outstanding $750,000.00
A similar showing of the treasury stock is also considered best, although
good authority can be found for its inclusion among the assets.
Preferred Stock Covered by Redemption Contract
On the border line between liabilities and proprietorship is preferred
stock covered by an unfulfilled redemption contract. Such stock is issued
with a definite redemption contract to become effective at stated dates, and
is manifestly different from preferred stock redeemable upon call at any
time after a named date. In the latter case the option of redemption is with
the company, whereas in the former case the company binds itself to a
contract enforceable at a definitely stated time. From the financial
standpoint the wisdom of a company binding itself to a contract enforceable
some time in the future may be open to question because of the inability at
the time of issue to foretell the company’s condition at the time of
redemption; although in this respect the condition is practically the same as
that confronting a company at the time of a bond issue. There is this marked
difference, however: A bond issue is always a liability and continues as
such after maturity; but in the case of a stock redeemable at a given date,
the point at issue is whether the failure of the company to redeem
automatically changes the status of the owner of the stock from that of a
proprietor to that of an outside creditor.
“For instance, a corporation sold $750,000 of first preferred stock, with
a provision for the retirement of $150,000 annually after a certain period
had elapsed. When the first instalment became due the corporation was
unable to meet its obligation. There was no provision in the certificate
bearing on the treatment of the overdue payment in the accounts or the
Page 327
balance sheets. The auditors declined to certify the balance sheet until a
decision was reached as to whether or not the amount represented a liability
to be liquidated as soon as funds were available. So long as this possibility
existed the position of the general creditors was subject to change. Finally it
was decided to secure an extension from all stockholders and upon
satisfactory evidences thereof the auditors passed the balance sheet.
“No general rule can be laid down for the auditor’s guidance in such
cases as this, as each case must be decided on its merits. The most
important facts for the auditor to ascertain are the rights of stockholders to
insist upon payment, and the aggregates and due dates of all probable
obligations. Their disposition in the accounts is then a matter of disclosing
full information to creditors, prospective creditors, and to other
stockholders.”[51]
decision was reached as to whether or not the amount represented a liability
to be liquidated as soon as funds were available. So long as this possibility
existed the position of the general creditors was subject to change. Finally it
was decided to secure an extension from all stockholders and upon
satisfactory evidences thereof the auditors passed the balance sheet.
“No general rule can be laid down for the auditor’s guidance in such
cases as this, as each case must be decided on its merits. The most
important facts for the auditor to ascertain are the rights of stockholders to
insist upon payment, and the aggregates and due dates of all probable
obligations. Their disposition in the accounts is then a matter of disclosing
full information to creditors, prospective creditors, and to other
stockholders.”[51]
Page 328
CHAPTER XXII
PROFITS
Difficulty of Determining Profits
What constitutes a profit is oftentimes a perplexing question and at all
times its determination is more an estimate than an absolute fact. This arises
from the nature of accounting itself in that so many items of expense are
known to exist and must accordingly be provided for but the amount of such
expenses cannot be exactly determined. This is seen to be true in the case of
the provision which must be made for bad and doubtful accounts and for
depreciation of fixed assets and is, of course, inherent in all problems of
valuation. As is proverbially true of the prescriptions of different physicians
for the same malady, so no two accountants would arrive at the same figure of
profit for any given concern.
Economic Definition
It may be of some advantage at this point to attempt a definition of profits
although to compress the meaning of the word within defined limits is hardly
possible and for this reason the formulation of a working definition is very
difficult. Etymologically, “profit” comes from the Latin word proficere,
meaning to make progress, and a better definition than this would be difficult
to find. At the best the term is an elusive one, being used with slightly different
connotations in different schools of thought. Thus, we find the word used and
defined in economics, law, and accountancy, and some of the definitions are
twisted almost to the point of absurdity. Alfred Marshall,[52] the English
economist, says: “If a person is engaged in business, he is sure to have to incur
certain outgoings for raw material, the hire of labour, etc. And, in that case, his
true or net income is found by deducting from his gross income ‘the outgoings
that belong to its production.’” Charles S. Devas[53] says: “The income from
production combining both labor and capital is profits.” He defines gross
income as “the total wealth added to the property of a given person in a given
time from whatever source ... and net income as gross income minus the
following items: (a) Destruction, damage, or loss by fire or other accident, by
violence, by thieves, by bad debtors. (b) Using up of materials in production,
PROFITS
Difficulty of Determining Profits
What constitutes a profit is oftentimes a perplexing question and at all
times its determination is more an estimate than an absolute fact. This arises
from the nature of accounting itself in that so many items of expense are
known to exist and must accordingly be provided for but the amount of such
expenses cannot be exactly determined. This is seen to be true in the case of
the provision which must be made for bad and doubtful accounts and for
depreciation of fixed assets and is, of course, inherent in all problems of
valuation. As is proverbially true of the prescriptions of different physicians
for the same malady, so no two accountants would arrive at the same figure of
profit for any given concern.
Economic Definition
It may be of some advantage at this point to attempt a definition of profits
although to compress the meaning of the word within defined limits is hardly
possible and for this reason the formulation of a working definition is very
difficult. Etymologically, “profit” comes from the Latin word proficere,
meaning to make progress, and a better definition than this would be difficult
to find. At the best the term is an elusive one, being used with slightly different
connotations in different schools of thought. Thus, we find the word used and
defined in economics, law, and accountancy, and some of the definitions are
twisted almost to the point of absurdity. Alfred Marshall,[52] the English
economist, says: “If a person is engaged in business, he is sure to have to incur
certain outgoings for raw material, the hire of labour, etc. And, in that case, his
true or net income is found by deducting from his gross income ‘the outgoings
that belong to its production.’” Charles S. Devas[53] says: “The income from
production combining both labor and capital is profits.” He defines gross
income as “the total wealth added to the property of a given person in a given
time from whatever source ... and net income as gross income minus the
following items: (a) Destruction, damage, or loss by fire or other accident, by
violence, by thieves, by bad debtors. (b) Using up of materials in production,
Page 329
and wear and tear of machinery and industrial buildings such as factories or
shops. (c) All sums spent on purchases of goods that are to serve the purchaser
not as subjects of enjoyment, but as means of getting an income. (d) All sums
spent on hire of goods that in like manner are to serve as means of getting an
income. (e) All payments for labor that in like manner are to serve as means of
getting an income.” One wonders if Marshall’s idea of incomings and
outgoings is limited to a cash basis or if he recognizes accruals. On the other
hand, from the point of view of accounting, Devas includes too much, as will
be pointed out later. E. R. A. Seligman[54] says: “Profits are the income from
business enterprise.... Profits are always a surplus. They are the difference
between the cost of production or acquisition and the selling price.” He
summarizes expenses of production as including cost of raw materials, wages,
rent, interest on capital borrowed or invested, taxes, and miscellaneous outlays
such as insurance, advertisements, and transportation expense. Again, he says:
[55]
“Income is that which comes in to an individual above all necessary
expenses of acquisition and which is available for his own consumption.” He
recognizes depreciation as a necessary expense.
All of this attests the statement made above that the formulation of a
satisfactory working rule for the determination of net profits, from the business
standpoint, is extremely difficult. It should be said, of course, that in some
respects the idea of net profit as used in economics differs from that used in
business; the chief difference being that interest on invested capital is in
economics looked upon as an expense deduction before the determination of
profits.
Legal Definition
The efforts of the law, as evidenced by court decisions, to mark out
definitely the meaning of net profits have resulted in many odd twists of terms
and meaning. In an English case[56] decided as recently as 1902, this language
is used: “If it is a mere question what were the profits made in a particular
year, it seems to me that the duty is to ascertain what cash has been received
and what cash has been expended, and, if that is fairly done, you know the
profits of the year. If there is a large outstanding liability which cannot be
settled, the partners will estimate that, and it will not be considered as part of
the profits. If there is a large outstanding possible loss, and there is a large sum
due to a client, then you would provide for that. But in ascertaining what is
really actually divisible for the year fairly, you would take the cash account as
it stands.” In the light of such mental obtuseness and obliquity, one cannot
shops. (c) All sums spent on purchases of goods that are to serve the purchaser
not as subjects of enjoyment, but as means of getting an income. (d) All sums
spent on hire of goods that in like manner are to serve as means of getting an
income. (e) All payments for labor that in like manner are to serve as means of
getting an income.” One wonders if Marshall’s idea of incomings and
outgoings is limited to a cash basis or if he recognizes accruals. On the other
hand, from the point of view of accounting, Devas includes too much, as will
be pointed out later. E. R. A. Seligman[54] says: “Profits are the income from
business enterprise.... Profits are always a surplus. They are the difference
between the cost of production or acquisition and the selling price.” He
summarizes expenses of production as including cost of raw materials, wages,
rent, interest on capital borrowed or invested, taxes, and miscellaneous outlays
such as insurance, advertisements, and transportation expense. Again, he says:
[55]
“Income is that which comes in to an individual above all necessary
expenses of acquisition and which is available for his own consumption.” He
recognizes depreciation as a necessary expense.
All of this attests the statement made above that the formulation of a
satisfactory working rule for the determination of net profits, from the business
standpoint, is extremely difficult. It should be said, of course, that in some
respects the idea of net profit as used in economics differs from that used in
business; the chief difference being that interest on invested capital is in
economics looked upon as an expense deduction before the determination of
profits.
Legal Definition
The efforts of the law, as evidenced by court decisions, to mark out
definitely the meaning of net profits have resulted in many odd twists of terms
and meaning. In an English case[56] decided as recently as 1902, this language
is used: “If it is a mere question what were the profits made in a particular
year, it seems to me that the duty is to ascertain what cash has been received
and what cash has been expended, and, if that is fairly done, you know the
profits of the year. If there is a large outstanding liability which cannot be
settled, the partners will estimate that, and it will not be considered as part of
the profits. If there is a large outstanding possible loss, and there is a large sum
due to a client, then you would provide for that. But in ascertaining what is
really actually divisible for the year fairly, you would take the cash account as
it stands.” In the light of such mental obtuseness and obliquity, one cannot
Page 330
wonder at the occasional reluctance of business to entrust the determination of
important matters to the courts.
In cheering contrast is a legal opinion quoted by R. H. Montgomery,[57] in
the following: “I should think that no commercial man would doubt that this is
the right course—that he must not calculate net profits until he has provided
for all the ordinary repairs and wear and tear occasioned by his business. That
being so, it appears to me you can have no net profits unless this sum has been
set aside.... If you had done what you ought to have done, that is, set aside
every year the sum necessary to make good the wear and tear in that year, then
in the following years you would have a sum sufficient to meet the extra cost.”
Even here confusion is apparent between a valuation reserve and a reserve
which has been funded and the emphasis is rather on the point of providing
funds necessary for the purpose—a financial problem as distinguished from an
effort to define net profits.
Between these extremes of legal opinion and phraseology one finds all
shades and degrees of understanding and misunderstanding. In recent years
there is evident in the decisions of our higher courts and of our many excellent
governmental commissions and bureaus a real appreciation of some of the
technical points involved in profits determination. It is believed that a body of
authoritative decisions will in time and perhaps soon reflect the best opinion of
the business men of the country.
Accounting Definition
The purpose of this chapter is to discuss some of the points at issue in this
vexed problem, but before entering upon this discussion it will be of advantage
to quote from leading authorities on the attitude of accountants towards the
determination of profits.
A. Lowes Dickinson[58] says: “In the widest possible view, profits may be
stated as the realized increment in value of the whole amount invested in an
undertaking; and, conversely, loss is the realized decrement. Inasmuch,
however, as the ultimate realization of the original investment is from the
nature of things deferred for a long period of years, during which partial
realizations are continually taking place, it becomes necessary to fall back on
estimates of value at certain definite periods, and to consider as profit and loss
the estimated increase or decrease between any two such periods.” It is in the
making of these estimates that the most difficult problems of profits
determination are met.
important matters to the courts.
In cheering contrast is a legal opinion quoted by R. H. Montgomery,[57] in
the following: “I should think that no commercial man would doubt that this is
the right course—that he must not calculate net profits until he has provided
for all the ordinary repairs and wear and tear occasioned by his business. That
being so, it appears to me you can have no net profits unless this sum has been
set aside.... If you had done what you ought to have done, that is, set aside
every year the sum necessary to make good the wear and tear in that year, then
in the following years you would have a sum sufficient to meet the extra cost.”
Even here confusion is apparent between a valuation reserve and a reserve
which has been funded and the emphasis is rather on the point of providing
funds necessary for the purpose—a financial problem as distinguished from an
effort to define net profits.
Between these extremes of legal opinion and phraseology one finds all
shades and degrees of understanding and misunderstanding. In recent years
there is evident in the decisions of our higher courts and of our many excellent
governmental commissions and bureaus a real appreciation of some of the
technical points involved in profits determination. It is believed that a body of
authoritative decisions will in time and perhaps soon reflect the best opinion of
the business men of the country.
Accounting Definition
The purpose of this chapter is to discuss some of the points at issue in this
vexed problem, but before entering upon this discussion it will be of advantage
to quote from leading authorities on the attitude of accountants towards the
determination of profits.
A. Lowes Dickinson[58] says: “In the widest possible view, profits may be
stated as the realized increment in value of the whole amount invested in an
undertaking; and, conversely, loss is the realized decrement. Inasmuch,
however, as the ultimate realization of the original investment is from the
nature of things deferred for a long period of years, during which partial
realizations are continually taking place, it becomes necessary to fall back on
estimates of value at certain definite periods, and to consider as profit and loss
the estimated increase or decrease between any two such periods.” It is in the
making of these estimates that the most difficult problems of profits
determination are met.
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Mr. Montgomery in his dictum, “The net profit of a business is the surplus
remaining from the earnings after providing for all costs, expenses, and
reserves for accrued or probable losses,” offers the best available working
definition, although a caution is needed against the danger of relying
exclusively upon any one definition.
Methods of Determining Profits
Systems of bookkeeping, in the main, provide two distinct methods for the
determination of profits, namely, by means of single entry and double entry.
The student is referred to the author’s first volume for the detailed working out
of profits by single entry. Here it is sufficient to say that the determination of
profits rests upon a comparison of assets and liabilities as at the beginning of a
fiscal period, with those as at the end of the period. Then the increase or
decrease in net worth as so determined, after making due allowances for any
withdrawals or investments of capital during the period, constitutes the figure
of net profit or loss for the period. The disadvantages and inaccuracies inherent
in this method have already been pointed out.
The method of determining profits by means of double entry provides an
entirely distinct set of accounts known as temporary proprietorship or profit
and loss accounts. These record the daily changes in net worth and must be
summarized through the Profit and Loss account at the close of the fiscal
period, at which time they must prove against the profits as determined by the
balance sheet, the method of which is essentially the single-entry method. In
addition to this control secured by checking the results obtained by one group
of accounts against those of another group, is the important advantage of
presenting in the record a mass of statistical information for guidance in the
conduct of a business, without which the present-day enterprise with its many
complexities of organization and working could not hope for any certain
measure of success.
The Problem a Question of Valuation
Inasmuch as every profit made must be reflected in a corresponding
increase of some asset or the decrease of a liability, and, conversely, every
expense incurred is reflected as a decrease of assets or increase of liabilities, it
is apparent that profits determination is largely a question of the valuation of
assets and liabilities and therefore rests upon the principles already established.
Thus the amount of gross profit is not determinable until the value of the stock
of merchandise on hand is known. Gross profit rests on inventory valuation,
remaining from the earnings after providing for all costs, expenses, and
reserves for accrued or probable losses,” offers the best available working
definition, although a caution is needed against the danger of relying
exclusively upon any one definition.
Methods of Determining Profits
Systems of bookkeeping, in the main, provide two distinct methods for the
determination of profits, namely, by means of single entry and double entry.
The student is referred to the author’s first volume for the detailed working out
of profits by single entry. Here it is sufficient to say that the determination of
profits rests upon a comparison of assets and liabilities as at the beginning of a
fiscal period, with those as at the end of the period. Then the increase or
decrease in net worth as so determined, after making due allowances for any
withdrawals or investments of capital during the period, constitutes the figure
of net profit or loss for the period. The disadvantages and inaccuracies inherent
in this method have already been pointed out.
The method of determining profits by means of double entry provides an
entirely distinct set of accounts known as temporary proprietorship or profit
and loss accounts. These record the daily changes in net worth and must be
summarized through the Profit and Loss account at the close of the fiscal
period, at which time they must prove against the profits as determined by the
balance sheet, the method of which is essentially the single-entry method. In
addition to this control secured by checking the results obtained by one group
of accounts against those of another group, is the important advantage of
presenting in the record a mass of statistical information for guidance in the
conduct of a business, without which the present-day enterprise with its many
complexities of organization and working could not hope for any certain
measure of success.
The Problem a Question of Valuation
Inasmuch as every profit made must be reflected in a corresponding
increase of some asset or the decrease of a liability, and, conversely, every
expense incurred is reflected as a decrease of assets or increase of liabilities, it
is apparent that profits determination is largely a question of the valuation of
assets and liabilities and therefore rests upon the principles already established.
Thus the amount of gross profit is not determinable until the value of the stock
of merchandise on hand is known. Gross profit rests on inventory valuation,
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whether that be accomplished by the perpetual inventory method or that of
periodic stock-taking. While under the double-entry system the charges for
expense are more or less fixed and certain and not so dependent on inventory,
it has been seen in Chapters XIV and XIX that before accuracy can be secured,
here too there must be an inventory or appraisal to determine the prepaid and
accrued expense items. The basis for valuing these was indicated in the
chapters referred to. Estimates of depreciation, bad debts, and other similar
items must also be made to secure a proper appraisal of the corresponding
asset items. Similarly, in the determination of other income, accruals and
prepayments must be taken into account. In the making of the record of
temporary proprietorship data, the fundamental distinction between capital and
revenue charges is vital and must be kept constantly in view.
Thus the problem of profits is seen to be in its broader aspects the same
problem of valuation to which attention has already been directed. It is
purposed here to point out the application of the valuation problem to the
periodic determination of profits and to re-examine some phases of the
problem from the standpoint of profits as distinguished from that of assets.
Effect of Asset Losses on Future Profits
The first question for discussion may be stated as follows: In the
determination of periodic profits must all the data which have affected
proprietorship during that period be summarized in order to make a proper
showing of profits for the period? An illustration will better present the issue.
A manufacturing concern with plants in many places suffers a heavy loss from
fire. Must this loss be considered (1) as an expense applicable to the current
period and to be taken account of before the determination of profits for the
period; or (2) may it be treated as a deferred expense to be shared by several
succeeding periods; or (3) may it be charged directly against capital?
Three somewhat different solutions are thus presented. The first treats the
loss as a temporary proprietorship charge; the second as a deferred charge to
operation and so includes the portion deferred among the assets and to this
extent does not reflect the loss as a diminution of net worth; and the third treats
the loss as a charge against vested proprietorship.
Any adequate treatment of the question requires a consideration of (1) the
type of business organization, i.e., single proprietorship, partnership, or
corporation; (2) the appropriation of profits, whether they are to be withdrawn
or reinvested in the business; and (3) the nature of the loss, as to whether fixed
periodic stock-taking. While under the double-entry system the charges for
expense are more or less fixed and certain and not so dependent on inventory,
it has been seen in Chapters XIV and XIX that before accuracy can be secured,
here too there must be an inventory or appraisal to determine the prepaid and
accrued expense items. The basis for valuing these was indicated in the
chapters referred to. Estimates of depreciation, bad debts, and other similar
items must also be made to secure a proper appraisal of the corresponding
asset items. Similarly, in the determination of other income, accruals and
prepayments must be taken into account. In the making of the record of
temporary proprietorship data, the fundamental distinction between capital and
revenue charges is vital and must be kept constantly in view.
Thus the problem of profits is seen to be in its broader aspects the same
problem of valuation to which attention has already been directed. It is
purposed here to point out the application of the valuation problem to the
periodic determination of profits and to re-examine some phases of the
problem from the standpoint of profits as distinguished from that of assets.
Effect of Asset Losses on Future Profits
The first question for discussion may be stated as follows: In the
determination of periodic profits must all the data which have affected
proprietorship during that period be summarized in order to make a proper
showing of profits for the period? An illustration will better present the issue.
A manufacturing concern with plants in many places suffers a heavy loss from
fire. Must this loss be considered (1) as an expense applicable to the current
period and to be taken account of before the determination of profits for the
period; or (2) may it be treated as a deferred expense to be shared by several
succeeding periods; or (3) may it be charged directly against capital?
Three somewhat different solutions are thus presented. The first treats the
loss as a temporary proprietorship charge; the second as a deferred charge to
operation and so includes the portion deferred among the assets and to this
extent does not reflect the loss as a diminution of net worth; and the third treats
the loss as a charge against vested proprietorship.
Any adequate treatment of the question requires a consideration of (1) the
type of business organization, i.e., single proprietorship, partnership, or
corporation; (2) the appropriation of profits, whether they are to be withdrawn
or reinvested in the business; and (3) the nature of the loss, as to whether fixed
Page 333
or current assets were affected. The practical aspect of the problem is the
adoption of a policy not in contravention with the law, and in the determination
of this phase of the subject there are some court decisions none of which,
however, seem entirely trustworthy.
It must be borne in mind that in the types of organization known as single
proprietorship and partnership, there is little legal restriction in their formation
and operation. The law presumes that the full liability of the owner or owners
offers sufficient protection to creditors. Hence the withdrawal of profits or
capital is not safeguarded in any way in the interest of creditors. With the
corporation, however, provision is specific that nothing shall be returned to the
stockholder except profits so long as the business continues in operation.
Exception here is usually made for those concerns operating assets which are
subject to depletion, in which case it has been held that dividends may include
a return of the depleted portion. The theory of the law is that, except as just
indicated, the capital of a corporation is an indication to creditors of the
amount by which the assets may suffer shrinkage and their claims still be
protected in full. Hence, the return of capital in the form of dividends is not
allowed, as that would impair the margin of safety for creditors.
From the practical standpoint, therefore, the problem concerns only the
corporate form of organization and that only in its relation to dividend
payments. So long as the profits are reinvested in the business, neither
creditors nor owners have any cause for action, except in case of fraud.
Legal Decisions as to Asset Losses
In decisions relating to this question of asset losses, the courts have seen fit
to make a distinction between what they term fixed and circulating capital,
corresponding in the main to the fixed and current classification of assets for
the balance sheet. In the leading English case,[59] it was held that a trust
company holding stock, which during the last business year paid 50 per cent
dividend but which before the end of the year became utterly worthless, may
include the 50 per cent in its yearly profit, without deducting a penny for the
depreciation of the property from which this profit was derived. In the
language of the court Lord Justice Lindley said: “Fixed capital may be sunk
and lost and yet the excess of current receipts over current payments may be
divided. But floating or circulating capital must be kept up, as otherwise it will
enter into and form part of such excess (seeing that circulating capital, with the
particulars of its purchase and sale, must appear in revenue account), in which
adoption of a policy not in contravention with the law, and in the determination
of this phase of the subject there are some court decisions none of which,
however, seem entirely trustworthy.
It must be borne in mind that in the types of organization known as single
proprietorship and partnership, there is little legal restriction in their formation
and operation. The law presumes that the full liability of the owner or owners
offers sufficient protection to creditors. Hence the withdrawal of profits or
capital is not safeguarded in any way in the interest of creditors. With the
corporation, however, provision is specific that nothing shall be returned to the
stockholder except profits so long as the business continues in operation.
Exception here is usually made for those concerns operating assets which are
subject to depletion, in which case it has been held that dividends may include
a return of the depleted portion. The theory of the law is that, except as just
indicated, the capital of a corporation is an indication to creditors of the
amount by which the assets may suffer shrinkage and their claims still be
protected in full. Hence, the return of capital in the form of dividends is not
allowed, as that would impair the margin of safety for creditors.
From the practical standpoint, therefore, the problem concerns only the
corporate form of organization and that only in its relation to dividend
payments. So long as the profits are reinvested in the business, neither
creditors nor owners have any cause for action, except in case of fraud.
Legal Decisions as to Asset Losses
In decisions relating to this question of asset losses, the courts have seen fit
to make a distinction between what they term fixed and circulating capital,
corresponding in the main to the fixed and current classification of assets for
the balance sheet. In the leading English case,[59] it was held that a trust
company holding stock, which during the last business year paid 50 per cent
dividend but which before the end of the year became utterly worthless, may
include the 50 per cent in its yearly profit, without deducting a penny for the
depreciation of the property from which this profit was derived. In the
language of the court Lord Justice Lindley said: “Fixed capital may be sunk
and lost and yet the excess of current receipts over current payments may be
divided. But floating or circulating capital must be kept up, as otherwise it will
enter into and form part of such excess (seeing that circulating capital, with the
particulars of its purchase and sale, must appear in revenue account), in which
Page 334
case to divide such excess without deducting the capital which forms part of it
will be contrary to law.”
The stock held by the trust company was for permanent investment and
therefore in the nature of a fixed asset. The language of the court is quite
specific and there would seem to be no need for including all or any portion of
the loss in the current statement of profit and loss. Other later decisions have
somewhat extended the doctrine so that it has been held that the current profits
may be determined without making any provision for a loss, even of
circulating capital, occurring in a previous year. Thus it would seem that so far
as the legality of profits determination is concerned, each fiscal period may be
counted as entirely free from liability for the happenings in other periods—a
unit of business history distinct from all other units. These decisions are
English cases and have not always been followed in this country. For a
statement of the prevailing opinion in this country, see page 443 of Chapter
XXIV, “Dividends.” The danger of the position is apparent. In the hands of
unscrupulous managers the profit and loss might be so manipulated that
alternate years would always show profits in spite of the fact that the
company’s capital was constantly being depleted.
Loss Charged against Current Profits
In stating the question on page 393, three alternatives were presented by
way of solution. The first of these suggested that the entire loss be treated as a
charge against the profits of the current period. It has been seen that there is no
support in law for this method of handling the loss, nor is there any need or
justification for it from the standpoint of correct accounting theory. Only such
losses as occur more or less regularly and which within the experience of the
business can be fairly accurately estimated, are proper charges to the current
period. It is not the function of the periodic profit and loss statement to reflect
charges covering contingencies which with almost equal certainty may or may
not materialize.
Loss Treated as Deferred Expense Charge
The second solution suggested, viz., that the loss be treated as a deferred
expense to be shared by several succeeding periods, has much to commend it
and little to condemn it, except a possible lack of business foresight as will be
evident when the third solution is examined. It may be argued, and with a good
show of reason, that such losses are so infrequent, occurring perhaps only once
or twice in the life of any business, as to make it unfair as between periods to
will be contrary to law.”
The stock held by the trust company was for permanent investment and
therefore in the nature of a fixed asset. The language of the court is quite
specific and there would seem to be no need for including all or any portion of
the loss in the current statement of profit and loss. Other later decisions have
somewhat extended the doctrine so that it has been held that the current profits
may be determined without making any provision for a loss, even of
circulating capital, occurring in a previous year. Thus it would seem that so far
as the legality of profits determination is concerned, each fiscal period may be
counted as entirely free from liability for the happenings in other periods—a
unit of business history distinct from all other units. These decisions are
English cases and have not always been followed in this country. For a
statement of the prevailing opinion in this country, see page 443 of Chapter
XXIV, “Dividends.” The danger of the position is apparent. In the hands of
unscrupulous managers the profit and loss might be so manipulated that
alternate years would always show profits in spite of the fact that the
company’s capital was constantly being depleted.
Loss Charged against Current Profits
In stating the question on page 393, three alternatives were presented by
way of solution. The first of these suggested that the entire loss be treated as a
charge against the profits of the current period. It has been seen that there is no
support in law for this method of handling the loss, nor is there any need or
justification for it from the standpoint of correct accounting theory. Only such
losses as occur more or less regularly and which within the experience of the
business can be fairly accurately estimated, are proper charges to the current
period. It is not the function of the periodic profit and loss statement to reflect
charges covering contingencies which with almost equal certainty may or may
not materialize.
Loss Treated as Deferred Expense Charge
The second solution suggested, viz., that the loss be treated as a deferred
expense to be shared by several succeeding periods, has much to commend it
and little to condemn it, except a possible lack of business foresight as will be
evident when the third solution is examined. It may be argued, and with a good
show of reason, that such losses are so infrequent, occurring perhaps only once
or twice in the life of any business, as to make it unfair as between periods to
Page 335
burden some with a charge of this sort and not all. For comparative purposes,
the spreading of the loss over several periods will tend to obscure the true state
of operations for those periods, although that is largely a matter of the way in
which results are presented. The situation is relentless, however. If it is desired
to recoup the loss in order not to show an impairment of capital, the loss must
be charged in its entirety or piecemeal against profits. If there are no
accumulated profits against which it can be charged in its entirety, it must be
charged piecemeal against current profits.
Loss Charged to Capital
The third solution suggested that the charge be made directly against
capital. Without the limitation as to the policy of recouping the loss mentioned
above, this solution may take two somewhat different directions. If a surplus
has been accumulated out of previous profits, such surplus constitutes a part of
the capital and provides the logical place for setting up the charge. If no
surplus is available, the loss must be charged against the capital stock, thus
constituting an impairment of it. In either case, the results of the current
period’s operation are not affected, except in so far as a diminution of the
assets may have made necessary a curtailment of operation. Of course, the
charge against the capital stock, whether made direct to the account or carried
in a separate account, does not automatically bring about a reduction of the
capital stock; that can be accomplished only by legal process and is often
shunned because of the difficulties incident thereto and also because of a
possible reflection on the concern’s credit occasioned thereby. The charge does
indicate a reduction in the value of the shares outstanding. Since there is no
compulsion in law and there may be no need from a business standpoint that
the loss be recouped, undoubtedly this third method offers the best solution
both practically and theoretically.
That this is so is brought out clearly by H. R. Hatfield’s almost classic
illustration:[60] “An individual’s entire income is derived from ten houses each
worth $10,000 and each yielding 10 per cent net income. If two of these
houses burn down, uninsured, the common sense view is that the proprietor’s
income is thereby cut down from $10,000 to $8,000 per annum, and that
coincidentally, there is a loss of capital of $20,000. It never occurs to him that
he must consider his income as entirely cut off for two years until the principal
can be restored. Similarly it might be an act of cruelty to dependent
stockholders to stop dividends entirely until an exceptional loss is reimbursed.
The main difficulty is that in a corporation such an occurrence really calls for a
the spreading of the loss over several periods will tend to obscure the true state
of operations for those periods, although that is largely a matter of the way in
which results are presented. The situation is relentless, however. If it is desired
to recoup the loss in order not to show an impairment of capital, the loss must
be charged in its entirety or piecemeal against profits. If there are no
accumulated profits against which it can be charged in its entirety, it must be
charged piecemeal against current profits.
Loss Charged to Capital
The third solution suggested that the charge be made directly against
capital. Without the limitation as to the policy of recouping the loss mentioned
above, this solution may take two somewhat different directions. If a surplus
has been accumulated out of previous profits, such surplus constitutes a part of
the capital and provides the logical place for setting up the charge. If no
surplus is available, the loss must be charged against the capital stock, thus
constituting an impairment of it. In either case, the results of the current
period’s operation are not affected, except in so far as a diminution of the
assets may have made necessary a curtailment of operation. Of course, the
charge against the capital stock, whether made direct to the account or carried
in a separate account, does not automatically bring about a reduction of the
capital stock; that can be accomplished only by legal process and is often
shunned because of the difficulties incident thereto and also because of a
possible reflection on the concern’s credit occasioned thereby. The charge does
indicate a reduction in the value of the shares outstanding. Since there is no
compulsion in law and there may be no need from a business standpoint that
the loss be recouped, undoubtedly this third method offers the best solution
both practically and theoretically.
That this is so is brought out clearly by H. R. Hatfield’s almost classic
illustration:[60] “An individual’s entire income is derived from ten houses each
worth $10,000 and each yielding 10 per cent net income. If two of these
houses burn down, uninsured, the common sense view is that the proprietor’s
income is thereby cut down from $10,000 to $8,000 per annum, and that
coincidentally, there is a loss of capital of $20,000. It never occurs to him that
he must consider his income as entirely cut off for two years until the principal
can be restored. Similarly it might be an act of cruelty to dependent
stockholders to stop dividends entirely until an exceptional loss is reimbursed.
The main difficulty is that in a corporation such an occurrence really calls for a
Page 336
reduction of the nominal capital, a cancellation of part of the capital stock....
The criticism properly to be made is not so much that dividends are paid
before restoring the capital ... but rather that the capital stock has not been
reduced to correspond with the amount of remaining assets, before the
dividend is paid.”
It should be stated that this criticism is of little real weight if the balance
sheet shows the true condition of the business. Carrying the loss as a part of
the assets, particularly if clothed with a title the meaning of which even a code
expert could but lamely guess at, is to be condemned. If, however, the title
clearly indicates the nature of the item, the situation is not so bad, although it
does reflect the slavery to form which compels some very well-meaning
individuals to show impairment of capital on the asset side of the balance sheet
for the sake of making it balance. The best practice compels the showing of
impairment items as direct deductions from capital. The carrying value of the
asset destroyed must, of course, be reduced to accord with the facts of present
value, and, if there is no surplus available, the amount of the loss should be
shown as a deduction from the capital stock outstanding, short-extended, with
the present capital full-extended, somewhat as follows:
Capital Stock Outstanding $1,000,000.00
Fire and Earthquake Loss
resulting in impairment 250,000.00
Net Capital available for the business $750,000.00
Profit on Work in Progress
A second problem to be solved in the determination of profits is concerned
with the allowance or non-allowance of profit on work in progress but not
completed. Most manufacturing and contracting concerns have at all times a
more or less constant volume of work in various stages of completion. At the
close of the fiscal period when results are summarized, the proper treatment of
this uncompleted work is an important matter. The general principles
governing the valuation of this work were discussed in Chapter XIII where it
was pointed out that in the main conservative business policy demands that
work in progress be included in the inventory at full cost, which is to include
both prime cost and an equitable share of burden accrued to date. Manifestly
this principle precludes the taking of any profit, the theory being that there is
no profit until goods are sold. A full discussion of the subject requires separate
The criticism properly to be made is not so much that dividends are paid
before restoring the capital ... but rather that the capital stock has not been
reduced to correspond with the amount of remaining assets, before the
dividend is paid.”
It should be stated that this criticism is of little real weight if the balance
sheet shows the true condition of the business. Carrying the loss as a part of
the assets, particularly if clothed with a title the meaning of which even a code
expert could but lamely guess at, is to be condemned. If, however, the title
clearly indicates the nature of the item, the situation is not so bad, although it
does reflect the slavery to form which compels some very well-meaning
individuals to show impairment of capital on the asset side of the balance sheet
for the sake of making it balance. The best practice compels the showing of
impairment items as direct deductions from capital. The carrying value of the
asset destroyed must, of course, be reduced to accord with the facts of present
value, and, if there is no surplus available, the amount of the loss should be
shown as a deduction from the capital stock outstanding, short-extended, with
the present capital full-extended, somewhat as follows:
Capital Stock Outstanding $1,000,000.00
Fire and Earthquake Loss
resulting in impairment 250,000.00
Net Capital available for the business $750,000.00
Profit on Work in Progress
A second problem to be solved in the determination of profits is concerned
with the allowance or non-allowance of profit on work in progress but not
completed. Most manufacturing and contracting concerns have at all times a
more or less constant volume of work in various stages of completion. At the
close of the fiscal period when results are summarized, the proper treatment of
this uncompleted work is an important matter. The general principles
governing the valuation of this work were discussed in Chapter XIII where it
was pointed out that in the main conservative business policy demands that
work in progress be included in the inventory at full cost, which is to include
both prime cost and an equitable share of burden accrued to date. Manifestly
this principle precludes the taking of any profit, the theory being that there is
no profit until goods are sold. A full discussion of the subject requires separate
Page 337
consideration of work which is being done on order or contract and work for
the concern’s own stock-in-trade, due weight being given always as to whether
the unit of work is large or small.
Goods Made for Stock but not Sold
The general principle mentioned above must usually be applied to the
valuation of the concern’s own stock-in-trade in process of manufacture. Here
sales are being made constantly from finished stock and manufacture
replenishes the stock. But the essential step before profits can be claimed, viz.,
making the sale, usually comes after the process of manufacture and not
before. It may sometimes happen that stock is sold out ahead of its
manufacture, because the factory is not able to keep up with sales. It is not
intended here to include the case in which it is the custom of the trade to sell
goods in advance of their manufacture and regulate the operation of the factory
to turning out the advance orders booked. This will be considered later. The
discussion here concerns those firms which usually keep their finished stock
well ahead of sales but because of the exigencies of the market find themselves
behind their sales. Such a situation is sometimes called a sellers’ market. If
purchasers contract for goods with full knowledge of factory conditions, such
sales are in the nature of work on contract and might in unusual instances be so
treated. Usually, however, conservative management requires that no profits be
taken under such circumstances.
Goods Made to Order
Where the factory works only on order, conditions as to profit-taking are
somewhat changed. Here, the sale has already been made for delivery of the
product at some future time, named or left indefinite. While, of course,
cancellation of the order is always possible before date of delivery and
acceptance, inasmuch as here we have under consideration a special product
made to individual specifications and not a stock or standardized article,
cancellation of the contract is not probable without incurrence of damages or
even being held to specific performance. Under these circumstances it is
apparent that, within reasonable limits, a portion of the profit may be taken up
in the current period, which has, of course, done a portion of the work and
therefore earned a portion of the profit, if there is one. This last contingency is,
of course, the crux of the whole problem. If a portion of the profit is taken, this
necessitates a predetermination of profit on the whole contract, an estimate of
the portion of the contract completed, and adequate provision for unforeseen
the concern’s own stock-in-trade, due weight being given always as to whether
the unit of work is large or small.
Goods Made for Stock but not Sold
The general principle mentioned above must usually be applied to the
valuation of the concern’s own stock-in-trade in process of manufacture. Here
sales are being made constantly from finished stock and manufacture
replenishes the stock. But the essential step before profits can be claimed, viz.,
making the sale, usually comes after the process of manufacture and not
before. It may sometimes happen that stock is sold out ahead of its
manufacture, because the factory is not able to keep up with sales. It is not
intended here to include the case in which it is the custom of the trade to sell
goods in advance of their manufacture and regulate the operation of the factory
to turning out the advance orders booked. This will be considered later. The
discussion here concerns those firms which usually keep their finished stock
well ahead of sales but because of the exigencies of the market find themselves
behind their sales. Such a situation is sometimes called a sellers’ market. If
purchasers contract for goods with full knowledge of factory conditions, such
sales are in the nature of work on contract and might in unusual instances be so
treated. Usually, however, conservative management requires that no profits be
taken under such circumstances.
Goods Made to Order
Where the factory works only on order, conditions as to profit-taking are
somewhat changed. Here, the sale has already been made for delivery of the
product at some future time, named or left indefinite. While, of course,
cancellation of the order is always possible before date of delivery and
acceptance, inasmuch as here we have under consideration a special product
made to individual specifications and not a stock or standardized article,
cancellation of the contract is not probable without incurrence of damages or
even being held to specific performance. Under these circumstances it is
apparent that, within reasonable limits, a portion of the profit may be taken up
in the current period, which has, of course, done a portion of the work and
therefore earned a portion of the profit, if there is one. This last contingency is,
of course, the crux of the whole problem. If a portion of the profit is taken, this
necessitates a predetermination of profit on the whole contract, an estimate of
the portion of the contract completed, and adequate provision for unforeseen
Page 338
difficulties in completing the work. Where conditions are such that these things
can be done with any degree of certainty, there is not only no objection to
taking up a portion of the profit for the current period, but it is the only way in
which profits may be allocated to the period earning them and so stabilized
somewhat as between periods. As has been said already a number of times, the
summary of results at the close of regular periods is in many cases based on
estimate, which in the final analysis is merely the expression of an opinion. If
the estimates are made with due care, in the light of all available information
and probable contingencies, and without intent to deceive or defraud, more
than that cannot be asked of any concern.
The practical application of this principle requires consideration. In some
few cases the volume of product passing through the factory will be fairly
constant as between periods. Where this is so—and frequent tests should be
made to establish it—it would be a useless expenditure of effort to make the
estimates necessary for determining profits on uncompleted work. The same
situation is met with also in concerns where the unit of work is small. Here the
effort, entailed in making the estimate is more than offset by any advantage
gained thereby. If the product is somewhat standardized, it may be possible as
a result of past experience to make a rough estimate on the basis of the volume
of work in progress instead of by means of an examination of the conditions of
each contract. Such a policy is fraught with many pitfalls and, as a usual thing,
does not commend itself to conservative management; speculative conditions
are too many.
Profits on Long-Term Contracts
Where the unit of work is large, conditions are somewhat different,
however. The necessary estimates are not based on so many uncertainties, and,
oftentimes, financial considerations and an equitable treatment of stockholders
demand the determination of profits on work in progress. Thus, one contract
extending over a number of years may occupy the entire attention and facilities
of a concern. To withhold profits if earned, until the completion of the contract
might work a real injustice. Such contracts are usually financed by means of
periodic payments on account, based on a careful estimate by the supervising
engineer or architect of the portion completed on such dates. As these
estimates are sufficiently accurate on which to base payment of contract price,
they can be allowed to serve as the basis for a determination of profits after
liberal reserves for contingencies are made.
can be done with any degree of certainty, there is not only no objection to
taking up a portion of the profit for the current period, but it is the only way in
which profits may be allocated to the period earning them and so stabilized
somewhat as between periods. As has been said already a number of times, the
summary of results at the close of regular periods is in many cases based on
estimate, which in the final analysis is merely the expression of an opinion. If
the estimates are made with due care, in the light of all available information
and probable contingencies, and without intent to deceive or defraud, more
than that cannot be asked of any concern.
The practical application of this principle requires consideration. In some
few cases the volume of product passing through the factory will be fairly
constant as between periods. Where this is so—and frequent tests should be
made to establish it—it would be a useless expenditure of effort to make the
estimates necessary for determining profits on uncompleted work. The same
situation is met with also in concerns where the unit of work is small. Here the
effort, entailed in making the estimate is more than offset by any advantage
gained thereby. If the product is somewhat standardized, it may be possible as
a result of past experience to make a rough estimate on the basis of the volume
of work in progress instead of by means of an examination of the conditions of
each contract. Such a policy is fraught with many pitfalls and, as a usual thing,
does not commend itself to conservative management; speculative conditions
are too many.
Profits on Long-Term Contracts
Where the unit of work is large, conditions are somewhat different,
however. The necessary estimates are not based on so many uncertainties, and,
oftentimes, financial considerations and an equitable treatment of stockholders
demand the determination of profits on work in progress. Thus, one contract
extending over a number of years may occupy the entire attention and facilities
of a concern. To withhold profits if earned, until the completion of the contract
might work a real injustice. Such contracts are usually financed by means of
periodic payments on account, based on a careful estimate by the supervising
engineer or architect of the portion completed on such dates. As these
estimates are sufficiently accurate on which to base payment of contract price,
they can be allowed to serve as the basis for a determination of profits after
liberal reserves for contingencies are made.
Page 339
The nature and terms of the contract itself will usually indicate the method
of estimating the profit. If the price agreed upon is for the contract as a whole,
then extraordinary care must be exercised in estimating the portion completed
and almost a seer’s prevision of the requirements to complete is needed. If, on
the other hand, the contract is broken into smaller units on which price is based
and there is no guarantee as to the number of units in the contract, profit may
be taken on the number of units completed. Thus, a contract calling for
excavation of earth or other material may be taken at a named price per cubic
yard. The building of a canal, the driving of a tunnel, the construction of a dam
and reservoir, are frequently handled on this or a similar basis. So, also, the use
of a concern’s equipment and organization on a per diem basis. Under these
conditions each fiscal period can safely take its profits or losses with little
regard for the uncompleted portion of the work. Contracts taken on a so-called
“cost plus” basis, i.e., at cost plus a definitely agreed upon per cent of profit,
may have their profits determined without consideration of the uncompleted
portion.
Profit on Goods Awaiting Delivery
Similar to the problem of profits on work in progress is that of profits on
goods awaiting delivery. The goods have been sold, are completed, and may
even be prepared for shipment. All that remains is delivery and that cannot be
effected until the date agreed upon. In some lines of trade this method of sale
is a time-honored and even necessary custom. The practice is found in some
kinds of clothing industries, woolen manufactures, farm implements, etc. Here
because the product is a standard product, cancellations take place and are
usually allowed right up to, and in some instances beyond, the date of
shipment. Because of this trade practice, profits should never be taken until
delivery has been effected. To a similar or even greater extent than with work
in progress, costs and expenses are under this principle incurred and charged in
one period and the profit is taken in another period which is not thus charged
with the cost of getting the income.
Two methods of handling the difficulty are met. The one operates on the
expectation that the volume of such orders awaiting delivery is fairly constant
as between periods; hence, the income from goods of this sort delivered during
the current period is charged with the costs and expenses of goods to be
delivered in future periods. This is the rule-of-thumb method to be used where
accurate allocation of costs is neither necessary nor justified by results.
of estimating the profit. If the price agreed upon is for the contract as a whole,
then extraordinary care must be exercised in estimating the portion completed
and almost a seer’s prevision of the requirements to complete is needed. If, on
the other hand, the contract is broken into smaller units on which price is based
and there is no guarantee as to the number of units in the contract, profit may
be taken on the number of units completed. Thus, a contract calling for
excavation of earth or other material may be taken at a named price per cubic
yard. The building of a canal, the driving of a tunnel, the construction of a dam
and reservoir, are frequently handled on this or a similar basis. So, also, the use
of a concern’s equipment and organization on a per diem basis. Under these
conditions each fiscal period can safely take its profits or losses with little
regard for the uncompleted portion of the work. Contracts taken on a so-called
“cost plus” basis, i.e., at cost plus a definitely agreed upon per cent of profit,
may have their profits determined without consideration of the uncompleted
portion.
Profit on Goods Awaiting Delivery
Similar to the problem of profits on work in progress is that of profits on
goods awaiting delivery. The goods have been sold, are completed, and may
even be prepared for shipment. All that remains is delivery and that cannot be
effected until the date agreed upon. In some lines of trade this method of sale
is a time-honored and even necessary custom. The practice is found in some
kinds of clothing industries, woolen manufactures, farm implements, etc. Here
because the product is a standard product, cancellations take place and are
usually allowed right up to, and in some instances beyond, the date of
shipment. Because of this trade practice, profits should never be taken until
delivery has been effected. To a similar or even greater extent than with work
in progress, costs and expenses are under this principle incurred and charged in
one period and the profit is taken in another period which is not thus charged
with the cost of getting the income.
Two methods of handling the difficulty are met. The one operates on the
expectation that the volume of such orders awaiting delivery is fairly constant
as between periods; hence, the income from goods of this sort delivered during
the current period is charged with the costs and expenses of goods to be
delivered in future periods. This is the rule-of-thumb method to be used where
accurate allocation of costs is neither necessary nor justified by results.
Page 340
The other and more accurate method consists of deferring the costs and
expenses properly applicable to the deferred income. But the difficulty of
determining just what expenses are so applicable often causes this method to
break down, giving less accurate and dependable results than the first. The
roseate optimism of the average proprietor or manager as to his own business
almost always results in a too liberal estimate of the portion of expense to be
applied against the deferred income. In treating this problem of profits in
connection with contracts and the length of the cost period (Chapter XIII), the
principle was stated that such goods should be included in the inventory at
cost. This results in deferring the main item of cost, but omitting the further
costs of selling and administration which belong to all sales effort made and to
the progress of the order up to the point of delivery. While theoretically these
should be deferred, practically the estimate of the amount to be deferred
should lean on the side of too little rather than too much. Where, as stated
above, the volume of this kind of trade is fairly constant, the rule-of-thumb
method first stated gives more satisfactory and safer results.
Interdepartment Profits
The problem of interdepartment profits was stated and discussed briefly in
Chapter XIII, page 233, and will later be treated in another connection (see
page 607 following). Here, it may be repeated that while such profits are not to
be allowed because they are not yet realized, they may, under exceptional
circumstances, be estimated and shown if offset by reserves of an exactly equal
amount.
Profits Due to Appreciation of Assets
The problem of profits due to appreciation of assets, both fixed and
current, has also been handled in the chapters on valuing the various assets. All
that need be said here is that such profits are not realized until the asset is sold.
While for purposes of credit it may be wise and proper to show the true
valuation of the assets, for the purpose of profits, particularly profits available
for dividends, such appreciation in values must not be taken into account. It
should be remembered that appreciating the value of fixed assets frequently
results in the necessity of meeting higher depreciation charges and is thus not
an unalloyed gain. The payment of dividends based on such profits would,
without taking profits from other sources into consideration, always result in
the diminution of the fund of working capital.
Capital Profits
expenses properly applicable to the deferred income. But the difficulty of
determining just what expenses are so applicable often causes this method to
break down, giving less accurate and dependable results than the first. The
roseate optimism of the average proprietor or manager as to his own business
almost always results in a too liberal estimate of the portion of expense to be
applied against the deferred income. In treating this problem of profits in
connection with contracts and the length of the cost period (Chapter XIII), the
principle was stated that such goods should be included in the inventory at
cost. This results in deferring the main item of cost, but omitting the further
costs of selling and administration which belong to all sales effort made and to
the progress of the order up to the point of delivery. While theoretically these
should be deferred, practically the estimate of the amount to be deferred
should lean on the side of too little rather than too much. Where, as stated
above, the volume of this kind of trade is fairly constant, the rule-of-thumb
method first stated gives more satisfactory and safer results.
Interdepartment Profits
The problem of interdepartment profits was stated and discussed briefly in
Chapter XIII, page 233, and will later be treated in another connection (see
page 607 following). Here, it may be repeated that while such profits are not to
be allowed because they are not yet realized, they may, under exceptional
circumstances, be estimated and shown if offset by reserves of an exactly equal
amount.
Profits Due to Appreciation of Assets
The problem of profits due to appreciation of assets, both fixed and
current, has also been handled in the chapters on valuing the various assets. All
that need be said here is that such profits are not realized until the asset is sold.
While for purposes of credit it may be wise and proper to show the true
valuation of the assets, for the purpose of profits, particularly profits available
for dividends, such appreciation in values must not be taken into account. It
should be remembered that appreciating the value of fixed assets frequently
results in the necessity of meeting higher depreciation charges and is thus not
an unalloyed gain. The payment of dividends based on such profits would,
without taking profits from other sources into consideration, always result in
the diminution of the fund of working capital.
Capital Profits
Page 341
There remains a final problem, viz., that of capital profits, which is more a
question of their disposition than determination. When any of the fixed assets
are sold, the profits, if any, are classed as capital profits. These are as
legitimate as those arising from sale of stock-in-trade or other source, and
belong to the owners. The question of their disposition hinges mostly on
practical considerations. If the sale is for cash, funds are available for
distribution without encroaching upon the working capital. If not for cash,
payment of dividends based on such profits might seriously diminish working
capital. The question as to whether capital profits should ever be distributed is,
of course, a mooted one. Many well-known cases of such distribution—the so-
called cutting of juicy melons—are on record. Conditions seem to justify their
payment at times, and under other equally impelling conditions distribution of
them should not be made. As a general policy it is always safe to set aside such
profits in a special reserve to be used to care for capital losses. If the company
is well provided with such reserves beyond any reasonable doubt, it is
oftentimes unwise and unjust to withhold their distribution. Of a similar nature
and to be handled under like considerations are the profits arising from sale of
capital stock at a premium, the reissue of forfeited stock, etc.
In concluding this subject no better summarization of the accounting
principles and practical considerations to govern in the determination of profits
can be given than the following from A. Lowes Dickinson:[61]
“1. All waste, both of fixed and circulating assets, incident to the process of
earning profits by the conversion of circulating assets must be made good out
of the profits earned.
2. Profits realized on sales of fixed assets should be first applied to make
good estimated depreciation (if any) in other fixed assets not resulting from the
ordinary conduct of the business. If there is no such depreciation, such profits
may be distributed as dividends, but should be distinguished from the
operating profits.
3. A sufficient surplus should be accumulated (in addition to the provisions
required to maintain wasting capital assets) for the purpose of making good
losses due to shrinkage in values of fixed assets arising from causes other than
the ordinary operations of the company. This provision must, however, be
considered more a question of policy than a requirement of sound accounting.”
question of their disposition than determination. When any of the fixed assets
are sold, the profits, if any, are classed as capital profits. These are as
legitimate as those arising from sale of stock-in-trade or other source, and
belong to the owners. The question of their disposition hinges mostly on
practical considerations. If the sale is for cash, funds are available for
distribution without encroaching upon the working capital. If not for cash,
payment of dividends based on such profits might seriously diminish working
capital. The question as to whether capital profits should ever be distributed is,
of course, a mooted one. Many well-known cases of such distribution—the so-
called cutting of juicy melons—are on record. Conditions seem to justify their
payment at times, and under other equally impelling conditions distribution of
them should not be made. As a general policy it is always safe to set aside such
profits in a special reserve to be used to care for capital losses. If the company
is well provided with such reserves beyond any reasonable doubt, it is
oftentimes unwise and unjust to withhold their distribution. Of a similar nature
and to be handled under like considerations are the profits arising from sale of
capital stock at a premium, the reissue of forfeited stock, etc.
In concluding this subject no better summarization of the accounting
principles and practical considerations to govern in the determination of profits
can be given than the following from A. Lowes Dickinson:[61]
“1. All waste, both of fixed and circulating assets, incident to the process of
earning profits by the conversion of circulating assets must be made good out
of the profits earned.
2. Profits realized on sales of fixed assets should be first applied to make
good estimated depreciation (if any) in other fixed assets not resulting from the
ordinary conduct of the business. If there is no such depreciation, such profits
may be distributed as dividends, but should be distinguished from the
operating profits.
3. A sufficient surplus should be accumulated (in addition to the provisions
required to maintain wasting capital assets) for the purpose of making good
losses due to shrinkage in values of fixed assets arising from causes other than
the ordinary operations of the company. This provision must, however, be
considered more a question of policy than a requirement of sound accounting.”
Page 342
CHAPTER XXIII
SURPLUS AND RESERVES
Definition
Under the corporate form of organization, “surplus” in its broadest sense
represents the difference between the net worth of the business and the capital
stock issued and outstanding. Because of the legal requirement that the value of
the capital stock be shown always at the original amount—which is usually par—
any increments or decrements in value because of profits or losses made and
reinvested in the enterprise must be shown under separate heads. Thus surplus—
or deficit—is the general term to indicate this increase in value. In England the
term “rest” is used in almost this same sense. “Margin” is also a title occasionally
seen.
Because of a much narrower technical meaning given to surplus, the general
adoption of another term with the broader connotation above given would serve a
really useful purpose. Of the titles in use, margin seems best to express the exact
shade of meaning. In the interest of a standard terminology, the highest
accounting authorities are coming to restrict surplus to that portion of the margin
available for dividends and in that sense the word will be used in this chapter.
Contrary uses of the word are frequently met. In banking institutions the surplus
is almost as inviolable as the capital stock itself and is never used for dividend
purposes. In government-controlled or supervised institutions, these special uses
of the term have become too well established by law and custom ever to hope for
a change in the interest of general uniformity.
Creation of Margin
The sources of the margin have for the most part been already indicated. The
chief source is the net profit for the period as determined by the Profit and Loss
account balance. What enters into that balance has been discussed in Chapter
XXII, where it was also pointed out that under some circumstances it may be
entirely legitimate to carry some temporary proprietorship items directly to a
vested proprietorship account instead of by way of the summary account. Thus
there may be other sources of margin than the current balance of Profit and Loss
—extraordinary items whose inclusion with current summaries of operation
SURPLUS AND RESERVES
Definition
Under the corporate form of organization, “surplus” in its broadest sense
represents the difference between the net worth of the business and the capital
stock issued and outstanding. Because of the legal requirement that the value of
the capital stock be shown always at the original amount—which is usually par—
any increments or decrements in value because of profits or losses made and
reinvested in the enterprise must be shown under separate heads. Thus surplus—
or deficit—is the general term to indicate this increase in value. In England the
term “rest” is used in almost this same sense. “Margin” is also a title occasionally
seen.
Because of a much narrower technical meaning given to surplus, the general
adoption of another term with the broader connotation above given would serve a
really useful purpose. Of the titles in use, margin seems best to express the exact
shade of meaning. In the interest of a standard terminology, the highest
accounting authorities are coming to restrict surplus to that portion of the margin
available for dividends and in that sense the word will be used in this chapter.
Contrary uses of the word are frequently met. In banking institutions the surplus
is almost as inviolable as the capital stock itself and is never used for dividend
purposes. In government-controlled or supervised institutions, these special uses
of the term have become too well established by law and custom ever to hope for
a change in the interest of general uniformity.
Creation of Margin
The sources of the margin have for the most part been already indicated. The
chief source is the net profit for the period as determined by the Profit and Loss
account balance. What enters into that balance has been discussed in Chapter
XXII, where it was also pointed out that under some circumstances it may be
entirely legitimate to carry some temporary proprietorship items directly to a
vested proprietorship account instead of by way of the summary account. Thus
there may be other sources of margin than the current balance of Profit and Loss
—extraordinary items whose inclusion with current summaries of operation
Page 343
would render those summaries useless as a guide for judging comparative results
of various periods.
Capital Stock Premiums. Sometimes, for the purpose of creating a margin at
the inception of an enterprise a fund is contributed beyond the par value of the
capital stock issued. This is accomplished by purchase of the stock at a premium,
and is frequently seen in banking institutions, where it serves as an easy and
speedy way to satisfy the law’s requirements for the accumulation of a “surplus.”
The effect of this is to give the institution a better standing than it would
otherwise have. The reduction of the capital stock outstanding without full
recompense to the stockholder also results in the creation of margin. This is often
done in reorganizations when fewer shares of the new stock are given than were
held of the old. The effect, then, is to set up a book profit against which may be
charged the existing deficit, and so secure a balance between the real net worth
and the par of the new stock issue.
Stock Donation. Another source of margin is a stock donation. This may
result in only a book profit. It is exceedingly difficult and generally impossible to
determine the true value of many speculative ventures, such as mining
enterprises. As a general rule, capitalization based on opinion is usually
overcapitalization. While a stock donation may have no relation to real values
and is merely a method of securing working capital, its effect when the stock is
sold is to increase the cash asset and show a profit of an equal amount. Some
authorities hold that instead of retaining the profit on the books, the logical thing
is to reduce the carrying values of the speculative assets by the amount of the
realized profit on stock donation. There would be more reason for this treatment
were there any real relationship between the amount of the stock donation and
the overvaluation of the assets. Since usually there is none and the whole
undertaking is speculative, there is no valid objection to showing the realized
profit, as the public is sufficiently warned by the nature of the enterprise. All
stock donation is not of this sort, however. Occasionally a very real profit results
which should be treated as a margin item.
Stock Assessments, etc. Similar to a stock donation is a stock assessment. In
cases of reorganization or of impending bankruptcy, a pro rata assessment is
levied on the outstanding shares. Being a donation, it constitutes a proprietorship
increase item and becomes a part of the margin. This method is frequently used
for the purpose of wiping out a deficit, an impairment of capital, and is, of
course, a real profit as distinguished from a book profit. Similarly, additional
payments made by common shareholders to convert their holdings into preferred
shares are a realized profit and should be recorded as part of the margin.
of various periods.
Capital Stock Premiums. Sometimes, for the purpose of creating a margin at
the inception of an enterprise a fund is contributed beyond the par value of the
capital stock issued. This is accomplished by purchase of the stock at a premium,
and is frequently seen in banking institutions, where it serves as an easy and
speedy way to satisfy the law’s requirements for the accumulation of a “surplus.”
The effect of this is to give the institution a better standing than it would
otherwise have. The reduction of the capital stock outstanding without full
recompense to the stockholder also results in the creation of margin. This is often
done in reorganizations when fewer shares of the new stock are given than were
held of the old. The effect, then, is to set up a book profit against which may be
charged the existing deficit, and so secure a balance between the real net worth
and the par of the new stock issue.
Stock Donation. Another source of margin is a stock donation. This may
result in only a book profit. It is exceedingly difficult and generally impossible to
determine the true value of many speculative ventures, such as mining
enterprises. As a general rule, capitalization based on opinion is usually
overcapitalization. While a stock donation may have no relation to real values
and is merely a method of securing working capital, its effect when the stock is
sold is to increase the cash asset and show a profit of an equal amount. Some
authorities hold that instead of retaining the profit on the books, the logical thing
is to reduce the carrying values of the speculative assets by the amount of the
realized profit on stock donation. There would be more reason for this treatment
were there any real relationship between the amount of the stock donation and
the overvaluation of the assets. Since usually there is none and the whole
undertaking is speculative, there is no valid objection to showing the realized
profit, as the public is sufficiently warned by the nature of the enterprise. All
stock donation is not of this sort, however. Occasionally a very real profit results
which should be treated as a margin item.
Stock Assessments, etc. Similar to a stock donation is a stock assessment. In
cases of reorganization or of impending bankruptcy, a pro rata assessment is
levied on the outstanding shares. Being a donation, it constitutes a proprietorship
increase item and becomes a part of the margin. This method is frequently used
for the purpose of wiping out a deficit, an impairment of capital, and is, of
course, a real profit as distinguished from a book profit. Similarly, additional
payments made by common shareholders to convert their holdings into preferred
shares are a realized profit and should be recorded as part of the margin.
Page 344
Capital Profits and Bonuses. Capital profits, as discussed in Chapter XXII,
have their proper place of record direct into some margin account rather than by
way of the current Profit and Loss. Donations from the outside, such as factory
sites and other bonuses, sometimes given to induce enterprises to locate in
certain places, must also be treated as entries direct to a margin account. These
and other like items constitute the chief sources of the margin.
Disposition of Profits
The statement of profit and loss carries the summary of operations to the
point of showing a net profit or a loss for the period. The next step for
consideration is the disposition made of these profits. This is sometimes spoken
of as the appropriation of profits. Two practices are met at this point. Under the
one, appropriation is made directly from Profit and Loss for all desired purposes.
Any unappropriated balance goes into Surplus account, which will represent the
balance of profits available for dividends but not used. Under the other, the Profit
and Loss balance is transferred to Surplus out of which all appropriations are
made, the residue remaining therein showing the same condition as under the
first method. Where this second method is followed—and it is more prevalent
than the first—a statement of surplus is needed for full information of the
period’s transactions, thus providing a connecting link between the statement of
profit and loss and the balance sheet. The form of this statement is given on page
426.
Reserves
From the point of view of the stockholder’s immediate interest, the
appropriation of profits for dividends is his chief concern. Other and equally vital
and urgent uses are found for profits in any well-managed concern with an
expanding outlook towards the future. The appropriations of these profits to
definite uses are very generally carried under the title of reserves with suitable
descriptive phrases. Thus we may have a Sinking Fund Reserve, an Insurance
Reserve, a Building Fund Reserve. Sometimes these are called “reserve funds”
but the demands of an accurate nomenclature limit the use of “fund” to an asset
account. The title “undivided profits” is also met. Where careful differentiation is
made, “surplus” should be used to denote profits available for dividends;
“reserve,” for profits set aside for a specific purpose; and “undivided profits,” for
those on which no definite action has been taken.
Different Meanings of Reserve
have their proper place of record direct into some margin account rather than by
way of the current Profit and Loss. Donations from the outside, such as factory
sites and other bonuses, sometimes given to induce enterprises to locate in
certain places, must also be treated as entries direct to a margin account. These
and other like items constitute the chief sources of the margin.
Disposition of Profits
The statement of profit and loss carries the summary of operations to the
point of showing a net profit or a loss for the period. The next step for
consideration is the disposition made of these profits. This is sometimes spoken
of as the appropriation of profits. Two practices are met at this point. Under the
one, appropriation is made directly from Profit and Loss for all desired purposes.
Any unappropriated balance goes into Surplus account, which will represent the
balance of profits available for dividends but not used. Under the other, the Profit
and Loss balance is transferred to Surplus out of which all appropriations are
made, the residue remaining therein showing the same condition as under the
first method. Where this second method is followed—and it is more prevalent
than the first—a statement of surplus is needed for full information of the
period’s transactions, thus providing a connecting link between the statement of
profit and loss and the balance sheet. The form of this statement is given on page
426.
Reserves
From the point of view of the stockholder’s immediate interest, the
appropriation of profits for dividends is his chief concern. Other and equally vital
and urgent uses are found for profits in any well-managed concern with an
expanding outlook towards the future. The appropriations of these profits to
definite uses are very generally carried under the title of reserves with suitable
descriptive phrases. Thus we may have a Sinking Fund Reserve, an Insurance
Reserve, a Building Fund Reserve. Sometimes these are called “reserve funds”
but the demands of an accurate nomenclature limit the use of “fund” to an asset
account. The title “undivided profits” is also met. Where careful differentiation is
made, “surplus” should be used to denote profits available for dividends;
“reserve,” for profits set aside for a specific purpose; and “undivided profits,” for
those on which no definite action has been taken.
Different Meanings of Reserve
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Because of the loose way in which the term reserve is used by the layman and
its different uses by the professional accountant, an examination of these uses
will be made at this point. As a distinctive banking term, “reserve” is used to
indicate the amount of cash and cash items on hand and on deposit which under
the law may be counted as a cash reserve fund held against deposits and note
issues. This use of “reserve” is limited strictly to financial institutions.
We find also various so-called reserves shown on the commercial balance
sheet, both among the liabilities and the assets. As deductions from the assets are
the various depreciation reserves and reserves for bad and doubtful accounts and
notes receivable. These items are “offsets” to the carrying values of the assets in
order to effect a true valuation of them. For reasons previously set forth, these
offsets are carried in accounts separate from their corresponding assets. Thus
they are in the nature of suspended credits to asset accounts and, if properly
estimated, are in no sense related to profits; nor have they any of the elements of
profits or proprietorship in them. It is unfortunate that there is lacking an
adequate title, other than reserve, for this group of items. The terms “allowance”
and “estimate” have been suggested, but so far have not found general favor. This
group of reserves are called valuation reserves.
Reserve for Bad Debts
A fine distinction is sometimes drawn between the reserve for depreciation
and the reserve for doubtful accounts, on the ground that at the time of the
creation of the reserve in the one case, the depreciation is an accomplished fact,
all that is then required being a fair estimate of it; whereas in the other case no
particular account is known to be uncollectible, business experience teaching,
however, that in the aggregate there will be some loss from this source. The
purpose of this reserve is to bring about as on a given date an appraisal of the
claims against customers in the light of past experience, and so apply the expense
due to this cause to the period in which the sale transaction took place. This
purpose is not always accurately accomplished but the estimate at the close of
each period does effect an equalizing of the bad debts expense from year to year.
This distinction makes the reserve for doubtful accounts closely approximate to a
contingent reserve, as will be seen later. It seems best, however, to hold to the
original classification and include the bad debts reserve with the other valuation
reserves.
Under- and Over-Estimate of Reserves
Inasmuch as these reserves must from the nature of things always be
estimates, the probability exists of an under-or over-estimate. It is apparent that
its different uses by the professional accountant, an examination of these uses
will be made at this point. As a distinctive banking term, “reserve” is used to
indicate the amount of cash and cash items on hand and on deposit which under
the law may be counted as a cash reserve fund held against deposits and note
issues. This use of “reserve” is limited strictly to financial institutions.
We find also various so-called reserves shown on the commercial balance
sheet, both among the liabilities and the assets. As deductions from the assets are
the various depreciation reserves and reserves for bad and doubtful accounts and
notes receivable. These items are “offsets” to the carrying values of the assets in
order to effect a true valuation of them. For reasons previously set forth, these
offsets are carried in accounts separate from their corresponding assets. Thus
they are in the nature of suspended credits to asset accounts and, if properly
estimated, are in no sense related to profits; nor have they any of the elements of
profits or proprietorship in them. It is unfortunate that there is lacking an
adequate title, other than reserve, for this group of items. The terms “allowance”
and “estimate” have been suggested, but so far have not found general favor. This
group of reserves are called valuation reserves.
Reserve for Bad Debts
A fine distinction is sometimes drawn between the reserve for depreciation
and the reserve for doubtful accounts, on the ground that at the time of the
creation of the reserve in the one case, the depreciation is an accomplished fact,
all that is then required being a fair estimate of it; whereas in the other case no
particular account is known to be uncollectible, business experience teaching,
however, that in the aggregate there will be some loss from this source. The
purpose of this reserve is to bring about as on a given date an appraisal of the
claims against customers in the light of past experience, and so apply the expense
due to this cause to the period in which the sale transaction took place. This
purpose is not always accurately accomplished but the estimate at the close of
each period does effect an equalizing of the bad debts expense from year to year.
This distinction makes the reserve for doubtful accounts closely approximate to a
contingent reserve, as will be seen later. It seems best, however, to hold to the
original classification and include the bad debts reserve with the other valuation
reserves.
Under- and Over-Estimate of Reserves
Inasmuch as these reserves must from the nature of things always be
estimates, the probability exists of an under-or over-estimate. It is apparent that
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an under-estimate effects an inflation of profits due to an overvaluation of the
assets. Equally apparent is it that an over-estimate brings about an
understatement of profits due to an undervaluation of the assets. The effect of this
is to make the valuation reserve account a mixed account. Instead of its content
being solely a suspended credit to an asset, it includes also a true reserve of
profits. If at any time the facts indicate a too liberal or too parsimonious estimate
in the past, adjustment should be made to accord with the newly determined facts
of experience. An immediate adjustment is usually preferable to a gradual one
effected by an allowance below or above the new basis determined for the
estimate.
Depletion Reserves
Similar to the depreciation reserve is the depletion reserve. On the basis of
the value at which the wasting or depleting asset was originally brought upon the
books, a periodic estimate of the portion used up in operation is necessary to
show the true present value of the asset. Thus, timber and mining properties
require for their periodic appraisal an estimate of the extent of exhaustion of the
natural product. This is neither required by law nor always by business policy.
But when the estimate is made it is in the nature of a valuation reserve and will
be so classed here.
Operating Reserves for Accrued Costs
Another group of items, frequently carried under the title reserves, includes
estimates of expenses the exact amount of which is not known at the time of
closing the books, and sometimes those of which the exact amount is known but
which are unpaid as on that date. Among the first are such items as taxes, sales
discounts, and the like. Among the second are wages, salaries, rents, etc.,
accrued. These two classes are together sometimes called “operating reserves.”
There is some difference of opinion with regard to the proper allocation of
taxes and estimated sales discounts. Inasmuch as taxes are not usually
determined, or at least payable, during the period covered by them, there is a
temptation to defer their incidence to a later period. If the taxes become a claim
of the state against the property as on a given date, certainly they should be
treated as applicable to the period covered by the claim even though the amount
of them cannot with accuracy be determined.
With regard to sales discount, the situation is somewhat analogous. At the
close of any fiscal period, some of the open claims against customers are by the
sales contract subject to discount, and experience proves that some of these
assets. Equally apparent is it that an over-estimate brings about an
understatement of profits due to an undervaluation of the assets. The effect of this
is to make the valuation reserve account a mixed account. Instead of its content
being solely a suspended credit to an asset, it includes also a true reserve of
profits. If at any time the facts indicate a too liberal or too parsimonious estimate
in the past, adjustment should be made to accord with the newly determined facts
of experience. An immediate adjustment is usually preferable to a gradual one
effected by an allowance below or above the new basis determined for the
estimate.
Depletion Reserves
Similar to the depreciation reserve is the depletion reserve. On the basis of
the value at which the wasting or depleting asset was originally brought upon the
books, a periodic estimate of the portion used up in operation is necessary to
show the true present value of the asset. Thus, timber and mining properties
require for their periodic appraisal an estimate of the extent of exhaustion of the
natural product. This is neither required by law nor always by business policy.
But when the estimate is made it is in the nature of a valuation reserve and will
be so classed here.
Operating Reserves for Accrued Costs
Another group of items, frequently carried under the title reserves, includes
estimates of expenses the exact amount of which is not known at the time of
closing the books, and sometimes those of which the exact amount is known but
which are unpaid as on that date. Among the first are such items as taxes, sales
discounts, and the like. Among the second are wages, salaries, rents, etc.,
accrued. These two classes are together sometimes called “operating reserves.”
There is some difference of opinion with regard to the proper allocation of
taxes and estimated sales discounts. Inasmuch as taxes are not usually
determined, or at least payable, during the period covered by them, there is a
temptation to defer their incidence to a later period. If the taxes become a claim
of the state against the property as on a given date, certainly they should be
treated as applicable to the period covered by the claim even though the amount
of them cannot with accuracy be determined.
With regard to sales discount, the situation is somewhat analogous. At the
close of any fiscal period, some of the open claims against customers are by the
sales contract subject to discount, and experience proves that some of these
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discounts will be taken advantage of. Here also, difference of opinion prevails as
to the proper allocation of the expense. Should the period in which the sale is
made suffer the loss, or should it be charged to the one in which the discount is
taken? If sales discount is looked upon either as a direct deduction from sales or
as a selling expense, certainly it should be charged to the period making the sale.
On the other hand, if it is regarded as an item of financial management, a means
of securing ready funds, it is sometimes argued (though this is not the usual point
of view) that the period enjoying the benefit should also be charged with the
expense of securing the benefit. Against this argument it may be pointed out that
the current period carrying the customers’ accounts which are subject to discount
fails to show its liability, based on the sales agreement, to accept something less
than the face amount of the claims. A balance sheet in which no suitable
provision is made therefor is one which does not reflect the true status of all
items, and to that extent is not a good balance sheet. Provision should be made
not only for those expenses which are known to have been incurred and which
remain unpaid, but also for those which the statistics of experience show will
have to be met. Conservative practice, therefore, requires the inclusion of this
estimate and applies it as an expense of the period in which the originating
transaction took place. All the costs of the contract entered into, of which
expected sales discount is one, are made to apply to the period giving rise to the
contract.
Collection Costs not under Contract
The above argument is occasionally made use of in support of the inclusion
of expected collection costs on claims against customers outstanding at the close
of a period. From a theoretical aspect the point may be argued, but, unlike the
item of sales discount, these are not costs which the concern is liable for under
contract. From a practical standpoint, except under very unusual conditions, it is
an undesirable refinement of the principle of allocation of costs as between
periods. Where a collection department is maintained, costs of collection are
practically uniform from period to period and are best considered as expenses of
the period in which the cost is incurred.
Sales Discounts on the Balance Sheet
As to the manner of showing expected sales discounts on the balance sheet,
practice is not uniform. It is sometimes shown added to the reserve for doubtful
accounts and the sum of the two deducted from claims against customers,
indicating thus the amount which it is expected can be realized therefrom. Others
show it among the liabilities, on the ground that it differs from the estimate for
to the proper allocation of the expense. Should the period in which the sale is
made suffer the loss, or should it be charged to the one in which the discount is
taken? If sales discount is looked upon either as a direct deduction from sales or
as a selling expense, certainly it should be charged to the period making the sale.
On the other hand, if it is regarded as an item of financial management, a means
of securing ready funds, it is sometimes argued (though this is not the usual point
of view) that the period enjoying the benefit should also be charged with the
expense of securing the benefit. Against this argument it may be pointed out that
the current period carrying the customers’ accounts which are subject to discount
fails to show its liability, based on the sales agreement, to accept something less
than the face amount of the claims. A balance sheet in which no suitable
provision is made therefor is one which does not reflect the true status of all
items, and to that extent is not a good balance sheet. Provision should be made
not only for those expenses which are known to have been incurred and which
remain unpaid, but also for those which the statistics of experience show will
have to be met. Conservative practice, therefore, requires the inclusion of this
estimate and applies it as an expense of the period in which the originating
transaction took place. All the costs of the contract entered into, of which
expected sales discount is one, are made to apply to the period giving rise to the
contract.
Collection Costs not under Contract
The above argument is occasionally made use of in support of the inclusion
of expected collection costs on claims against customers outstanding at the close
of a period. From a theoretical aspect the point may be argued, but, unlike the
item of sales discount, these are not costs which the concern is liable for under
contract. From a practical standpoint, except under very unusual conditions, it is
an undesirable refinement of the principle of allocation of costs as between
periods. Where a collection department is maintained, costs of collection are
practically uniform from period to period and are best considered as expenses of
the period in which the cost is incurred.
Sales Discounts on the Balance Sheet
As to the manner of showing expected sales discounts on the balance sheet,
practice is not uniform. It is sometimes shown added to the reserve for doubtful
accounts and the sum of the two deducted from claims against customers,
indicating thus the amount which it is expected can be realized therefrom. Others
show it among the liabilities, on the ground that it differs from the estimate for
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bad debts in that it is an expense for which the concern has made itself liable
under its sales contract. The distinction is finely drawn but probably well taken.
Distinction between Reserves and Accrued Items
The use of the title reserve for some of the items included as operating
reserves is unfortunate and leads to confusion both in terminology and in
understanding. Why unpaid expenses of any kind should be called reserves for
expenses when the amount of them is definitely known has never been
satisfactorily explained; yet the practice is sometimes met. There is some excuse
in the case of expense items the amount of which cannot be definitely determined
either from the nature of the item itself or other conditions over which the
concern has no control. Thus, “Reserve for Wages” is usually a misnomer, the
title “Wages Accrued” showing the item correctly; but “Reserve for Taxes,”
while just as true a liability as the other item, may be justified on the ground that
the latter is only an estimate subject to correction when the exact amount is
known, whereas the former is already definitely known.
Contingent Reserves
So-called contingent reserves are sometimes handled as a part of this group,
although best classified by themselves. A contingent reserve is one which
represents an effort to provide for certain contingencies, such as guarantees on
work done or products sold, lawsuits pending adjudication, etc. As R. H.
Montgomery[62] so pertinently says: “the reserve should be based on evidence
more tangible than a mere desire to be conservative. A vague feeling that
something might have been overlooked which would decrease the assets or
increase the liabilities is not the proper subject for a reserve. Conservative
management ‘reserves’ part of its surplus for such contingencies, but it appears as
surplus and not as a liability.” As mentioned above, sometimes the reserve for
bad debts is classed as a contingent reserve. Contingency is inherent in the item
but the certainty of its occurrence cannot be reasoned away. The use of
contingent reserves may therefore well be limited to provision against contingent
liabilities. In other words, they represent the best available estimate of the
amount of such liabilities. To draw a dividing line between operating and
contingent reserves is extremely difficult; both are created by charges to various
expense accounts. It is merely a matter of degree as to the certainty of the events’
happening for which provision is being made. On the border line between the
two are such items as reserves for insurance where the concern carries its own
insurance and must make a periodic expense charge in lieu of the usual
premiums; reserves for pensions where a pension policy is in effect, the charge
under its sales contract. The distinction is finely drawn but probably well taken.
Distinction between Reserves and Accrued Items
The use of the title reserve for some of the items included as operating
reserves is unfortunate and leads to confusion both in terminology and in
understanding. Why unpaid expenses of any kind should be called reserves for
expenses when the amount of them is definitely known has never been
satisfactorily explained; yet the practice is sometimes met. There is some excuse
in the case of expense items the amount of which cannot be definitely determined
either from the nature of the item itself or other conditions over which the
concern has no control. Thus, “Reserve for Wages” is usually a misnomer, the
title “Wages Accrued” showing the item correctly; but “Reserve for Taxes,”
while just as true a liability as the other item, may be justified on the ground that
the latter is only an estimate subject to correction when the exact amount is
known, whereas the former is already definitely known.
Contingent Reserves
So-called contingent reserves are sometimes handled as a part of this group,
although best classified by themselves. A contingent reserve is one which
represents an effort to provide for certain contingencies, such as guarantees on
work done or products sold, lawsuits pending adjudication, etc. As R. H.
Montgomery[62] so pertinently says: “the reserve should be based on evidence
more tangible than a mere desire to be conservative. A vague feeling that
something might have been overlooked which would decrease the assets or
increase the liabilities is not the proper subject for a reserve. Conservative
management ‘reserves’ part of its surplus for such contingencies, but it appears as
surplus and not as a liability.” As mentioned above, sometimes the reserve for
bad debts is classed as a contingent reserve. Contingency is inherent in the item
but the certainty of its occurrence cannot be reasoned away. The use of
contingent reserves may therefore well be limited to provision against contingent
liabilities. In other words, they represent the best available estimate of the
amount of such liabilities. To draw a dividing line between operating and
contingent reserves is extremely difficult; both are created by charges to various
expense accounts. It is merely a matter of degree as to the certainty of the events’
happening for which provision is being made. On the border line between the
two are such items as reserves for insurance where the concern carries its own
insurance and must make a periodic expense charge in lieu of the usual
premiums; reserves for pensions where a pension policy is in effect, the charge
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creating it being here viewed as a part of the wages expense—the share of wages
to be paid in the future which must be borne by the current period; reserves for
sick benefits, which are in all respects similar to pension reserves; and so on. In
some cases reserves for supersession of patents, or other assets whose length of
service life is dependent on extreme contingency, are classed with this group.
Deferred Income—Misuse of Term
Deferred income is sometimes classed as a reserve. Thus, insurance
companies carry the portion of their unearned premiums as on a given date, as a
reserve. The use of the title is well established in that connection and the nature
of the items is well understood. On commercial balance sheets where no outside
authority can give a definite meaning to the term, its use for deferred income is to
be deprecated and discouraged. Deferred income is a liability and not a reserve;
the current period has not rendered the service to earn the income and is liable to
the period in which the service is rendered.
Proprietorship Reserves
This disposes of all the asset and liability reserves and leaves for
consideration the true profits or proprietorship reserves. As between these two
main classes of reserves, as their titles indicate, the proper allocation of the one is
among the assets or liabilities, while the other must be shown as a part of the net
worth of the corporation. As to the nature of proprietorship reserves little more
need be said. There are just two classes of items met here, viz., those shown as
such openly on the balance sheet and those which are hidden or secret, latent
among the various other items on the balance sheet. Proprietorship reserves
represent profits reinvested in the business. Any profits, operating or capital, not
paid out as dividends give rise to proprietorship reserves.
Secret Reserves
So-called secret reserves are brought about in various ways. Their creation
may be intentional or accidental, but their source is the same in either case.
Reserves of profits may be hidden either by undervaluation of the assets or
overvaluation of the liabilities. Undervaluation of the assets may point to an
ultra-conservative policy of management. Thus, some concerns write off the
value of their fixed equipment of various kinds as rapidly as the net profits can
absorb it and still leave sufficient for a reasonable dividend. Financial institutions
in this way carry their furniture and fixtures and sometimes even banking houses,
at ridiculously low figures or do not show them at all.
to be paid in the future which must be borne by the current period; reserves for
sick benefits, which are in all respects similar to pension reserves; and so on. In
some cases reserves for supersession of patents, or other assets whose length of
service life is dependent on extreme contingency, are classed with this group.
Deferred Income—Misuse of Term
Deferred income is sometimes classed as a reserve. Thus, insurance
companies carry the portion of their unearned premiums as on a given date, as a
reserve. The use of the title is well established in that connection and the nature
of the items is well understood. On commercial balance sheets where no outside
authority can give a definite meaning to the term, its use for deferred income is to
be deprecated and discouraged. Deferred income is a liability and not a reserve;
the current period has not rendered the service to earn the income and is liable to
the period in which the service is rendered.
Proprietorship Reserves
This disposes of all the asset and liability reserves and leaves for
consideration the true profits or proprietorship reserves. As between these two
main classes of reserves, as their titles indicate, the proper allocation of the one is
among the assets or liabilities, while the other must be shown as a part of the net
worth of the corporation. As to the nature of proprietorship reserves little more
need be said. There are just two classes of items met here, viz., those shown as
such openly on the balance sheet and those which are hidden or secret, latent
among the various other items on the balance sheet. Proprietorship reserves
represent profits reinvested in the business. Any profits, operating or capital, not
paid out as dividends give rise to proprietorship reserves.
Secret Reserves
So-called secret reserves are brought about in various ways. Their creation
may be intentional or accidental, but their source is the same in either case.
Reserves of profits may be hidden either by undervaluation of the assets or
overvaluation of the liabilities. Undervaluation of the assets may point to an
ultra-conservative policy of management. Thus, some concerns write off the
value of their fixed equipment of various kinds as rapidly as the net profits can
absorb it and still leave sufficient for a reasonable dividend. Financial institutions
in this way carry their furniture and fixtures and sometimes even banking houses,
at ridiculously low figures or do not show them at all.
Page 350
Undervaluations are accomplished in various ways. Charging an excessive
rate of depreciation; making unnecessarily large reserves for uncollectible
accounts, sales discounts, etc.; showing a more rapid depletion of natural assets
than justified by the amounts used; charging the sums spent for assets to an
operating expense; setting up an excessive cost of goods sold by means of
inventory valuations of stock-in-trade at a figure lower than cost or market;
crediting items of income to asset accounts instead of to income accounts, such
as rentals on properties owned; crediting interest and dividends received to the
stocks and bonds accounts—all of these serve the purpose of creating hidden
reserves by means of a misstatement of fact.
Items wrongfully included among the liabilities bring about the same result.
Here, however, the procedure is somewhat more patent because the creditors
themselves check up on all actual liabilities. Liabilities can be settled only by an
actual reduction of assets. Manipulation of the operating and contingent reserves
explained above offers, however, an easy means of overvaluing the liabilities. A
too liberal estimate of the amounts of these reserves makes them represent in part
true proprietorship reserves but the proprietorship element in them is obscured by
their title and their inclusion among the liabilities on the balance sheet.
It is, of course, apparent that no balance sheet containing secret reserves is a
true statement of condition and the practice of creating secret reserves must
usually—perhaps always—be condemned.
Argument for Secret Reserve
In justification of the secret reserve, it is sometimes said that in certain lines
of business where the maintenance of unquestioned credit or the promotion of a
stability ordinarily lacking in speculative enterprises is highly desirable, there is a
very pressing need for the secret reserve. Through its use, extraordinary losses,
which otherwise would result in very unfavorable fluctuations of stock values,
may be absorbed by means of a charge to some undervalued asset and so bring it
to its true value; or by a charge against an over-estimated liability reserve and so
bring it to a true showing. This frees the current profit and loss from the charge,
maintains a regularity of net profits, and prevents the disasters sometimes
attendant upon violent fluctuations of stock values brought about by the
knowledge of these extraordinary losses. That is the strongest case which can be
made out in favor of the secret reserve.
Argument against Secret Reserve
rate of depreciation; making unnecessarily large reserves for uncollectible
accounts, sales discounts, etc.; showing a more rapid depletion of natural assets
than justified by the amounts used; charging the sums spent for assets to an
operating expense; setting up an excessive cost of goods sold by means of
inventory valuations of stock-in-trade at a figure lower than cost or market;
crediting items of income to asset accounts instead of to income accounts, such
as rentals on properties owned; crediting interest and dividends received to the
stocks and bonds accounts—all of these serve the purpose of creating hidden
reserves by means of a misstatement of fact.
Items wrongfully included among the liabilities bring about the same result.
Here, however, the procedure is somewhat more patent because the creditors
themselves check up on all actual liabilities. Liabilities can be settled only by an
actual reduction of assets. Manipulation of the operating and contingent reserves
explained above offers, however, an easy means of overvaluing the liabilities. A
too liberal estimate of the amounts of these reserves makes them represent in part
true proprietorship reserves but the proprietorship element in them is obscured by
their title and their inclusion among the liabilities on the balance sheet.
It is, of course, apparent that no balance sheet containing secret reserves is a
true statement of condition and the practice of creating secret reserves must
usually—perhaps always—be condemned.
Argument for Secret Reserve
In justification of the secret reserve, it is sometimes said that in certain lines
of business where the maintenance of unquestioned credit or the promotion of a
stability ordinarily lacking in speculative enterprises is highly desirable, there is a
very pressing need for the secret reserve. Through its use, extraordinary losses,
which otherwise would result in very unfavorable fluctuations of stock values,
may be absorbed by means of a charge to some undervalued asset and so bring it
to its true value; or by a charge against an over-estimated liability reserve and so
bring it to a true showing. This frees the current profit and loss from the charge,
maintains a regularity of net profits, and prevents the disasters sometimes
attendant upon violent fluctuations of stock values brought about by the
knowledge of these extraordinary losses. That is the strongest case which can be
made out in favor of the secret reserve.
Argument against Secret Reserve
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The fact, however, must not be overlooked that without any understatement
or misrepresentation of property values at any time there could just as easily be
created an open “surplus” or margin of an amount equal to the secret reserve,
against which these losses could as well be charged. The creation of such a
margin can be justified on the same grounds on which the justification of the
secret reserve is attempted, viz., the maintenance of high credit and stability. The
reduction of the margin through its absorption of the loss would, of course, be
somewhat more patent than the reappearance of values previously written off,
although analysis of a balance sheet will invariably bring the true state of affairs
to light. Furthermore, present stockholders, and certainly prospective investors
and creditors, have a right to know the true condition of affairs. The appearance
of a large proprietorship in addition to capital stock, revealed by a sizable
margin, gives the stock a value in addition to that based solely on the dividend
rate. A stockholder has a right to his share of the profits during the period of his
ownership. If it is not received in the form of dividends, he should at least be
partially recompensed when he disposes of his holdings, by an increased price for
the stock as reflected by the portion of profits reinvested in the business.
The attitude occasionally taken that directors know best what information as
to true condition of affairs should be given to the owners and what should be
withheld, should, in these days of increasing publicity, be given no serious
consideration. In the hands of unscrupulous directors, the secret reserve is an
instrument for the covering up of questionable and even fraudulent practices.
Stock values can be intentionally hammered down by a false showing of profits
and so inure to the benefit of a group of prospective purchasers desiring to
“freeze out” unsuspecting stockholders. All in all, therefore, little can be said in
justification, but much in condemnation, of the practice of accumulating secret
reserves.
Earmarking of Reserves
According to the definition of surplus laid down in the beginning of this
chapter, limiting the term strictly to the profits available for dividends, those
profits which are applied to reinvestment for specific purposes must be separated
from the “surplus” and given distinguishing marks to indicate their purpose.
Thus, profits reserved for the purpose of acquiring a fund of assets out of which
to pay off debt obligations maturing in the future may be set aside under the title
“Sinking Fund Reserve”; those set aside for the purpose of extension of plant as
“Building Fund Reserve”; those for the purpose of providing a pension fund as
“Pension Fund Reserve”; and so on. This is sometimes called “earmarking” the
reserve.
or misrepresentation of property values at any time there could just as easily be
created an open “surplus” or margin of an amount equal to the secret reserve,
against which these losses could as well be charged. The creation of such a
margin can be justified on the same grounds on which the justification of the
secret reserve is attempted, viz., the maintenance of high credit and stability. The
reduction of the margin through its absorption of the loss would, of course, be
somewhat more patent than the reappearance of values previously written off,
although analysis of a balance sheet will invariably bring the true state of affairs
to light. Furthermore, present stockholders, and certainly prospective investors
and creditors, have a right to know the true condition of affairs. The appearance
of a large proprietorship in addition to capital stock, revealed by a sizable
margin, gives the stock a value in addition to that based solely on the dividend
rate. A stockholder has a right to his share of the profits during the period of his
ownership. If it is not received in the form of dividends, he should at least be
partially recompensed when he disposes of his holdings, by an increased price for
the stock as reflected by the portion of profits reinvested in the business.
The attitude occasionally taken that directors know best what information as
to true condition of affairs should be given to the owners and what should be
withheld, should, in these days of increasing publicity, be given no serious
consideration. In the hands of unscrupulous directors, the secret reserve is an
instrument for the covering up of questionable and even fraudulent practices.
Stock values can be intentionally hammered down by a false showing of profits
and so inure to the benefit of a group of prospective purchasers desiring to
“freeze out” unsuspecting stockholders. All in all, therefore, little can be said in
justification, but much in condemnation, of the practice of accumulating secret
reserves.
Earmarking of Reserves
According to the definition of surplus laid down in the beginning of this
chapter, limiting the term strictly to the profits available for dividends, those
profits which are applied to reinvestment for specific purposes must be separated
from the “surplus” and given distinguishing marks to indicate their purpose.
Thus, profits reserved for the purpose of acquiring a fund of assets out of which
to pay off debt obligations maturing in the future may be set aside under the title
“Sinking Fund Reserve”; those set aside for the purpose of extension of plant as
“Building Fund Reserve”; those for the purpose of providing a pension fund as
“Pension Fund Reserve”; and so on. This is sometimes called “earmarking” the
reserve.
Page 352
Separation into differently named reserves serves no other purpose, however;
it does not in any way insure the inviolability of the reserve; it acts merely as
evidence of the intention and purpose of the board of directors which authorized
the application of profits to that purpose. It is the expression of a business policy
and as such is, without other compelling force, subject to the approval and
continuance or to the disapproval and nullification of any subsequent board.
These reserves are profits and as such belong to the shareholders and may be
distributed among them as dividends. A reasonably conservative policy as to
reserves usually has the support of stockholders, and a subsequent board will not
risk loss of position and standing with the stockholders by a change of policy as
to reserves without good and sufficient reasons for doing so.
Continuity of Reserve Policy
Effort is sometimes made to secure continuity of the reserve policy. This may
be accomplished in several ways. Oftentimes it is made compulsory by outside
regulatory authority, as in the case of national banks which are required to set
aside annually a certain part of their profits until these have accumulated to an
amount equal to 20% of their capital stock. Similar conservatism can also be
compelled by contract entered into with creditors. It is a frequent provision of the
trust agreement covering an issue of bonds that “there shall be set aside out of
profits” a certain amount at the close of each fiscal period for the purpose of
creating a fund with which to redeem the bond issue when it falls due. The funds
may be placed in the hands of a trustee, which guarantees the application of them
to their intended use but does not, of course, insure the retention of profits to an
equal amount in the business. Finally boards of directors may be compelled by
the stockholders to adhere to a certain policy by provision in the by-laws for the
accumulation of reserves. This policy is, of course, subject to change by the
stockholders themselves. Where the power to make and change by-laws is put in
the hands of the directors, this last method is not applicable.
Reserves may always be made a part of the permanent capital through their
distribution in the form of a stock dividend. This secures the continuance of
profits reserved to date but does not guarantee either a similar application of
future reserves or even a continuance of the present reserve policy.
Covered Reserves
When a reserve is spoken of as being covered, it is meant that specific funds
have been set aside for the purpose named, in amount equal to the reserve. As in
the case of sinking funds, the assets set aside may be invested in stocks and
bonds control of which remains with the company itself; or the assets may be
it does not in any way insure the inviolability of the reserve; it acts merely as
evidence of the intention and purpose of the board of directors which authorized
the application of profits to that purpose. It is the expression of a business policy
and as such is, without other compelling force, subject to the approval and
continuance or to the disapproval and nullification of any subsequent board.
These reserves are profits and as such belong to the shareholders and may be
distributed among them as dividends. A reasonably conservative policy as to
reserves usually has the support of stockholders, and a subsequent board will not
risk loss of position and standing with the stockholders by a change of policy as
to reserves without good and sufficient reasons for doing so.
Continuity of Reserve Policy
Effort is sometimes made to secure continuity of the reserve policy. This may
be accomplished in several ways. Oftentimes it is made compulsory by outside
regulatory authority, as in the case of national banks which are required to set
aside annually a certain part of their profits until these have accumulated to an
amount equal to 20% of their capital stock. Similar conservatism can also be
compelled by contract entered into with creditors. It is a frequent provision of the
trust agreement covering an issue of bonds that “there shall be set aside out of
profits” a certain amount at the close of each fiscal period for the purpose of
creating a fund with which to redeem the bond issue when it falls due. The funds
may be placed in the hands of a trustee, which guarantees the application of them
to their intended use but does not, of course, insure the retention of profits to an
equal amount in the business. Finally boards of directors may be compelled by
the stockholders to adhere to a certain policy by provision in the by-laws for the
accumulation of reserves. This policy is, of course, subject to change by the
stockholders themselves. Where the power to make and change by-laws is put in
the hands of the directors, this last method is not applicable.
Reserves may always be made a part of the permanent capital through their
distribution in the form of a stock dividend. This secures the continuance of
profits reserved to date but does not guarantee either a similar application of
future reserves or even a continuance of the present reserve policy.
Covered Reserves
When a reserve is spoken of as being covered, it is meant that specific funds
have been set aside for the purpose named, in amount equal to the reserve. As in
the case of sinking funds, the assets set aside may be invested in stocks and
bonds control of which remains with the company itself; or the assets may be
Page 353
turned over to a trustee who then has control of their investment and use. The
student is referred to Chapter XXV on sinking funds for a full discussion of the
merits and disadvantages of the two methods as to control over the funds.
In connection with covered reserves, attention is called again to the use, in
the interest of standard practice, of the caption “reserve fund” as a suitable title
for the assets placed in the fund, and the caption “reserve,” with suitable
descriptive phrase, as the title for the reserved profits, the proprietorship element
of the transaction.
Classification of Reserves
Before leaving the subject of reserves, it is purposed to give several
classifications of the various kinds of reserves. Paul-Joseph Esquerré[63]
classifies reserves under the following heads: (1) Reserves for Depreciation; (2)
Operating Reserves; (3) Reserves for Surplus Contingencies; (4) Reserves for
Redemption of Debt; (5) Secret Reserves; and (6) Reserves for Exhaustion of
Physical Assets. Their titles well indicate the kinds of items included under each
head.
H. R. Hatfield[64] classifies them on the basis of the use to which they are to
be put, not attempting a classification to include all items shown on the balance
sheet under the caption of a “reserve,” but limiting it to reserves of profits. His
classes are:
“1. Reserves created to provide a permanent increase of
capital.
(a) As an additional guaranty to creditors.
(b) To provide for extension of its fixed or other capital assets
2. Reserves created to provide an additional capital which
can be used to cover unusual losses or to provide for
other emergencies without encroaching on the nominal
capital.
3. Reserves created to provide for equalizing dividends by
retaining part of one year’s profit to be used to make
up scanty profits for other years.”
The classification used here has as its basis the place of allocation of the
various reserves in the balance sheet because their nature determines their place,
which after all is the important consideration. From that point of view two broad
student is referred to Chapter XXV on sinking funds for a full discussion of the
merits and disadvantages of the two methods as to control over the funds.
In connection with covered reserves, attention is called again to the use, in
the interest of standard practice, of the caption “reserve fund” as a suitable title
for the assets placed in the fund, and the caption “reserve,” with suitable
descriptive phrase, as the title for the reserved profits, the proprietorship element
of the transaction.
Classification of Reserves
Before leaving the subject of reserves, it is purposed to give several
classifications of the various kinds of reserves. Paul-Joseph Esquerré[63]
classifies reserves under the following heads: (1) Reserves for Depreciation; (2)
Operating Reserves; (3) Reserves for Surplus Contingencies; (4) Reserves for
Redemption of Debt; (5) Secret Reserves; and (6) Reserves for Exhaustion of
Physical Assets. Their titles well indicate the kinds of items included under each
head.
H. R. Hatfield[64] classifies them on the basis of the use to which they are to
be put, not attempting a classification to include all items shown on the balance
sheet under the caption of a “reserve,” but limiting it to reserves of profits. His
classes are:
“1. Reserves created to provide a permanent increase of
capital.
(a) As an additional guaranty to creditors.
(b) To provide for extension of its fixed or other capital assets
2. Reserves created to provide an additional capital which
can be used to cover unusual losses or to provide for
other emergencies without encroaching on the nominal
capital.
3. Reserves created to provide for equalizing dividends by
retaining part of one year’s profit to be used to make
up scanty profits for other years.”
The classification used here has as its basis the place of allocation of the
various reserves in the balance sheet because their nature determines their place,
which after all is the important consideration. From that point of view two broad
Page 354
classes may be marked off as discussed in the preceding pages, viz.: (1) valuation
reserves, using the term with a somewhat more extended meaning than is
customary; and (2) proprietorship reserves. Under valuation reserves will be
included all reserves shown either as deductions from the assets or as liabilities.
Here the term reserve will be limited to those items which are estimated, as
distinguished from those the amount of which is definitely known. The other
items which are sometimes wrongly called reserves, as discussed on page 415,
will not be included here, other titles being more accurately descriptive of them.
1. Valuation Reserves
(a) Asset Valuation Reserves
1. Depreciation Reserves
2. Depletion Reserves
3. Bad Debts Reserves
4. Appreciation Reserves
5. Market Fluctuations Reserves, etc.
(b) Liability Valuation Reserves
1. Operating Reserves
2. Contingent Reserves
2. Proprietorship Reserves
(a) Secret Reserves
(b) Open Reserves
1. Reserves for Debt Extinguishment
2. Reserves for Plant Extensions
3. Reserves for Working Capital, etc.
Legitimate Use of Surplus Account
There remains only a consideration of the Surplus account. The manner of
handling the surplus as a clearing account for the appropriation of net profits has
already been treated. After profits have been appropriated or reserved out of it for
specific purposes, the surplus shows by its balance the portion still available for
dividends. As has been indicated, it is not usually desirable to use all of it for
dividends, a sufficiently large balance being always maintained for such purposes
as stabilizing the dividend policy, strengthening credit, and other surplus
contingencies.
reserves, using the term with a somewhat more extended meaning than is
customary; and (2) proprietorship reserves. Under valuation reserves will be
included all reserves shown either as deductions from the assets or as liabilities.
Here the term reserve will be limited to those items which are estimated, as
distinguished from those the amount of which is definitely known. The other
items which are sometimes wrongly called reserves, as discussed on page 415,
will not be included here, other titles being more accurately descriptive of them.
1. Valuation Reserves
(a) Asset Valuation Reserves
1. Depreciation Reserves
2. Depletion Reserves
3. Bad Debts Reserves
4. Appreciation Reserves
5. Market Fluctuations Reserves, etc.
(b) Liability Valuation Reserves
1. Operating Reserves
2. Contingent Reserves
2. Proprietorship Reserves
(a) Secret Reserves
(b) Open Reserves
1. Reserves for Debt Extinguishment
2. Reserves for Plant Extensions
3. Reserves for Working Capital, etc.
Legitimate Use of Surplus Account
There remains only a consideration of the Surplus account. The manner of
handling the surplus as a clearing account for the appropriation of net profits has
already been treated. After profits have been appropriated or reserved out of it for
specific purposes, the surplus shows by its balance the portion still available for
dividends. As has been indicated, it is not usually desirable to use all of it for
dividends, a sufficiently large balance being always maintained for such purposes
as stabilizing the dividend policy, strengthening credit, and other surplus
contingencies.
Page 355
Surplus account is frequently as badly abused as the proverbial “general”
expense account, by being used as a dumping ground. It has, however, a
legitimate and an illegitimate use. As the Profit and Loss account is strictly
limited to use as a clearing account for the normal items of income and expense
applicable to the current period’s operations, manifestly all other charges and
credits to proprietorship must be cared for elsewhere. With very few exceptions
—such as premiums and discounts on capital stock, donated working capital, etc.
—these charges and credits are made to Surplus. High accounting authority
deprecates the use of Surplus for these purposes, on the ground that too often it is
used as a convenient place in which to hide items properly chargeable to the
current Profit and Loss but which would not make a favorable impression if
shown there. Just as with many other abused accounts, its wrongful use hardly
constitutes sufficient grounds for withholding sanction of legitimate use. Where
it is felt that certain items should not go directly into Surplus they should be
recorded in a final section of the Profit and Loss account, just before its balance
is shown transferred to Surplus. As the financial statements are usually
published, this method secures more certain publicity to these items.
Occasionally, instead of the use of either Profit and Loss or Surplus for this
purpose, an account is set up on the books called “Surplus Adjustments” through
which these items are cleared into Surplus. The objection raised above to this use
of Surplus applies with equal force to “Surplus Adjustment.”
Statement of Surplus
At the close of each period account must usually be taken of a group of items
which cannot properly be treated as belonging to that period. Some of these may
be items which were overlooked at the close of previous fiscal periods and
cannot now be taken into the record for that period. Some things may wrongfully
have been included in, or omitted from, the inventory; the inventory may have
been under-or overvalued; errors may have been made in the separation of capital
from revenue expenditures; wrong depreciation and bad debts estimates may
have been made—these and similar items call for adjustment at the close of the
current period. Where adjustments are few and simple, the statement of surplus
on the balance sheet may be extended sufficiently to include them. Much better,
however, is it to append as a schedule or statement in support of the balance
sheet, a statement of surplus, showing therein the detail of all entries affecting it
during and at the close of the current period. Particularly is this desirable when
the statements of financial condition are prepared for internal use.
Such a statement of surplus should start with the amount of surplus as at the
close of the previous period. Then the adjustments applicable to that period
expense account, by being used as a dumping ground. It has, however, a
legitimate and an illegitimate use. As the Profit and Loss account is strictly
limited to use as a clearing account for the normal items of income and expense
applicable to the current period’s operations, manifestly all other charges and
credits to proprietorship must be cared for elsewhere. With very few exceptions
—such as premiums and discounts on capital stock, donated working capital, etc.
—these charges and credits are made to Surplus. High accounting authority
deprecates the use of Surplus for these purposes, on the ground that too often it is
used as a convenient place in which to hide items properly chargeable to the
current Profit and Loss but which would not make a favorable impression if
shown there. Just as with many other abused accounts, its wrongful use hardly
constitutes sufficient grounds for withholding sanction of legitimate use. Where
it is felt that certain items should not go directly into Surplus they should be
recorded in a final section of the Profit and Loss account, just before its balance
is shown transferred to Surplus. As the financial statements are usually
published, this method secures more certain publicity to these items.
Occasionally, instead of the use of either Profit and Loss or Surplus for this
purpose, an account is set up on the books called “Surplus Adjustments” through
which these items are cleared into Surplus. The objection raised above to this use
of Surplus applies with equal force to “Surplus Adjustment.”
Statement of Surplus
At the close of each period account must usually be taken of a group of items
which cannot properly be treated as belonging to that period. Some of these may
be items which were overlooked at the close of previous fiscal periods and
cannot now be taken into the record for that period. Some things may wrongfully
have been included in, or omitted from, the inventory; the inventory may have
been under-or overvalued; errors may have been made in the separation of capital
from revenue expenditures; wrong depreciation and bad debts estimates may
have been made—these and similar items call for adjustment at the close of the
current period. Where adjustments are few and simple, the statement of surplus
on the balance sheet may be extended sufficiently to include them. Much better,
however, is it to append as a schedule or statement in support of the balance
sheet, a statement of surplus, showing therein the detail of all entries affecting it
during and at the close of the current period. Particularly is this desirable when
the statements of financial condition are prepared for internal use.
Such a statement of surplus should start with the amount of surplus as at the
close of the previous period. Then the adjustments applicable to that period
Page 356
should be shown, thus determining the true surplus for the period. Following that
should appear the entries made directly to Surplus for the current period, the net
profit transferred thereto, and finally all appropriations of profit, leaving as the
balance of Surplus the same amount which appears in the balance sheet. In
skeleton form the statement should appear somewhat as follows:
X Y Z Company
Statement of Surplus, June 30, 1918
Balance of Surplus as on December 31, 1917 $.....
Adjustments applicable to period ending December 31, 1917:
Additions:
Inventory omissions, undervaluations, etc. $.....
Items wrongly charged to Revenue .....
Over-estimate of Depreciation, etc. ..... .....
Deductions:
Inventory overvaluations, etc. $.....
Items wrongly charged to Capital .....
Under-estimates of Depreciation, etc. ..... .....
Net Increase (or Decrease) .....
True Surplus as on December 31, 1917 $.....
Extraordinary Profits (or Losses) this period $.....
Net Profit this period ..... .....
Amount available for appropriation $.....
Appropriations of Surplus:
Reserves (shown in detail) $.....
Dividends ..... .....
Net Balance in Surplus as on June 30, 1918 $.....
should appear the entries made directly to Surplus for the current period, the net
profit transferred thereto, and finally all appropriations of profit, leaving as the
balance of Surplus the same amount which appears in the balance sheet. In
skeleton form the statement should appear somewhat as follows:
X Y Z Company
Statement of Surplus, June 30, 1918
Balance of Surplus as on December 31, 1917 $.....
Adjustments applicable to period ending December 31, 1917:
Additions:
Inventory omissions, undervaluations, etc. $.....
Items wrongly charged to Revenue .....
Over-estimate of Depreciation, etc. ..... .....
Deductions:
Inventory overvaluations, etc. $.....
Items wrongly charged to Capital .....
Under-estimates of Depreciation, etc. ..... .....
Net Increase (or Decrease) .....
True Surplus as on December 31, 1917 $.....
Extraordinary Profits (or Losses) this period $.....
Net Profit this period ..... .....
Amount available for appropriation $.....
Appropriations of Surplus:
Reserves (shown in detail) $.....
Dividends ..... .....
Net Balance in Surplus as on June 30, 1918 $.....
Page 357
CHAPTER XXIV
DIVIDENDS
Introduction
Dividends, as the term is generally used, may be defined as those profits
of a corporation which are divided among the owners. Except in the case of
wasting assets, the law is very explicit in limiting dividends to profits.
Therefore profits need to be determined with painstaking care. Most of the
major problems met in the determination of profits were discussed in
Chapter XXII. Here it is purposed to limit the discussion to one phase of the
disposition of profits, viz., as dividends, having treated in Chapter XXIII
other appropriations of profit for reserves and surplus.
Disposition of Corporation Profits
The profits of a solvent going corporation, whether current profits or
those reinvested in the business, are owned absolutely by the owners of the
corporation and are subject to their disposition and control, except where
the law imposes restrictions. Oftentimes, the stockholders themselves
impose restrictions by incorporating restrictive provisions in the charter or
by-laws of the corporation. Of course, the same power which made them
has power to remove them, though the exercise of the amending power is
usually more difficult than the original expression of that power in enacting
rules. The nature of a corporation is such, however, that many acts and
privileges which are per se rights of the stockholders must in their exercise
be delegated to others. Thus, while the right of ownership and control of the
profits of a corporation is inherent in its proprietorship, the control is
indirect—through the medium of a board of directors subject to periodic
review and election by the owners. This board, during the period of its
incumbency, acts for the stockholders and, during the prosecution of its
duties, if performed in good faith, with sound judgment, and without
fraudulent intent, is free from interference.
Shareholders’ Rights as to Profits
DIVIDENDS
Introduction
Dividends, as the term is generally used, may be defined as those profits
of a corporation which are divided among the owners. Except in the case of
wasting assets, the law is very explicit in limiting dividends to profits.
Therefore profits need to be determined with painstaking care. Most of the
major problems met in the determination of profits were discussed in
Chapter XXII. Here it is purposed to limit the discussion to one phase of the
disposition of profits, viz., as dividends, having treated in Chapter XXIII
other appropriations of profit for reserves and surplus.
Disposition of Corporation Profits
The profits of a solvent going corporation, whether current profits or
those reinvested in the business, are owned absolutely by the owners of the
corporation and are subject to their disposition and control, except where
the law imposes restrictions. Oftentimes, the stockholders themselves
impose restrictions by incorporating restrictive provisions in the charter or
by-laws of the corporation. Of course, the same power which made them
has power to remove them, though the exercise of the amending power is
usually more difficult than the original expression of that power in enacting
rules. The nature of a corporation is such, however, that many acts and
privileges which are per se rights of the stockholders must in their exercise
be delegated to others. Thus, while the right of ownership and control of the
profits of a corporation is inherent in its proprietorship, the control is
indirect—through the medium of a board of directors subject to periodic
review and election by the owners. This board, during the period of its
incumbency, acts for the stockholders and, during the prosecution of its
duties, if performed in good faith, with sound judgment, and without
fraudulent intent, is free from interference.
Shareholders’ Rights as to Profits
Page 358
Shareholders’ rights in regard to sharing in the profits are therefore
dependent upon the action of their elected board of directors. As soon as
that board authorizes a dividend, however, its control over the portion of the
profits so appropriated ceases except as to the routine of payment of the
dividend. The right which the stockholder thereafter possesses is of the
same nature as the claim of an outside creditor, and in the event of
dissolution the assets of the corporation must be applied to the liquidation
of this claim equally with all other unsecured claims. Thus, a claim for
dividends must be met before the determination of the net assets with which
the ownership of capital stock is liquidated.
Directors’ Control over Profits
As stated above with regard to profits generally, the directors have
entire control of the declaration of dividends, except where limitation is
specifically imposed by the state or by the owners as expressed in charter or
by-laws. The following expression of directors’ power over profits and
dividends, contained in the English Companies (Consolidation) Act of 1908
is typical of most laws covering the question: “The directors may, before
recommending any dividend, set aside out of the profits of the company
such sums as they think proper as a reserve or reserves which shall, at the
discretion of the directors, be applicable for meeting contingencies, or for
equalizing dividends, or for any other purpose to which the profits of the
company may be properly applied, and pending such application may, at the
like discretion, either be employed in the business of the company or be
invested in such investments (other than shares of the company) as the
directors may from time to time think fit.”
Provisos as to Declaration of Dividends
Specific provision may be made in the by-laws covering the declaration
of dividends. Thus, the directors may there be ordered to set aside for
specific purposes a certain amount of the profits earned and to declare
dividends only from any residue. This may represent a permanent policy but
usually only temporary; that is, periodic reservation of profits may continue
until a definitely named reserve (or surplus) has been created, after which
all profits become free for such disposition as the directors may see fit to
make. A somewhat different policy is occasionally prescribed by which the
directors are ordered to pay out of each period’s profits dividends of a
dependent upon the action of their elected board of directors. As soon as
that board authorizes a dividend, however, its control over the portion of the
profits so appropriated ceases except as to the routine of payment of the
dividend. The right which the stockholder thereafter possesses is of the
same nature as the claim of an outside creditor, and in the event of
dissolution the assets of the corporation must be applied to the liquidation
of this claim equally with all other unsecured claims. Thus, a claim for
dividends must be met before the determination of the net assets with which
the ownership of capital stock is liquidated.
Directors’ Control over Profits
As stated above with regard to profits generally, the directors have
entire control of the declaration of dividends, except where limitation is
specifically imposed by the state or by the owners as expressed in charter or
by-laws. The following expression of directors’ power over profits and
dividends, contained in the English Companies (Consolidation) Act of 1908
is typical of most laws covering the question: “The directors may, before
recommending any dividend, set aside out of the profits of the company
such sums as they think proper as a reserve or reserves which shall, at the
discretion of the directors, be applicable for meeting contingencies, or for
equalizing dividends, or for any other purpose to which the profits of the
company may be properly applied, and pending such application may, at the
like discretion, either be employed in the business of the company or be
invested in such investments (other than shares of the company) as the
directors may from time to time think fit.”
Provisos as to Declaration of Dividends
Specific provision may be made in the by-laws covering the declaration
of dividends. Thus, the directors may there be ordered to set aside for
specific purposes a certain amount of the profits earned and to declare
dividends only from any residue. This may represent a permanent policy but
usually only temporary; that is, periodic reservation of profits may continue
until a definitely named reserve (or surplus) has been created, after which
all profits become free for such disposition as the directors may see fit to
make. A somewhat different policy is occasionally prescribed by which the
directors are ordered to pay out of each period’s profits dividends of a
Page 359
named amount, after which any residue shall be carried to a reserve (or
surplus). The objection to this latter policy, as ordered in the by-laws, is that
it ties the hands of the directors to the division of profits among the owners
regardless of the exigencies of new situations, as they arise, bringing very
different conditions from those under which the policy was originally
ordered.
The power of the directors as to declaration of dividends extends not
only to common stock but also to preferred. No dividends, common or
preferred, can be declared except from profits. Legal inhibition of the
payment of dividends out of capital is one of the chief points of difference
between the corporate and other forms of business organization.
As stated in a preceding section, regulatory bodies and commissions
sometimes impose rules compelling corporations over which they have
authority to set aside to surplus some portion of the profits before the
declaration of any dividend.
Stockholders’ Rights to Dividends
Where profits exist, either earned currently or accumulated, the matter
of a declaration of dividends is thus seen to be always a question of
financial policy. In view of the other problems confronting the corporation
—its policy of growth and expansion to meet competition and enter other
markets, its specific and pressing requirements for funds—the question of
the wisdom of a declaration and payment of dividends frequently demands
careful consideration. If under the circumstances, in the exercise of their
discretion, the directors do not declare dividends, their action is final and, in
the absence of fraud or an abuse of discretion, will not usually be interfered
with by the courts.
Courts do sometimes intervene, however, as in Matter of Rogers, 161 N.
Y. 108 (1899): “The directors must act in good faith. If they fail to do so
and it clearly appears that they have accumulated earnings not required in
the prosecution of the business which they withhold from the stockholders
for illegitimate purposes, a court of equity may interfere and compel a
distribution of such earnings.” Again, in Hunter v. Roberts, Throp & Co., 83
Mich. 63 (1890), the court said: “Courts of equity will not interfere in the
management of the directors unless it is clearly made to appear that they are
guilty of fraud or misappropriation of the corporate funds or refuse to
surplus). The objection to this latter policy, as ordered in the by-laws, is that
it ties the hands of the directors to the division of profits among the owners
regardless of the exigencies of new situations, as they arise, bringing very
different conditions from those under which the policy was originally
ordered.
The power of the directors as to declaration of dividends extends not
only to common stock but also to preferred. No dividends, common or
preferred, can be declared except from profits. Legal inhibition of the
payment of dividends out of capital is one of the chief points of difference
between the corporate and other forms of business organization.
As stated in a preceding section, regulatory bodies and commissions
sometimes impose rules compelling corporations over which they have
authority to set aside to surplus some portion of the profits before the
declaration of any dividend.
Stockholders’ Rights to Dividends
Where profits exist, either earned currently or accumulated, the matter
of a declaration of dividends is thus seen to be always a question of
financial policy. In view of the other problems confronting the corporation
—its policy of growth and expansion to meet competition and enter other
markets, its specific and pressing requirements for funds—the question of
the wisdom of a declaration and payment of dividends frequently demands
careful consideration. If under the circumstances, in the exercise of their
discretion, the directors do not declare dividends, their action is final and, in
the absence of fraud or an abuse of discretion, will not usually be interfered
with by the courts.
Courts do sometimes intervene, however, as in Matter of Rogers, 161 N.
Y. 108 (1899): “The directors must act in good faith. If they fail to do so
and it clearly appears that they have accumulated earnings not required in
the prosecution of the business which they withhold from the stockholders
for illegitimate purposes, a court of equity may interfere and compel a
distribution of such earnings.” Again, in Hunter v. Roberts, Throp & Co., 83
Mich. 63 (1890), the court said: “Courts of equity will not interfere in the
management of the directors unless it is clearly made to appear that they are
guilty of fraud or misappropriation of the corporate funds or refuse to
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declare a dividend when the corporation has a surplus of net profits which it
can, without detriment to its business, divide among its stockholders, and
when a refusal to do so would amount to such an abuse of discretion as
would constitute a fraud or breach of that good faith which they are bound
to exercise towards the stockholders.”
In the case of preferred dividends, the courts are somewhat readier to
act because of the ease of a fraudulent retention of profits. Where stock is
non-cumulative and non-participating and particularly if non-voting, it
would be possible for a board of directors to refuse dividend declarations
for a number of years and then pay to common stockholders most of the
profits so saved. Such a policy is so manifestly unfair and fraudulent as to
warrant immediate intervention of the court. When stock is cumulative as to
unpaid dividends, such a policy could not be practiced, as the corporation
cannot declare dividends unless profits are made, nor, except as above
stated, need it declare dividends even when profits are made. But upon the
declaration of a dividend, the rights of cumulative preferred shareholders
require the payment of all accumulation of unpaid dividends before the
other classes of stockholders can share.
Declaration of Dividends
The matter of a declaration of dividends is usually a formal one. The
minute book record must always show the authorization. It may appear as a
formal resolution or merely as a statement of the declaration. Such
resolution or statement will usually carry the amount of the dividend, which
may be either a named per cent on the par value of the stock (or the amount
paid up on the stock where stock is not full-paid), or it may be a named
amount on each share; the date on which it is effective; the date and manner
of payment; and to whom payable, i.e., to the stockholders as of a given
date. Dividends may be declared to become effective on some future date
but never on a past date. Antedating a dividend so as to make it apply to
past stockholders who may no longer have any interest in the corporation
would manifestly be unfair, opening the way to manipulation and fraud.
A stockholder is entitled to notice of every dividend declaration. This
may come to him by published notice in the newspapers or through the
mails. A dividend check mailed to his last-known address has been held to
constitute sufficient notice.
can, without detriment to its business, divide among its stockholders, and
when a refusal to do so would amount to such an abuse of discretion as
would constitute a fraud or breach of that good faith which they are bound
to exercise towards the stockholders.”
In the case of preferred dividends, the courts are somewhat readier to
act because of the ease of a fraudulent retention of profits. Where stock is
non-cumulative and non-participating and particularly if non-voting, it
would be possible for a board of directors to refuse dividend declarations
for a number of years and then pay to common stockholders most of the
profits so saved. Such a policy is so manifestly unfair and fraudulent as to
warrant immediate intervention of the court. When stock is cumulative as to
unpaid dividends, such a policy could not be practiced, as the corporation
cannot declare dividends unless profits are made, nor, except as above
stated, need it declare dividends even when profits are made. But upon the
declaration of a dividend, the rights of cumulative preferred shareholders
require the payment of all accumulation of unpaid dividends before the
other classes of stockholders can share.
Declaration of Dividends
The matter of a declaration of dividends is usually a formal one. The
minute book record must always show the authorization. It may appear as a
formal resolution or merely as a statement of the declaration. Such
resolution or statement will usually carry the amount of the dividend, which
may be either a named per cent on the par value of the stock (or the amount
paid up on the stock where stock is not full-paid), or it may be a named
amount on each share; the date on which it is effective; the date and manner
of payment; and to whom payable, i.e., to the stockholders as of a given
date. Dividends may be declared to become effective on some future date
but never on a past date. Antedating a dividend so as to make it apply to
past stockholders who may no longer have any interest in the corporation
would manifestly be unfair, opening the way to manipulation and fraud.
A stockholder is entitled to notice of every dividend declaration. This
may come to him by published notice in the newspapers or through the
mails. A dividend check mailed to his last-known address has been held to
constitute sufficient notice.
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Liability of Directors
Together with the power and control over dividends by the directors is a
responsibility and liability for those wrongly declared. The law is very
specific and emphatic in its refusal to allow dividends except from profits.
The State of New York in its Stock Corporation Law has this to say with
regard to the liability of directors for making unauthorized dividends: “The
directors of a stock corporation shall not make dividends, except from the
surplus profits arising from the business of such corporation, nor divide,
withdraw, or in any way pay to the stockholders or any of them, any part of
the capital of such corporation, or reduce its capital stock, except as
authorized by law. In the case of any violation of the provisions of this
section, the directors under whose administration the same may have
happened, except those who may have caused their dissent therefrom to be
entered at large upon the minutes of such directors at the time, or were not
present when the same happened, shall jointly and severally be liable to
such corporation and to the creditors thereof to the full amount of any loss
sustained by such corporation or its creditors respectively by reason of such
withdrawal, division, or reduction.”[65]
In some states the liability of directors is made to include, in addition to
restitution of the amounts wrongfully paid, liability for all debts contracted
during their term of office and even to a body judgment for misdemeanor.
The stockholders receiving such a dividend are held to have known of its
illegality and are liable for restitution. While payment of dividends out of
capital is the most frequent source of illegality, a declaration of dividends
contrary to the provisions of the charter or by-laws relative thereto, or a
declaration which disregards the rights of other stockholders, is equally
illegal. Thus, a dividend paid before reserving profits, where the by-laws
require antecedent reservation or one paid to common shareholders ahead
of an accumulated dividend to cumulative preferred stockholders, is classed
as illegal.
Revocation of Dividends
A dividend once legally declared and of which notice has been given
cannot be revoked. As stated above, such a dividend becomes a claim
against the corporation and ranks with the claims of outside creditors. Even
further than this, it has been held that if actual funds have been set aside, as
Together with the power and control over dividends by the directors is a
responsibility and liability for those wrongly declared. The law is very
specific and emphatic in its refusal to allow dividends except from profits.
The State of New York in its Stock Corporation Law has this to say with
regard to the liability of directors for making unauthorized dividends: “The
directors of a stock corporation shall not make dividends, except from the
surplus profits arising from the business of such corporation, nor divide,
withdraw, or in any way pay to the stockholders or any of them, any part of
the capital of such corporation, or reduce its capital stock, except as
authorized by law. In the case of any violation of the provisions of this
section, the directors under whose administration the same may have
happened, except those who may have caused their dissent therefrom to be
entered at large upon the minutes of such directors at the time, or were not
present when the same happened, shall jointly and severally be liable to
such corporation and to the creditors thereof to the full amount of any loss
sustained by such corporation or its creditors respectively by reason of such
withdrawal, division, or reduction.”[65]
In some states the liability of directors is made to include, in addition to
restitution of the amounts wrongfully paid, liability for all debts contracted
during their term of office and even to a body judgment for misdemeanor.
The stockholders receiving such a dividend are held to have known of its
illegality and are liable for restitution. While payment of dividends out of
capital is the most frequent source of illegality, a declaration of dividends
contrary to the provisions of the charter or by-laws relative thereto, or a
declaration which disregards the rights of other stockholders, is equally
illegal. Thus, a dividend paid before reserving profits, where the by-laws
require antecedent reservation or one paid to common shareholders ahead
of an accumulated dividend to cumulative preferred stockholders, is classed
as illegal.
Revocation of Dividends
A dividend once legally declared and of which notice has been given
cannot be revoked. As stated above, such a dividend becomes a claim
against the corporation and ranks with the claims of outside creditors. Even
further than this, it has been held that if actual funds have been set aside, as
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by deposit in a bank, for the payment of these dividends, these funds cannot
be touched by other creditors in case of insolvency, but must be applied to
the payment of dividends.
With regard to the revocation of dividends, such action is held to be
possible only until the fact of declaration has become known outside the
board of directors. The revocation of a dividend is merely looked upon as a
reconsideration of business policy. In case of illegally declared dividends,
they may be revoked by the directors any time previous to payment and the
directors may be enjoined from making payment of them.
Payment of Dividends
Inasmuch as a declared dividend becomes a debt of the corporation, it
may be settled by whatever means another debt might be. Thus, if a
stockholder owes anything to the corporation, the debt for dividends may be
used as an offset and only the net payment be made or received, as the case
may be. In this way dividends may be made to apply to unpaid
subscriptions on capital stock.
After the declaration of dividends provision must be made to pay them.
Before the declaration, a report from the treasurer will have probably shown
the financial condition of the company to be such as to warrant the
payment. Unless specifically ordered otherwise, payment in cash is
understood. Payment of the dividend is a duty of the treasurer. If present at
the board meeting when the dividend is declared, that is sufficient
notification to him to make arrangement for paying it. If not, notice may
come to him verbally, by an inspection of the minute book, or by formal
notice from the secretary.
Dividends may be paid by check through the mail or by notifying the
stockholders to appear at a designated place to claim their dividends. Under
this latter procedure, receipt for the dividend is usually made by signature
of a form of receipt in the dividend book. Where payment is made by check,
the signing of a formal receipt may or may not be required. In a large
corporation the stock of which is widely held, a distinct series of checks
formally marked “Dividend Check” is made use of. If these checks bear an
identification phrase on their face, as Dividend No. ..., indorsement by the
holder upon receipt of payment by the bank and the bank’s cancellation
stamp undoubtedly constitute sufficient receipt for payment. However, if
be touched by other creditors in case of insolvency, but must be applied to
the payment of dividends.
With regard to the revocation of dividends, such action is held to be
possible only until the fact of declaration has become known outside the
board of directors. The revocation of a dividend is merely looked upon as a
reconsideration of business policy. In case of illegally declared dividends,
they may be revoked by the directors any time previous to payment and the
directors may be enjoined from making payment of them.
Payment of Dividends
Inasmuch as a declared dividend becomes a debt of the corporation, it
may be settled by whatever means another debt might be. Thus, if a
stockholder owes anything to the corporation, the debt for dividends may be
used as an offset and only the net payment be made or received, as the case
may be. In this way dividends may be made to apply to unpaid
subscriptions on capital stock.
After the declaration of dividends provision must be made to pay them.
Before the declaration, a report from the treasurer will have probably shown
the financial condition of the company to be such as to warrant the
payment. Unless specifically ordered otherwise, payment in cash is
understood. Payment of the dividend is a duty of the treasurer. If present at
the board meeting when the dividend is declared, that is sufficient
notification to him to make arrangement for paying it. If not, notice may
come to him verbally, by an inspection of the minute book, or by formal
notice from the secretary.
Dividends may be paid by check through the mail or by notifying the
stockholders to appear at a designated place to claim their dividends. Under
this latter procedure, receipt for the dividend is usually made by signature
of a form of receipt in the dividend book. Where payment is made by check,
the signing of a formal receipt may or may not be required. In a large
corporation the stock of which is widely held, a distinct series of checks
formally marked “Dividend Check” is made use of. If these checks bear an
identification phrase on their face, as Dividend No. ..., indorsement by the
holder upon receipt of payment by the bank and the bank’s cancellation
stamp undoubtedly constitute sufficient receipt for payment. However, if
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desirable, a formal receipt may be issued with the check and its return
requested. In a small corporation, the regular check series may be used and
marked as dividend checks.
Dividends Paid as Salaries
A peculiar method of payment of dividends is by means of excess
salaries—which is largely a matter of bookkeeping. In a close corporation
where all the stockholders are officers of the corporation, salaries, in
addition to those regularly paid, may be voted in lieu of dividends. The
courts have held that, so long as all the parties interested—incorporators,
stockholders, directors, and officers—assent to the scheme for the
distribution of profits by the payment of salaries, the plan is not
objectionable. Salaries so paid would usually be in proportion to holdings
of stock and as such become dividends, merely booked as salary.
Methods of Paying Dividends
An interesting point is raised in the question as to whether it is legal or
wise to borrow funds to pay dividends. This question in its turn raises the
point as to the various ways in which dividends may be paid. In addition to
the payment of dividends in cash, other property owned, such as the stock
and bonds of other concerns, even the more or less fixed assets if these can
be apportioned, may be used for this purpose. The issue of the company’s
obligations in the form of its own bonds, or in a special form of promise to
pay known as dividend scrip; and, furthermore, the absorption of the
dividend by the business through the issue of its own shares—both these
methods have been employed to liquidate the dividend obligation.
It will be noted that payment by cash or other asset has the effect of
decreasing the assets in order to decrease the liability for dividends; that
payment by the issue of bonds or scrip cancels one kind of liability by the
issue of another kind; whereas payment by the issue of the company’s own
shares liquidates the liability by increasing proprietorship through the issue
of stock, thus reinvesting in the business the portion of profits distributed as
dividends.
Borrowing to Pay Dividends
requested. In a small corporation, the regular check series may be used and
marked as dividend checks.
Dividends Paid as Salaries
A peculiar method of payment of dividends is by means of excess
salaries—which is largely a matter of bookkeeping. In a close corporation
where all the stockholders are officers of the corporation, salaries, in
addition to those regularly paid, may be voted in lieu of dividends. The
courts have held that, so long as all the parties interested—incorporators,
stockholders, directors, and officers—assent to the scheme for the
distribution of profits by the payment of salaries, the plan is not
objectionable. Salaries so paid would usually be in proportion to holdings
of stock and as such become dividends, merely booked as salary.
Methods of Paying Dividends
An interesting point is raised in the question as to whether it is legal or
wise to borrow funds to pay dividends. This question in its turn raises the
point as to the various ways in which dividends may be paid. In addition to
the payment of dividends in cash, other property owned, such as the stock
and bonds of other concerns, even the more or less fixed assets if these can
be apportioned, may be used for this purpose. The issue of the company’s
obligations in the form of its own bonds, or in a special form of promise to
pay known as dividend scrip; and, furthermore, the absorption of the
dividend by the business through the issue of its own shares—both these
methods have been employed to liquidate the dividend obligation.
It will be noted that payment by cash or other asset has the effect of
decreasing the assets in order to decrease the liability for dividends; that
payment by the issue of bonds or scrip cancels one kind of liability by the
issue of another kind; whereas payment by the issue of the company’s own
shares liquidates the liability by increasing proprietorship through the issue
of stock, thus reinvesting in the business the portion of profits distributed as
dividends.
Borrowing to Pay Dividends
Page 364
The answer to the question as to the legality of borrowing funds to pay
dividends may be inferred from the discussion above as to the status of a
declared dividend. Where the question of legality is not involved in the
declaration of dividends, i.e., where a declared dividend is legal in all
respects, the legality of borrowing to pay the dividend is no more open to
question than the legality of borrowing to pay any other legally contracted
debt. Though there may be ample profits, the affairs of a corporation may
be in such shape financially that the payment of a dividend would result
disastrously to the shareholders and even to the creditors. Here it is possible
to enjoin the directors from making payment. Action cannot be based on the
illegality of making payment but on the abuse of discretion amounting to
illegality in the declaration of the dividend.
If by so doing the finances of a corporation are not crippled, there is no
more legal objection to borrowing to pay a dividend debt than to borrow to
pay other debts. The courts have not always held so, however, but the
weight of authority seems to be that where profits have been earned but
become tied up in the enterprise the corporation may “borrow money on the
faith of it and divide that,” may sell the property in which the profits are
tied up and distribute the proceeds, or may borrow funds on the general
credit of the corporation sufficient to meet the dividend payments.
It has even been held that where the income has been applied to the
extension and betterment of the plant but the expenditure has been wrongly
booked as an expense charge instead of being capitalized, the income so
used may be recreated on the books by proper correcting entries and
dividends declared and paid therefrom. To the accountant such a procedure
seems perfectly correct, though the courts usually look askance at anything
savoring of a payment of dividends out of capital.
The chief question involved, therefore, in borrowing funds for the
payment of dividends is purely a financial one and the wisdom of such a
procedure must be based on financial considerations. If from that
standpoint, it is deemed feasible to borrow, the further question as to the
form of the loan must be considered. Is it for the best financial interest of
the company to borrow on short or long time, to create a floating or a
funded debt, etc.—these points require consideration and can, of course, be
answered only in the light of the conditions prevailing in each case as to the
status of the working capital requirements.
dividends may be inferred from the discussion above as to the status of a
declared dividend. Where the question of legality is not involved in the
declaration of dividends, i.e., where a declared dividend is legal in all
respects, the legality of borrowing to pay the dividend is no more open to
question than the legality of borrowing to pay any other legally contracted
debt. Though there may be ample profits, the affairs of a corporation may
be in such shape financially that the payment of a dividend would result
disastrously to the shareholders and even to the creditors. Here it is possible
to enjoin the directors from making payment. Action cannot be based on the
illegality of making payment but on the abuse of discretion amounting to
illegality in the declaration of the dividend.
If by so doing the finances of a corporation are not crippled, there is no
more legal objection to borrowing to pay a dividend debt than to borrow to
pay other debts. The courts have not always held so, however, but the
weight of authority seems to be that where profits have been earned but
become tied up in the enterprise the corporation may “borrow money on the
faith of it and divide that,” may sell the property in which the profits are
tied up and distribute the proceeds, or may borrow funds on the general
credit of the corporation sufficient to meet the dividend payments.
It has even been held that where the income has been applied to the
extension and betterment of the plant but the expenditure has been wrongly
booked as an expense charge instead of being capitalized, the income so
used may be recreated on the books by proper correcting entries and
dividends declared and paid therefrom. To the accountant such a procedure
seems perfectly correct, though the courts usually look askance at anything
savoring of a payment of dividends out of capital.
The chief question involved, therefore, in borrowing funds for the
payment of dividends is purely a financial one and the wisdom of such a
procedure must be based on financial considerations. If from that
standpoint, it is deemed feasible to borrow, the further question as to the
form of the loan must be considered. Is it for the best financial interest of
the company to borrow on short or long time, to create a floating or a
funded debt, etc.—these points require consideration and can, of course, be
answered only in the light of the conditions prevailing in each case as to the
status of the working capital requirements.
Page 365
Dividends Paid in Property, or by Borrowing on Property
Payment of dividends by means of property is unusual. It is seldom that
the property held can be so divided as to serve this purpose without loss of
value. Exception is found in the case of liquidating dividends, discussed on
page 445, for which purpose often the shares of stock and bonds of the
vendee may be distributed as payment to the vendor’s stockholders. More
often, the stocks and bonds will be used as collateral for a loan with which
to pay the dividend, or the real estate will be mortgaged for the same
purpose, thus effecting a borrowing of funds, a discussion of which has just
been given. Plots of land may sometimes be so divided as to be acceptable
as equitable shares of a dividend, where the stock of a corporation is held in
comparatively large blocks.
Bond and Scrip Dividends
Reference also has been made to the issue of the company’s own
obligations for payment of the dividend. If financial policy dictates a long-
term obligation, payment may be made out of any unissued bonds which the
company may possess or by means of a bond issue for this specific purpose.
More usual, however, is the payment of dividends by means of short-
term obligations known as scrip or dividend scrip. Scrip takes many forms.
It is usually so drawn as to constitute the corporation’s promise to pay. It
may be unconditional, and so negotiable, or it may be hedged about with
limiting conditions. Date of payment may be absolute or contingent. Scrip
may be convertible into the bonds or stock of the company at the option of
either party. Unredeemed scrip may even bear dividends. Usually, however,
the issue of scrip is for the purpose of deferring date of payment of the
dividend until cash can be accumulated from sale of property or from the
profits of the new period.
Stock Dividends
The one remaining method of settling the dividend claim is by the issue
of stock. As pointed out above, the effect of this is to convert some portion
of the “margin” or surplus into capital stock. This change in the form of
proprietorship is accomplished by a reduction of proprietorship through the
declaration of a dividend and an equal increase of proprietorship through
payment of the dividend in stock of the company. The effect of a stock
Payment of dividends by means of property is unusual. It is seldom that
the property held can be so divided as to serve this purpose without loss of
value. Exception is found in the case of liquidating dividends, discussed on
page 445, for which purpose often the shares of stock and bonds of the
vendee may be distributed as payment to the vendor’s stockholders. More
often, the stocks and bonds will be used as collateral for a loan with which
to pay the dividend, or the real estate will be mortgaged for the same
purpose, thus effecting a borrowing of funds, a discussion of which has just
been given. Plots of land may sometimes be so divided as to be acceptable
as equitable shares of a dividend, where the stock of a corporation is held in
comparatively large blocks.
Bond and Scrip Dividends
Reference also has been made to the issue of the company’s own
obligations for payment of the dividend. If financial policy dictates a long-
term obligation, payment may be made out of any unissued bonds which the
company may possess or by means of a bond issue for this specific purpose.
More usual, however, is the payment of dividends by means of short-
term obligations known as scrip or dividend scrip. Scrip takes many forms.
It is usually so drawn as to constitute the corporation’s promise to pay. It
may be unconditional, and so negotiable, or it may be hedged about with
limiting conditions. Date of payment may be absolute or contingent. Scrip
may be convertible into the bonds or stock of the company at the option of
either party. Unredeemed scrip may even bear dividends. Usually, however,
the issue of scrip is for the purpose of deferring date of payment of the
dividend until cash can be accumulated from sale of property or from the
profits of the new period.
Stock Dividends
The one remaining method of settling the dividend claim is by the issue
of stock. As pointed out above, the effect of this is to convert some portion
of the “margin” or surplus into capital stock. This change in the form of
proprietorship is accomplished by a reduction of proprietorship through the
declaration of a dividend and an equal increase of proprietorship through
payment of the dividend in stock of the company. The effect of a stock
Page 366
dividend, therefore, is to fix a portion of the “margin” so that it becomes a
part of the permanent capital of the corporation and, as such, is no longer
subject to the direct control of the board of directors. Excepting in states
which expressly forbid the stock dividend—and even here the same result is
accomplished by other means—its legality is thoroughly established.
Thus, in Howell v. Chicago, etc., Ry. Co., 51 Barb. (N. Y.) 378 (1868),
the court said: “It becomes immaterial whether such increase (in capital) is
made by awarding the stock to stockholders as dividends in lieu of money,
retaining the money for the purpose of the company, or by paying the
stockholders the dividends in cash from the earnings of the company and
selling the stock in the market to raise money for the use of the company.”
In Williams v. Western Union Telegraph Co., 93 N. Y. 162 (1883), the court
ruled: “If it [the corporation] can issue stock in payment of property to be
obtained by it as part of its capital for its legitimate uses, why may it not
issue stock in payment for property in effect purchased of them [i.e., the
shareholders] and added to its permanent capital and which they relinquish
the right to have divided? So long as every dollar of stock issued by a
corporation is represented by a dollar of property, no harm can result to
individuals or the public from distributing stock to stockholders.... All that
can be required in any case is that there shall be an actual capital in property
representing the amount of share capital issued.”
Any unissued or treasury stock in the possession of the company may
be used for this purpose and, in the case of unissued stock, becomes full-
paid if the property against which it is issued is of equal value to it. If the
necessary legal requirements are met, even authority for an issue of new
stock may be given and the stock used for the purpose of paying the
dividend.
Stock Dividends in Estate Accounting. An interesting point is raised in
estate accounting as to whether a stock dividend should be treated as
principal or income as between the life-interest party and the
remainderman. In such a case, the income from the stock which yields the
dividend belongs to the life-interest party, while the stock itself is the
principal and belongs to the remainderman. Of course, any dividend
declared before the decedent’s death, though not payable until after it, is a
part of the principal of the estate. The original fund of principal being
established, all dividends, whether in cash or stock, which disburse current
part of the permanent capital of the corporation and, as such, is no longer
subject to the direct control of the board of directors. Excepting in states
which expressly forbid the stock dividend—and even here the same result is
accomplished by other means—its legality is thoroughly established.
Thus, in Howell v. Chicago, etc., Ry. Co., 51 Barb. (N. Y.) 378 (1868),
the court said: “It becomes immaterial whether such increase (in capital) is
made by awarding the stock to stockholders as dividends in lieu of money,
retaining the money for the purpose of the company, or by paying the
stockholders the dividends in cash from the earnings of the company and
selling the stock in the market to raise money for the use of the company.”
In Williams v. Western Union Telegraph Co., 93 N. Y. 162 (1883), the court
ruled: “If it [the corporation] can issue stock in payment of property to be
obtained by it as part of its capital for its legitimate uses, why may it not
issue stock in payment for property in effect purchased of them [i.e., the
shareholders] and added to its permanent capital and which they relinquish
the right to have divided? So long as every dollar of stock issued by a
corporation is represented by a dollar of property, no harm can result to
individuals or the public from distributing stock to stockholders.... All that
can be required in any case is that there shall be an actual capital in property
representing the amount of share capital issued.”
Any unissued or treasury stock in the possession of the company may
be used for this purpose and, in the case of unissued stock, becomes full-
paid if the property against which it is issued is of equal value to it. If the
necessary legal requirements are met, even authority for an issue of new
stock may be given and the stock used for the purpose of paying the
dividend.
Stock Dividends in Estate Accounting. An interesting point is raised in
estate accounting as to whether a stock dividend should be treated as
principal or income as between the life-interest party and the
remainderman. In such a case, the income from the stock which yields the
dividend belongs to the life-interest party, while the stock itself is the
principal and belongs to the remainderman. Of course, any dividend
declared before the decedent’s death, though not payable until after it, is a
part of the principal of the estate. The original fund of principal being
established, all dividends, whether in cash or stock, which disburse current
Page 367
earnings belong to the life-tenant as income. Where a dividend partakes of
the nature of a liquidating dividend—i.e., represents a return of some
portion of the net worth as at the decedent’s death—the portion so returned
should, in equity, be looked upon as principal.
Any stock dividend has the effect of lessening the value of the stock
previously outstanding by the circumstance that it, while issued at par, after
issue takes on its pro rata share in any accumulated margin. Thus, by the
very fact of payment of a dividend in stock, the principal of the estate
diminishes in value. Courts have usually held this proper, however, but in
cases of manifest injustice, as where profits have been reserved in large
amounts and thus have come to be treated as a part of the permanent capital,
the “cutting of the melon” in the form of a stock dividend would work so
markedly to the injury of the value of the principal that exception would be
made here.
Dividends Proportional to Holdings
Dividends must be exactly proportional to the holdings of stock. If there
is but one class of stock outstanding, each share must bear the same
dividend as every other share. Any other basis of distribution is sufficient
cause for asking the intervention of the court. If several classes of stock
have been issued, the same requirements hold within each class; but as
between the classes themselves the dividend rates may vary, this variation
frequently being the differentiating mark. Among the members of any class,
therefore, distribution must be made with absolute impartiality, the number
of shares held by each determining the amount of dividend for each owner.
Also, time and manner of payment, except by special consent, must be the
same for every member within each class.
To Whom Payable
As stated above, the formal resolution declaring the dividend prescribes
where it shall go, so there can be made up a list of those to whom the
dividends are to be paid. To accomplish this it is usually stated that the
stock records for transfer of stock ownership shall be closed between
certain named dates and that dividends will be paid to those who appear as
shareholders as on the initial date of the closed period. This makes it
possible to bring the stock record up to that date and determine who are
the nature of a liquidating dividend—i.e., represents a return of some
portion of the net worth as at the decedent’s death—the portion so returned
should, in equity, be looked upon as principal.
Any stock dividend has the effect of lessening the value of the stock
previously outstanding by the circumstance that it, while issued at par, after
issue takes on its pro rata share in any accumulated margin. Thus, by the
very fact of payment of a dividend in stock, the principal of the estate
diminishes in value. Courts have usually held this proper, however, but in
cases of manifest injustice, as where profits have been reserved in large
amounts and thus have come to be treated as a part of the permanent capital,
the “cutting of the melon” in the form of a stock dividend would work so
markedly to the injury of the value of the principal that exception would be
made here.
Dividends Proportional to Holdings
Dividends must be exactly proportional to the holdings of stock. If there
is but one class of stock outstanding, each share must bear the same
dividend as every other share. Any other basis of distribution is sufficient
cause for asking the intervention of the court. If several classes of stock
have been issued, the same requirements hold within each class; but as
between the classes themselves the dividend rates may vary, this variation
frequently being the differentiating mark. Among the members of any class,
therefore, distribution must be made with absolute impartiality, the number
of shares held by each determining the amount of dividend for each owner.
Also, time and manner of payment, except by special consent, must be the
same for every member within each class.
To Whom Payable
As stated above, the formal resolution declaring the dividend prescribes
where it shall go, so there can be made up a list of those to whom the
dividends are to be paid. To accomplish this it is usually stated that the
stock records for transfer of stock ownership shall be closed between
certain named dates and that dividends will be paid to those who appear as
shareholders as on the initial date of the closed period. This makes it
possible to bring the stock record up to that date and determine who are
Page 368
owners at that time. Thus, a dividend resolution may read somewhat as
follows:
A dividend, No. 94, of two and one-half per cent (2½%)
for the quarter ending March 31, 1918, has been declared by
the Board of Directors out of past earnings, payable April 1
to stockholders of record at the close of business March 23.
Stock transfer books will be closed from March 23 to April 1
inclusive.
The stock records may, however, remain open, the matter being one of
convenience only.
If a transfer of stock should take place subsequent to the named date of
record, sale is usually made ex-dividend. If, however, sale should be made
with right to the dividend, notification of the assignment of the dividend
before the mailing of the dividend checks by the secretary or treasurer
constitutes an order for him to pay the dividend to the new party. The same
rule would obtain in the case of a sale made previous to the declaration of
dividends but not recorded till afterwards; so also in the case of pledged
stock, although payment should be made to the pledgee. Unless the
corporation is notified, its list of stockholders according to its records
governs in determining the owners of the dividend.
Accounting Record
Little need be added to what has been said in other places as to the
method of handling dividend transactions on the books. Their declaration is
booked as a charge against either the current Profit and Loss or the Surplus
account, with a credit to Dividends Payable. Their payment by any of the
methods already discussed in this chapter cancels the Dividends Payable
account and is reflected either by a decrease of assets, an increase of
liabilities, or an increase of proprietorship. In setting up the entries, ample
explanations should be made in the record itself or by reference to the
minute book.
As to handling the payment of the dividend, methods vary somewhat.
The secretary’s list of stockholders made up from the stock records should
show the stockholders according to the kinds of stock they hold, the amount
of the holdings of each, the dividend rate on each class, and the amount of
follows:
A dividend, No. 94, of two and one-half per cent (2½%)
for the quarter ending March 31, 1918, has been declared by
the Board of Directors out of past earnings, payable April 1
to stockholders of record at the close of business March 23.
Stock transfer books will be closed from March 23 to April 1
inclusive.
The stock records may, however, remain open, the matter being one of
convenience only.
If a transfer of stock should take place subsequent to the named date of
record, sale is usually made ex-dividend. If, however, sale should be made
with right to the dividend, notification of the assignment of the dividend
before the mailing of the dividend checks by the secretary or treasurer
constitutes an order for him to pay the dividend to the new party. The same
rule would obtain in the case of a sale made previous to the declaration of
dividends but not recorded till afterwards; so also in the case of pledged
stock, although payment should be made to the pledgee. Unless the
corporation is notified, its list of stockholders according to its records
governs in determining the owners of the dividend.
Accounting Record
Little need be added to what has been said in other places as to the
method of handling dividend transactions on the books. Their declaration is
booked as a charge against either the current Profit and Loss or the Surplus
account, with a credit to Dividends Payable. Their payment by any of the
methods already discussed in this chapter cancels the Dividends Payable
account and is reflected either by a decrease of assets, an increase of
liabilities, or an increase of proprietorship. In setting up the entries, ample
explanations should be made in the record itself or by reference to the
minute book.
As to handling the payment of the dividend, methods vary somewhat.
The secretary’s list of stockholders made up from the stock records should
show the stockholders according to the kinds of stock they hold, the amount
of the holdings of each, the dividend rate on each class, and the amount of
Page 369
the dividend payable to each stockholder. This list, with its calculations
verified by the treasurer, is the schedule according to which the dividend
checks are made out. Where a separate series of checks is made out for this
purpose, it is best to draw a check on general cash for the full amount of the
dividend and deposit it to dividend account with the bank. The individual
dividend checks are drawn against this account and so the detail of the
transaction is kept off the general books.
If all checks reach their destination, the dividend liability is canceled. If
any are unclaimed, a liability exists on account of them offset by funds
appropriated and set aside for its cancellation. If the fund is in the hands of
a trustee—which is not usual—and so beyond the control of the
corporation, there would be no reason for including the liability on account
of such dividends on a balance sheet as of that date. Under most
circumstances, the cash in the fund should be counted as cash on hand and
the liability shown. When in this way an unexpended balance of cash is
shown in dividend account, subsequent charges against it must be carefully
watched to see that they are properly authorized, otherwise the way to
fraudulent practice is opened.
Relation of Capital Losses to Dividends
Reference was made in Chapter XXII on “Profits” to the relation of
capital losses to dividends. The laws are very explicit in their declaration
that dividends shall not be paid out of capital. In this connection two
problems treated in Chapter XXII must be reconsidered. Here it is purposed
simply to restate them and summarize conclusions. These problems are: (1)
the interpretation of the law’s requirements in relation to the payment of
dividends without providing for the depletion of wasting assets; and (2) the
bearing of the law on dividend payments without making good all previous
encroachments on capital.
With regard to the first problem, law and practice are pretty well
established and are in accord. The decision in the case of Lee v. Neuchatel
Asphalte Co., L. R. 41, Ch. D. 1 (1889), has been followed quite generally.
There it is held that “if the objects of the company include the sinking of
capital in the acquisition of wasting property, even depreciation by waste is
not necessarily a revenue charge, but may by the regulations be thrown
upon capital.” And again, if a company is formed “to acquire and work a
verified by the treasurer, is the schedule according to which the dividend
checks are made out. Where a separate series of checks is made out for this
purpose, it is best to draw a check on general cash for the full amount of the
dividend and deposit it to dividend account with the bank. The individual
dividend checks are drawn against this account and so the detail of the
transaction is kept off the general books.
If all checks reach their destination, the dividend liability is canceled. If
any are unclaimed, a liability exists on account of them offset by funds
appropriated and set aside for its cancellation. If the fund is in the hands of
a trustee—which is not usual—and so beyond the control of the
corporation, there would be no reason for including the liability on account
of such dividends on a balance sheet as of that date. Under most
circumstances, the cash in the fund should be counted as cash on hand and
the liability shown. When in this way an unexpended balance of cash is
shown in dividend account, subsequent charges against it must be carefully
watched to see that they are properly authorized, otherwise the way to
fraudulent practice is opened.
Relation of Capital Losses to Dividends
Reference was made in Chapter XXII on “Profits” to the relation of
capital losses to dividends. The laws are very explicit in their declaration
that dividends shall not be paid out of capital. In this connection two
problems treated in Chapter XXII must be reconsidered. Here it is purposed
simply to restate them and summarize conclusions. These problems are: (1)
the interpretation of the law’s requirements in relation to the payment of
dividends without providing for the depletion of wasting assets; and (2) the
bearing of the law on dividend payments without making good all previous
encroachments on capital.
With regard to the first problem, law and practice are pretty well
established and are in accord. The decision in the case of Lee v. Neuchatel
Asphalte Co., L. R. 41, Ch. D. 1 (1889), has been followed quite generally.
There it is held that “if the objects of the company include the sinking of
capital in the acquisition of wasting property, even depreciation by waste is
not necessarily a revenue charge, but may by the regulations be thrown
upon capital.” And again, if a company is formed “to acquire and work a
Page 370
property of a wasting nature, for example, a mine, a quarry, or a patent, the
capital expended in acquiring the property may be regarded as sunk and
gone, and if the company retains assets sufficient to pay its debts, it appears
to me that there is nothing whatever in the Act to prevent any excess of
money obtained by working the property over the cost of working it from
being divided amongst the shareholders.”
The inclusion in the periodic dividend of the return of a portion of the
capital thus legalized is approved from a business standpoint on the ground
that from its very nature the enterprise is speculative in greater or less
degree and creditors are therefore sufficiently warned in their dealings with
such a concern. Of course, if any such company expects to be permanently
engaged in such enterprises it may be the part of wisdom to reserve from
distribution all the capital or whatever portion of it may be necessary to
finance each new undertaking. This is solely a matter of business policy,
however. “It is for the shareholders to say whether or not they will put by a
sinking fund to meet the waste.... They may if they like, but they are not
bound so to provide.”[66]
As to the second question raised above, the general rule and practice in
this country requires the making good of such losses first and the payment
of dividends only from a resulting surplus. Shields v. Hobart, 172 Mo. 491,
517 (1902), states the prevailing law in the matter as follows: “Dividends
can properly be declared only from the profits over and above the capital
stock and the debts of the company.”
There may be circumstances in which this rule may work a very real
hardship, and there is some support both in law and in a sense of justice
under given conditions for the view that each period stands by itself so far
as dividends are concerned, and that there is no need to use the profits of
one period to make good the encroachments on capital of a previous period
before paying a dividend. In such cases, the remedy is provided by a
reduction of capital stock by the amount of the encroachment upon it. The
payment of dividends on the remainder is then above question of law or the
best business policy. In this connection the student is referred to page 395,
Chapter XXII, for an often-quoted decision of the English courts.
Liquidating Dividends
capital expended in acquiring the property may be regarded as sunk and
gone, and if the company retains assets sufficient to pay its debts, it appears
to me that there is nothing whatever in the Act to prevent any excess of
money obtained by working the property over the cost of working it from
being divided amongst the shareholders.”
The inclusion in the periodic dividend of the return of a portion of the
capital thus legalized is approved from a business standpoint on the ground
that from its very nature the enterprise is speculative in greater or less
degree and creditors are therefore sufficiently warned in their dealings with
such a concern. Of course, if any such company expects to be permanently
engaged in such enterprises it may be the part of wisdom to reserve from
distribution all the capital or whatever portion of it may be necessary to
finance each new undertaking. This is solely a matter of business policy,
however. “It is for the shareholders to say whether or not they will put by a
sinking fund to meet the waste.... They may if they like, but they are not
bound so to provide.”[66]
As to the second question raised above, the general rule and practice in
this country requires the making good of such losses first and the payment
of dividends only from a resulting surplus. Shields v. Hobart, 172 Mo. 491,
517 (1902), states the prevailing law in the matter as follows: “Dividends
can properly be declared only from the profits over and above the capital
stock and the debts of the company.”
There may be circumstances in which this rule may work a very real
hardship, and there is some support both in law and in a sense of justice
under given conditions for the view that each period stands by itself so far
as dividends are concerned, and that there is no need to use the profits of
one period to make good the encroachments on capital of a previous period
before paying a dividend. In such cases, the remedy is provided by a
reduction of capital stock by the amount of the encroachment upon it. The
payment of dividends on the remainder is then above question of law or the
best business policy. In this connection the student is referred to page 395,
Chapter XXII, for an often-quoted decision of the English courts.
Liquidating Dividends
Page 371
Any dividend which represents a return of any portion of the capital is
to the extent of the portion returned a liquidating dividend. In other words, a
payment to a stockholder on account of capital invested is a liquidating
dividend. Such a dividend is met when the affairs of a corporation are being
wound up. The liquidation of a corporation is discussed in a later chapter.
Here the term is only defined because of its relationship to the dividend
paid by a corporation which is operating a wasting asset of some sort.
Usually the dividends paid by such a concern are not separated as to
content, showing how much is profits and how much is a return of capital.
A commendable exception to this is seen in the recent dividend notice of the
Shattuck Arizona Copper Co., reading as follows:
The Board of Directors of Shattuck Arizona Copper
Company has this day declared a dividend of Twenty-Five
(25c.) cents per share, and a capital distribution of Twenty-
Five (25c.) cents per share, payable January 19, 1918, to
stockholders of record at the close of business December 31,
1917. Stock Transfer Books do not close.
November 30, 1917.
If a reserve for depletion of the property is set up, the offsetting charge
to Profit and Loss results in that account’s balance showing the true profit.
Dividends declared in excess of this represent the part of the capital being
returned. In booking these liquidating dividends, the charge must, in strict
theory, be made directly against Capital Stock account. A charge to an
account called “Capital Liquidated as Dividends,” “Capital Returned to
Stockholders in Dividends,” “Capital Payments,” or other self-explanatory
title, may be made instead of the direct charge to Capital Stock. If so, such
an account should be carried as a valuation account for Capital Stock and
shown on the balance sheet as a deduction from Capital Stock.
Where, as has been allowed in connection with income tax returns, there
has been a revaluation of properties operating wasting assets, and values in
excess of the capital stock are established, such excess may be brought onto
the books as a charge to Property or Plant and a credit to an account called
“Property Surplus” or other similar title. Dividends thereafter declared,
provided the depletion charge is made periodically, will be charged as to
their profits against Surplus and, as to their return of capital portion, against
to the extent of the portion returned a liquidating dividend. In other words, a
payment to a stockholder on account of capital invested is a liquidating
dividend. Such a dividend is met when the affairs of a corporation are being
wound up. The liquidation of a corporation is discussed in a later chapter.
Here the term is only defined because of its relationship to the dividend
paid by a corporation which is operating a wasting asset of some sort.
Usually the dividends paid by such a concern are not separated as to
content, showing how much is profits and how much is a return of capital.
A commendable exception to this is seen in the recent dividend notice of the
Shattuck Arizona Copper Co., reading as follows:
The Board of Directors of Shattuck Arizona Copper
Company has this day declared a dividend of Twenty-Five
(25c.) cents per share, and a capital distribution of Twenty-
Five (25c.) cents per share, payable January 19, 1918, to
stockholders of record at the close of business December 31,
1917. Stock Transfer Books do not close.
November 30, 1917.
If a reserve for depletion of the property is set up, the offsetting charge
to Profit and Loss results in that account’s balance showing the true profit.
Dividends declared in excess of this represent the part of the capital being
returned. In booking these liquidating dividends, the charge must, in strict
theory, be made directly against Capital Stock account. A charge to an
account called “Capital Liquidated as Dividends,” “Capital Returned to
Stockholders in Dividends,” “Capital Payments,” or other self-explanatory
title, may be made instead of the direct charge to Capital Stock. If so, such
an account should be carried as a valuation account for Capital Stock and
shown on the balance sheet as a deduction from Capital Stock.
Where, as has been allowed in connection with income tax returns, there
has been a revaluation of properties operating wasting assets, and values in
excess of the capital stock are established, such excess may be brought onto
the books as a charge to Property or Plant and a credit to an account called
“Property Surplus” or other similar title. Dividends thereafter declared,
provided the depletion charge is made periodically, will be charged as to
their profits against Surplus and, as to their return of capital portion, against
Page 372
Property Surplus until that is exhausted, after which the charge should be
made as indicated above.
made as indicated above.
Page 373
CHAPTER XXV
THE SINKING FUND
Origin and Use
The sinking fund is a recognized and well-established instrument for the financing
of business. A great deal has been written about the subject, and over some of its
phases much wordy warfare has raged. As usual, however, the controversy has had
little or no effect on the practical application of the principle of the fund.
The sinking fund seems to have been first used as a practical instrument for the
repayment of debt in the year 1716, although the idea germinated some time before
this. At first its application was limited entirely to public finance. Through the efforts
of Sir Robert Walpole, legislation was enacted in England which made certain
specified taxes perpetual. Any surplus remaining after applying them to the purpose
for which they were levied was to be put into a sinking fund for the purpose of paying
off the public debt. Due to bad administration of the fund, it was not successful. Its
use was attempted a second time in 1786 by William Pitt, at the instance of a Dr.
Price. Since then it has had a rather checkered career in public finance. In some fields,
notably among municipal corporations, the device has been very successful. Through
the extension of the principle to the field of business the sinking fund found the use to
which it was best adapted.
Definitions
A sinking fund may be defined as “a fund formed by the investment of annual
savings or other contributions with a view to the ultimate application of the moneys so
accumulated in the payment of a previously incurred ... debt.” An English accounting
authority defines a sinking fund as “a fund set aside out of assets and accumulated at
interest for the purpose of meeting a debt.”[67] This latter definition draws attention to
the fact that the sinking fund is a fund of assets—not simply a book account set up to
indicate recognition by the board of directors of the need of providing for payment of
a debt, but certain definite assets set aside and, after accumulation, to be used for that
purpose. Attention should also be called to the fact that usually the fund is not
dependent solely for its increase upon interest accretions. As generally handled, the
fund is added to at regular intervals by setting aside more or less regular amounts of
assets to be applied to the same purpose. Frequently the contract agreement entered
into between the company and the creditors holding the debt to be repaid governs in
detail the way in which the fund is to be provided and the way in which it is to be
handled.
THE SINKING FUND
Origin and Use
The sinking fund is a recognized and well-established instrument for the financing
of business. A great deal has been written about the subject, and over some of its
phases much wordy warfare has raged. As usual, however, the controversy has had
little or no effect on the practical application of the principle of the fund.
The sinking fund seems to have been first used as a practical instrument for the
repayment of debt in the year 1716, although the idea germinated some time before
this. At first its application was limited entirely to public finance. Through the efforts
of Sir Robert Walpole, legislation was enacted in England which made certain
specified taxes perpetual. Any surplus remaining after applying them to the purpose
for which they were levied was to be put into a sinking fund for the purpose of paying
off the public debt. Due to bad administration of the fund, it was not successful. Its
use was attempted a second time in 1786 by William Pitt, at the instance of a Dr.
Price. Since then it has had a rather checkered career in public finance. In some fields,
notably among municipal corporations, the device has been very successful. Through
the extension of the principle to the field of business the sinking fund found the use to
which it was best adapted.
Definitions
A sinking fund may be defined as “a fund formed by the investment of annual
savings or other contributions with a view to the ultimate application of the moneys so
accumulated in the payment of a previously incurred ... debt.” An English accounting
authority defines a sinking fund as “a fund set aside out of assets and accumulated at
interest for the purpose of meeting a debt.”[67] This latter definition draws attention to
the fact that the sinking fund is a fund of assets—not simply a book account set up to
indicate recognition by the board of directors of the need of providing for payment of
a debt, but certain definite assets set aside and, after accumulation, to be used for that
purpose. Attention should also be called to the fact that usually the fund is not
dependent solely for its increase upon interest accretions. As generally handled, the
fund is added to at regular intervals by setting aside more or less regular amounts of
assets to be applied to the same purpose. Frequently the contract agreement entered
into between the company and the creditors holding the debt to be repaid governs in
detail the way in which the fund is to be provided and the way in which it is to be
handled.
Page 374
A sinking fund may be used for other purposes than the payment of debt. Thus,
occasionally one finds it created for the purpose of providing funds for the retirement
of capital stock issues, notably preferred stocks of various kinds.
It may be well again to point out the unfortunate lack of uniformity in the use of
the term. Thus “Sinking Fund” as an item in the balance sheet is found sometimes
among the debits and sometimes among the credits. Other titles under which the item
appears are: Sinking Fund Account, Sinking Fund Reserve, Sinking Fund
Investments, Sinking Fund Trustee, and Sinking Fund Cash. While in this chapter the
term will be used to indicate assets set aside in a definite fund—and limitation to this
use is growing among the best authorities—explanation will also be given of what the
other uses indicate as to financial policy and the manner of booking such policy.
Mathematical Principles on which Based
The mathematical principles on which the computation of the sinking fund rests
will first be explained. The problem involved here is the calculation of the amount
which set aside periodically and invested at compound interest will provide a sum
sufficient to pay off the debt when it matures. Needless to say, the sinking fund is
usually applied only to the redemption of long-term debts, as only over a
comparatively long period is the real potency of the compound interest principle
secured. For the solution of the problem it must be known whether the periodic
increments to the fund are set aside at the end or at the beginning of the period. It is
usually understood to be at the end of the period unless otherwise specified.
Assume, therefore, that a bond issue is made with maturity in n years and that the
contract with the bondholders calls for the creation of a sinking fund with payment
thereinto at the end of each period. It is required to find the amount to be paid into the
fund periodically. We will assume that:
P = the principal sum to be redeemed at maturity
n = the number of periods till redemption
A = the amount paid into the sinking fund at the end of each period
r = the rate per cent per period at which the moneys in the
sinking fund are invested at compound interest
R = 1+r
Reference to Chapter XV, page 271, gives the amount, A, of a sum of money put
at compound interest at r% for a term of n years, as A(1 + r)ⁿ⁻¹. It is evident here that
the sum, A, paid into the fund will accumulate for n-1 years and that each succeeding
payment remains at interest one year less than the next preceding amount, the last
amount earning no interest. Accordingly, the first A—we will denote it as A₁—will
amount to A(1 + r)ⁿ⁻¹; A₂ will amount to A(1 + r)ⁿ⁻²; A₃ to A(1 + r)ⁿ⁻³; etc. The
occasionally one finds it created for the purpose of providing funds for the retirement
of capital stock issues, notably preferred stocks of various kinds.
It may be well again to point out the unfortunate lack of uniformity in the use of
the term. Thus “Sinking Fund” as an item in the balance sheet is found sometimes
among the debits and sometimes among the credits. Other titles under which the item
appears are: Sinking Fund Account, Sinking Fund Reserve, Sinking Fund
Investments, Sinking Fund Trustee, and Sinking Fund Cash. While in this chapter the
term will be used to indicate assets set aside in a definite fund—and limitation to this
use is growing among the best authorities—explanation will also be given of what the
other uses indicate as to financial policy and the manner of booking such policy.
Mathematical Principles on which Based
The mathematical principles on which the computation of the sinking fund rests
will first be explained. The problem involved here is the calculation of the amount
which set aside periodically and invested at compound interest will provide a sum
sufficient to pay off the debt when it matures. Needless to say, the sinking fund is
usually applied only to the redemption of long-term debts, as only over a
comparatively long period is the real potency of the compound interest principle
secured. For the solution of the problem it must be known whether the periodic
increments to the fund are set aside at the end or at the beginning of the period. It is
usually understood to be at the end of the period unless otherwise specified.
Assume, therefore, that a bond issue is made with maturity in n years and that the
contract with the bondholders calls for the creation of a sinking fund with payment
thereinto at the end of each period. It is required to find the amount to be paid into the
fund periodically. We will assume that:
P = the principal sum to be redeemed at maturity
n = the number of periods till redemption
A = the amount paid into the sinking fund at the end of each period
r = the rate per cent per period at which the moneys in the
sinking fund are invested at compound interest
R = 1+r
Reference to Chapter XV, page 271, gives the amount, A, of a sum of money put
at compound interest at r% for a term of n years, as A(1 + r)ⁿ⁻¹. It is evident here that
the sum, A, paid into the fund will accumulate for n-1 years and that each succeeding
payment remains at interest one year less than the next preceding amount, the last
amount earning no interest. Accordingly, the first A—we will denote it as A₁—will
amount to A(1 + r)ⁿ⁻¹; A₂ will amount to A(1 + r)ⁿ⁻²; A₃ to A(1 + r)ⁿ⁻³; etc. The
Page 375
sum of all these amounts must be equal to P, the debt to be redeemed. Therefore, the
equation may be formed:
A(1 + r)ⁿ⁻¹ + A(1 + r)ⁿ⁻² ... + A(1 + r) + A = P or
A(Rⁿ⁻¹ + Rⁿ⁻² ... + R + 1) = P, whence
Rⁿ - 1
A =P and
R-1
P(R - 1) Pr
A= Rⁿ - 1
or
Rⁿ - 1
,
which being interpreted means that the theoretical amount to be set aside at the end of
each period can be found by multiplying the amount of the debt by the fraction
r
Rⁿ - 1
If the annual payment is made into the fund at the beginning of each period instead of
at the end, then A will be
Pr
R(Rⁿ - 1)
and the multiplying fraction
r
.
R(Rⁿ - 1)
It is evident that in practice some allowance will usually have to be made for
failure to keep all payments in the fund and interest accretions thereto constantly
invested at the calculated rate. This is not a matter of serious import, however, for
small inaccuracies can be adjusted during the last period or the last few periods by
increasing or decreasing the annual payments as may appear necessary at those times.
From a financial standpoint it should be borne in mind that there is no absolute
necessity for the accumulations in the fund to be sufficient in all cases to retire the
entire debt. Refunding a portion of it may be resorted to. Other conditions being
equal, it should be a much easier task to borrow only a portion as compared with
borrowing the original amount.
Accumulation Based on Agreement
equation may be formed:
A(1 + r)ⁿ⁻¹ + A(1 + r)ⁿ⁻² ... + A(1 + r) + A = P or
A(Rⁿ⁻¹ + Rⁿ⁻² ... + R + 1) = P, whence
Rⁿ - 1
A =P and
R-1
P(R - 1) Pr
A= Rⁿ - 1
or
Rⁿ - 1
,
which being interpreted means that the theoretical amount to be set aside at the end of
each period can be found by multiplying the amount of the debt by the fraction
r
Rⁿ - 1
If the annual payment is made into the fund at the beginning of each period instead of
at the end, then A will be
Pr
R(Rⁿ - 1)
and the multiplying fraction
r
.
R(Rⁿ - 1)
It is evident that in practice some allowance will usually have to be made for
failure to keep all payments in the fund and interest accretions thereto constantly
invested at the calculated rate. This is not a matter of serious import, however, for
small inaccuracies can be adjusted during the last period or the last few periods by
increasing or decreasing the annual payments as may appear necessary at those times.
From a financial standpoint it should be borne in mind that there is no absolute
necessity for the accumulations in the fund to be sufficient in all cases to retire the
entire debt. Refunding a portion of it may be resorted to. Other conditions being
equal, it should be a much easier task to borrow only a portion as compared with
borrowing the original amount.
Accumulation Based on Agreement
Page 376
It is necessary to call attention to the inapplicability of the above method to all
cases. Of course, where the contract between the borrower and the lender makes
definite provision for the manner of creating and handling the sinking fund, that
contract must therefore govern. However, in the case of a concern operating wasting
assets, a frequent provision of the trust agreement in the case of a bond issue is that
the periodic payments into the fund shall be proportional to the amount of the natural
product extracted or used. Thus in the coal mining industry the trust agreement may
provide that, say, five cents for every ton mined shall be placed in a sinking fund. In
determining the amount for each ton, the total amount of the debt to be extinguished is
divided by the estimated number of tons of coal in the mine. This gives the amount of
the debt which each ton must bear. Conservatism and business prudence require an
ample allowance for mistakes in the estimate of tonnage which it will be profitable to
mine and, also, for a liberal margin of safety. The relation between the life of the
bonds and the estimated annual output has an important bearing also, for the charge
per ton must be sufficient on the basis of the tonnage mined during the period covered
by the bonds to retire the bonds at their maturity, regardless of how much coal there is
still in the mine at that time—unless a refunding operation is contemplated.
Similarly in the case of timber properties, sinking fund payments are usually
roughly proportional to the amount of timber cut; in earthwork or quarry enterprises,
to the amount of material removed or quarried; in real estate development companies,
to the number of divisions made ready for the market. In such cases the compound
interest method, scientifically accurate, often gives place to annuity methods more or
less roughly calculated, under which, by trust agreement, definitely named sums,
approximately sufficient to accomplish redemption at maturity, are set aside
periodically.
Other methods fix the amount as so many per cent of gross or net profit, of the
bonds outstanding, of total business done, etc. Oftentimes, scientific accuracy, even if
desirable, is impossible because of provisions in the trust agreement to the effect that
the moneys in the sinking fund are to be used for the purchase of the company’s own
bonds at market but providing a maximum price above which none are to be bought.
This involves purchases at a premium, or possibly a discount, unknown at the time the
periodic amount must be calculated. An amount figured on the maximum price would
be conservative; or the amount may be based on par with the stipulation that the
difference between par and market shall be handled each period through the profit and
loss.
Effect of Settlement of Debt
As an introduction to the discussion which will follow of the relation of the
sinking fund to profits, we will first consider the several ways in which a debt may be
settled. For that purpose there is nothing which makes clear the principle involved
better than the fundamental schedule of debit and credit, showing the interplay of all
cases. Of course, where the contract between the borrower and the lender makes
definite provision for the manner of creating and handling the sinking fund, that
contract must therefore govern. However, in the case of a concern operating wasting
assets, a frequent provision of the trust agreement in the case of a bond issue is that
the periodic payments into the fund shall be proportional to the amount of the natural
product extracted or used. Thus in the coal mining industry the trust agreement may
provide that, say, five cents for every ton mined shall be placed in a sinking fund. In
determining the amount for each ton, the total amount of the debt to be extinguished is
divided by the estimated number of tons of coal in the mine. This gives the amount of
the debt which each ton must bear. Conservatism and business prudence require an
ample allowance for mistakes in the estimate of tonnage which it will be profitable to
mine and, also, for a liberal margin of safety. The relation between the life of the
bonds and the estimated annual output has an important bearing also, for the charge
per ton must be sufficient on the basis of the tonnage mined during the period covered
by the bonds to retire the bonds at their maturity, regardless of how much coal there is
still in the mine at that time—unless a refunding operation is contemplated.
Similarly in the case of timber properties, sinking fund payments are usually
roughly proportional to the amount of timber cut; in earthwork or quarry enterprises,
to the amount of material removed or quarried; in real estate development companies,
to the number of divisions made ready for the market. In such cases the compound
interest method, scientifically accurate, often gives place to annuity methods more or
less roughly calculated, under which, by trust agreement, definitely named sums,
approximately sufficient to accomplish redemption at maturity, are set aside
periodically.
Other methods fix the amount as so many per cent of gross or net profit, of the
bonds outstanding, of total business done, etc. Oftentimes, scientific accuracy, even if
desirable, is impossible because of provisions in the trust agreement to the effect that
the moneys in the sinking fund are to be used for the purchase of the company’s own
bonds at market but providing a maximum price above which none are to be bought.
This involves purchases at a premium, or possibly a discount, unknown at the time the
periodic amount must be calculated. An amount figured on the maximum price would
be conservative; or the amount may be based on par with the stipulation that the
difference between par and market shall be handled each period through the profit and
loss.
Effect of Settlement of Debt
As an introduction to the discussion which will follow of the relation of the
sinking fund to profits, we will first consider the several ways in which a debt may be
settled. For that purpose there is nothing which makes clear the principle involved
better than the fundamental schedule of debit and credit, showing the interplay of all
Page 377
transactions as they are brought onto the books. At the risk of unnecessary repetition,
that schedule is accordingly set up here for ease of reference.
Schedule of Debit and Credit
Debit: Credit:
(1) Increase of assets (a) Decrease of assets
(2) Decrease of liabilities (b) Increase of liabilities
(3) Decrease of proprietorship (c) Increase of proprietorship
From this it is seen that the redemption of a debt—a number (2) transaction—may
be accompanied, and therefore accomplished, by any one of the three offsetting
credits or by a combination of them. A debt may be settled (a) by the conversion of an
asset; (b) by the creation of another liability; or (c) by an increase in net worth. Cash
or other assets may be used for the purpose, resulting in a decrease of assets, as in (a)
of the schedule. It should be noted that the borrowing of, say, $1,000 and its
repayment in cash leaves the borrower in the same relative financial condition as
before, except for the gain derived from the use of the money borrowed. Such loans,
to be repaid in this way, are usually of a temporary nature, to tide over an emergency
—such as the handling of the load of seasonal activity, or other similar situation. This
method of settlement is, of course, not confined to payment of debts for money
borrowed, but includes debts contracted for merchandise purchased on credit and
other current liabilities.
Again, a debt of one kind may be settled by the creation of a debt of another kind,
as in (b) of the above schedule. Thus, an open account payable may be converted into
a note or acceptance payable. Here, the liability canceled and the new one created are
usually of the same class, viz., current liabilities, and the need for a more or less
permanent increase in working funds is not contemplated. So also, a current liability,
or a group of them, may be converted into a funded debt. This may be deemed
advisable when it is seen that there will be a permanent, or at least a long-term, need
for funds which have up to this point been provided by short-term borrowings and
credits. Again, a refunding operation would have the effect of a decrease of one
liability offset by the increase of another.
Finally, a debt may be canceled through an increase of proprietorship, as in (c) of
the schedule. By this means the redemption of the debt may be direct or indirect.
Capital stock, either treasury or previously unissued stock, may be accepted by
creditors in satisfaction of their claims. They thus change their status from creditors to
proprietors and the result is an increase of the concern’s net worth. Indirectly a debt
may be settled by the reservation of profits. Instead of distributing the profits as
dividends, they may be retained in the business and so provide funds, i.e., assets, for
the redemption of debts. In either case the settlement of the debt has been effected by
means of increased net worth evidenced by new issues of stock or by reserved profits.
that schedule is accordingly set up here for ease of reference.
Schedule of Debit and Credit
Debit: Credit:
(1) Increase of assets (a) Decrease of assets
(2) Decrease of liabilities (b) Increase of liabilities
(3) Decrease of proprietorship (c) Increase of proprietorship
From this it is seen that the redemption of a debt—a number (2) transaction—may
be accompanied, and therefore accomplished, by any one of the three offsetting
credits or by a combination of them. A debt may be settled (a) by the conversion of an
asset; (b) by the creation of another liability; or (c) by an increase in net worth. Cash
or other assets may be used for the purpose, resulting in a decrease of assets, as in (a)
of the schedule. It should be noted that the borrowing of, say, $1,000 and its
repayment in cash leaves the borrower in the same relative financial condition as
before, except for the gain derived from the use of the money borrowed. Such loans,
to be repaid in this way, are usually of a temporary nature, to tide over an emergency
—such as the handling of the load of seasonal activity, or other similar situation. This
method of settlement is, of course, not confined to payment of debts for money
borrowed, but includes debts contracted for merchandise purchased on credit and
other current liabilities.
Again, a debt of one kind may be settled by the creation of a debt of another kind,
as in (b) of the above schedule. Thus, an open account payable may be converted into
a note or acceptance payable. Here, the liability canceled and the new one created are
usually of the same class, viz., current liabilities, and the need for a more or less
permanent increase in working funds is not contemplated. So also, a current liability,
or a group of them, may be converted into a funded debt. This may be deemed
advisable when it is seen that there will be a permanent, or at least a long-term, need
for funds which have up to this point been provided by short-term borrowings and
credits. Again, a refunding operation would have the effect of a decrease of one
liability offset by the increase of another.
Finally, a debt may be canceled through an increase of proprietorship, as in (c) of
the schedule. By this means the redemption of the debt may be direct or indirect.
Capital stock, either treasury or previously unissued stock, may be accepted by
creditors in satisfaction of their claims. They thus change their status from creditors to
proprietors and the result is an increase of the concern’s net worth. Indirectly a debt
may be settled by the reservation of profits. Instead of distributing the profits as
dividends, they may be retained in the business and so provide funds, i.e., assets, for
the redemption of debts. In either case the settlement of the debt has been effected by
means of increased net worth evidenced by new issues of stock or by reserved profits.
Page 378
In these various ways, therefore, a debt may be settled. As pointed out above, the
first method contemplates no permanent need for increased working funds and the
extinguishment of the debt leaves the borrower in approximately the same position
financially as before its incurrence. Under the second method, the relative positions
before and after are the same excepting in the case of funding a floating debt. Here a
permanent or long-term increase in working funds is secured. With the third method a
permanent increase is secured in the capital funds available for use in the business.
Financial policy, governed by the needs of the business and its markets, will always
dictate the method to be used for extinguishing or contracting a debt.
Relation of Fund to Profits
The relation of the sinking fund to profits will next claim our attention. This point
has been much debated, reaching the acrimonious stage at times. It is variously
contended: (1) that there is a necessary relationship between profits and the payment
of a debt; (2) that for final settlement only assets will suffice; and (3) that the policy of
reserving profits to an amount equal to the sinking fund is a policy not dictated by any
fundamental principle of relationship between profits and debt redemption.
With regard to the first claim, it is sufficient to call attention to the discussion
above where the various ways of paying a debt were considered. As there pointed out,
a reservation of profits may offer the only available means of providing assets with
which to redeem debts. Accordingly, at least an indirect relationship between profits
and debt redemption is established.
As regards the second point, that only assets can be used for the final payment of
debts, this also is seen to be too broad a claim, for the issue of new stock may
accomplish the same end—directly, as where issued to creditors, or indirectly, as
where sold and the proceeds applied to liquidate the claims of creditors.
As to the third claim, it might be said with equal relevance that there is no basic
relationship between debt redemption and any method of settlement. The assertion can
be made with little fear of contradiction that so long as the claims of creditors are
satisfied, the manner of doing it is of small importance. Of course, only the currency
of the realm is a legal tender for debts but, if other forms of payment prove
satisfactory and are accepted, the matter ends. It is therefore solely a question of
financial policy, no principles of accounting are involved, and the only point in which
accounting is concerned is in making the record so as truthfully to show what is taking
place, i.e., to reflect accurately the financial policy adopted.
If the needs of the business require a permanent addition to the capital, as
mentioned above, that can be secured in only two ways, viz.: (1) the sale of stock and
(2) the reservation of profits. If, on the other hand, the debts to be repaid have
provided funds for the emergency or purpose for which they were contracted and that
emergency or purpose no longer exists, then the repayment of those funds to the
first method contemplates no permanent need for increased working funds and the
extinguishment of the debt leaves the borrower in approximately the same position
financially as before its incurrence. Under the second method, the relative positions
before and after are the same excepting in the case of funding a floating debt. Here a
permanent or long-term increase in working funds is secured. With the third method a
permanent increase is secured in the capital funds available for use in the business.
Financial policy, governed by the needs of the business and its markets, will always
dictate the method to be used for extinguishing or contracting a debt.
Relation of Fund to Profits
The relation of the sinking fund to profits will next claim our attention. This point
has been much debated, reaching the acrimonious stage at times. It is variously
contended: (1) that there is a necessary relationship between profits and the payment
of a debt; (2) that for final settlement only assets will suffice; and (3) that the policy of
reserving profits to an amount equal to the sinking fund is a policy not dictated by any
fundamental principle of relationship between profits and debt redemption.
With regard to the first claim, it is sufficient to call attention to the discussion
above where the various ways of paying a debt were considered. As there pointed out,
a reservation of profits may offer the only available means of providing assets with
which to redeem debts. Accordingly, at least an indirect relationship between profits
and debt redemption is established.
As regards the second point, that only assets can be used for the final payment of
debts, this also is seen to be too broad a claim, for the issue of new stock may
accomplish the same end—directly, as where issued to creditors, or indirectly, as
where sold and the proceeds applied to liquidate the claims of creditors.
As to the third claim, it might be said with equal relevance that there is no basic
relationship between debt redemption and any method of settlement. The assertion can
be made with little fear of contradiction that so long as the claims of creditors are
satisfied, the manner of doing it is of small importance. Of course, only the currency
of the realm is a legal tender for debts but, if other forms of payment prove
satisfactory and are accepted, the matter ends. It is therefore solely a question of
financial policy, no principles of accounting are involved, and the only point in which
accounting is concerned is in making the record so as truthfully to show what is taking
place, i.e., to reflect accurately the financial policy adopted.
If the needs of the business require a permanent addition to the capital, as
mentioned above, that can be secured in only two ways, viz.: (1) the sale of stock and
(2) the reservation of profits. If, on the other hand, the debts to be repaid have
provided funds for the emergency or purpose for which they were contracted and that
emergency or purpose no longer exists, then the repayment of those funds to the
Page 379
creditors is the business policy dictated. Under these circumstances, to load the
business with capital funds not needed in the enterprise might well be the height of
business folly. According to the conditions to be faced, there may or may not be any
necessary connection between debts and profits.
It should be pointed out that the kind of debt—i.e., the long-term obligation—for
the settlement of which the sinking fund method is often employed, is almost
invariably an indication of the need of a larger capital fund. Recognition of this is
frequently evidenced by the provisions of the trust agreement requiring the payment
into the sinking fund out of profits of the periodic contributions. This forces the
ultimate increase of capital to be made by the owners. Two other alternatives are open,
viz.: borrowing again at the maturity of the debt—a refunding operation—and
securing additional capital through the sale of stock. Conditions of the financial
market at the time the funds are needed, the policy of the concern as to the admission
of other owners, and the relative bargaining strength of the two parties to the loan—
these are determining factors in the financial policy to be adopted.
Accounting for Sinking Fund
The various problems met in accounting for the sinking fund will now be
discussed. First among these is the manner of showing its status on the balance sheet.
This may be done in four different ways. Here, also, the chief problem involved is an
accounting problem only so far as it concerns the best manner of setting forth
truthfully the facts of financial policy.
1. The sinking fund, then, under suitable title, may appear only among the assets.
As to financial policy, this indicates the creation of a distinct fund of assets for the
purpose of the sinking fund but it does not show definitely the way in which they are
being provided. They may be secured by cutting down certain assets previously
carried in larger amount than is now deemed necessary; by a reinvestment of profits;
or by the sale of additional capital stock. The balance sheet is silent as to what method
is being employed.
2. The balance sheet may record the sinking fund status among the assets as a
definite fund and also among the items of net worth as a sinking fund reserve. As to
financial policy this not only indicates the creation of a fund of assets, but shows that
this was accomplished by a withholding of profits from the stockholders and a
reservation of them for this very purpose.
3. There may appear on the balance sheet as the only evidence of a sinking fund
policy the sinking fund reserve among the net worth items. This shows a reservation
of profits for this purpose and therefore their investment in the business. The reserve
is not a covered reserve, however, no definite assets being set apart as representing
these profits, or, if set apart, as having been already applied to the cancellation of a
portion of the debt. This latter phase is explained more fully on page 458 following.
business with capital funds not needed in the enterprise might well be the height of
business folly. According to the conditions to be faced, there may or may not be any
necessary connection between debts and profits.
It should be pointed out that the kind of debt—i.e., the long-term obligation—for
the settlement of which the sinking fund method is often employed, is almost
invariably an indication of the need of a larger capital fund. Recognition of this is
frequently evidenced by the provisions of the trust agreement requiring the payment
into the sinking fund out of profits of the periodic contributions. This forces the
ultimate increase of capital to be made by the owners. Two other alternatives are open,
viz.: borrowing again at the maturity of the debt—a refunding operation—and
securing additional capital through the sale of stock. Conditions of the financial
market at the time the funds are needed, the policy of the concern as to the admission
of other owners, and the relative bargaining strength of the two parties to the loan—
these are determining factors in the financial policy to be adopted.
Accounting for Sinking Fund
The various problems met in accounting for the sinking fund will now be
discussed. First among these is the manner of showing its status on the balance sheet.
This may be done in four different ways. Here, also, the chief problem involved is an
accounting problem only so far as it concerns the best manner of setting forth
truthfully the facts of financial policy.
1. The sinking fund, then, under suitable title, may appear only among the assets.
As to financial policy, this indicates the creation of a distinct fund of assets for the
purpose of the sinking fund but it does not show definitely the way in which they are
being provided. They may be secured by cutting down certain assets previously
carried in larger amount than is now deemed necessary; by a reinvestment of profits;
or by the sale of additional capital stock. The balance sheet is silent as to what method
is being employed.
2. The balance sheet may record the sinking fund status among the assets as a
definite fund and also among the items of net worth as a sinking fund reserve. As to
financial policy this not only indicates the creation of a fund of assets, but shows that
this was accomplished by a withholding of profits from the stockholders and a
reservation of them for this very purpose.
3. There may appear on the balance sheet as the only evidence of a sinking fund
policy the sinking fund reserve among the net worth items. This shows a reservation
of profits for this purpose and therefore their investment in the business. The reserve
is not a covered reserve, however, no definite assets being set apart as representing
these profits, or, if set apart, as having been already applied to the cancellation of a
portion of the debt. This latter phase is explained more fully on page 458 following.
Page 380
Unless the assets have been applied in this way, the balance sheet gives no assurance
to the creditors that funds will be available for the settlement of their claims at
maturity. It may be that the reserved profits are being used for further extensions of
plant and so will not be easily available at maturity of the obligations. Again they may
be invested in increased stocks of current assets and so be readily available. Only an
analysis of the balance sheet will show the financial policy that is being pursued.
4. There may be no record of the sinking fund transactions shown on the balance
sheet. This might come about through the cancellation of some portion of the debt by
the conversion of assets. The balance sheet, except by comparative analysis, carries no
indication of the way in which it is accomplished. It may be that it is being done at the
expense of current activities—a poor policy—or through the withholding of owners’
profits. The balance sheet is non-committal.
Whatever method indicates the policy being followed with regard to the sinking
fund is the one which should be employed. So far as possible indefiniteness of
expression as well as nomenclature should be avoided; not only does an indefinite
statement fail to show the policy but it may be misleading.
The Sinking Fund on the Balance Sheet
In drawing up the balance sheet, the sinking fund assets usually appear under the
caption “Investment of Sinking and Other Funds.” Occasionally one finds the Sinking
Fund account treated as a debit valuation account, being shown as a deduction from
the Bond account. Such treatment indicates the amount of bonded indebtedness not
yet provided for by the sinking fund—an item of hardly enough importance to justify
its separate showing, particularly when an easy comparison, under any other method,
will give the same information. The cancellation of assets against liabilities or of
liabilities against assets is not good accounting practice. Where, however, the trust
agreement provides for the investment of the sinking fund cash in the company’s own
bonds and the cancellation of these bonds as purchased instead of holding them in the
fund for the sake of their income accretions, the bonds so canceled would, of course,
be deducted from the amount previously outstanding and only the present liability for
bonds be shown. There is no objection to showing this deduction on the face of each
balance sheet, as it thus shows the amount redeemed during the current period. If the
company’s own bonds are purchased but kept live, it is better to show the sinking fund
among the assets. All sinking fund reserves should, of course, be listed in the net
worth section of the balance sheet.
Entries to Sinking Fund
Accounting for the sinking fund presents nothing new in principle. There are, in
the main, three kinds of entries to be made, viz.:
to the creditors that funds will be available for the settlement of their claims at
maturity. It may be that the reserved profits are being used for further extensions of
plant and so will not be easily available at maturity of the obligations. Again they may
be invested in increased stocks of current assets and so be readily available. Only an
analysis of the balance sheet will show the financial policy that is being pursued.
4. There may be no record of the sinking fund transactions shown on the balance
sheet. This might come about through the cancellation of some portion of the debt by
the conversion of assets. The balance sheet, except by comparative analysis, carries no
indication of the way in which it is accomplished. It may be that it is being done at the
expense of current activities—a poor policy—or through the withholding of owners’
profits. The balance sheet is non-committal.
Whatever method indicates the policy being followed with regard to the sinking
fund is the one which should be employed. So far as possible indefiniteness of
expression as well as nomenclature should be avoided; not only does an indefinite
statement fail to show the policy but it may be misleading.
The Sinking Fund on the Balance Sheet
In drawing up the balance sheet, the sinking fund assets usually appear under the
caption “Investment of Sinking and Other Funds.” Occasionally one finds the Sinking
Fund account treated as a debit valuation account, being shown as a deduction from
the Bond account. Such treatment indicates the amount of bonded indebtedness not
yet provided for by the sinking fund—an item of hardly enough importance to justify
its separate showing, particularly when an easy comparison, under any other method,
will give the same information. The cancellation of assets against liabilities or of
liabilities against assets is not good accounting practice. Where, however, the trust
agreement provides for the investment of the sinking fund cash in the company’s own
bonds and the cancellation of these bonds as purchased instead of holding them in the
fund for the sake of their income accretions, the bonds so canceled would, of course,
be deducted from the amount previously outstanding and only the present liability for
bonds be shown. There is no objection to showing this deduction on the face of each
balance sheet, as it thus shows the amount redeemed during the current period. If the
company’s own bonds are purchased but kept live, it is better to show the sinking fund
among the assets. All sinking fund reserves should, of course, be listed in the net
worth section of the balance sheet.
Entries to Sinking Fund
Accounting for the sinking fund presents nothing new in principle. There are, in
the main, three kinds of entries to be made, viz.:
Page 381
1. Those dealing with the original and subsequent periodic
payments into the fund.
2. Those required to book the trustee’s periodic report of his
handling of the fund.
3. Those to show the redemption of the debt and the final
disposition of the accounts relating to the fund.
In the illustration, for the sake of definiteness, it will be assumed that the
governing financial policy is the second one discussed above, according to which not
only is a sinking fund created but also an equal amount of profits is reserved each
period; that the funds are placed in the hands of a trustee for investment and that any
income from the investments is to go into the fund; and that it is desired to show both
the investments of the trustee and the unexpended balance of cash in his possession.
The account titles are suggestive only, many varying titles being used. The entries
required to show the original payments into the fund are:
(1) Sinking Fund Cash in Hands of Trustee $.....
Cash $.....
To record payment to trustee of first
payment into the sinking fund created
according to terms of trust agreement
to retire the first mortgage 6% bonds.
(2) Surplus .....
Sinking Fund Reserve .....
To show the creation of a reserve to provide
funds for the redemption of bonds.
Subsequent payments into the fund would be recorded in exactly the same way as the
original payments.
Booking the Trustee’s Report
Upon receipt of the trustee’s report on the handling of the fund, entries must be
made to bring a summary of the report onto the books. This report should cover a full
accounting of the funds turned over to the trustee, his investment of them, all expenses
of the trust, and any income received or accrued. The funds may be left for accretion
in a savings bank; they may be used to purchase high-grade securities; or with them
the very bonds which they are to redeem may be bought and canceled immediately, or
allowed to run, the interest accretions going into the fund also. Securities for
investment may be bought at a premium or a discount. Expenses will be incurred by
payments into the fund.
2. Those required to book the trustee’s periodic report of his
handling of the fund.
3. Those to show the redemption of the debt and the final
disposition of the accounts relating to the fund.
In the illustration, for the sake of definiteness, it will be assumed that the
governing financial policy is the second one discussed above, according to which not
only is a sinking fund created but also an equal amount of profits is reserved each
period; that the funds are placed in the hands of a trustee for investment and that any
income from the investments is to go into the fund; and that it is desired to show both
the investments of the trustee and the unexpended balance of cash in his possession.
The account titles are suggestive only, many varying titles being used. The entries
required to show the original payments into the fund are:
(1) Sinking Fund Cash in Hands of Trustee $.....
Cash $.....
To record payment to trustee of first
payment into the sinking fund created
according to terms of trust agreement
to retire the first mortgage 6% bonds.
(2) Surplus .....
Sinking Fund Reserve .....
To show the creation of a reserve to provide
funds for the redemption of bonds.
Subsequent payments into the fund would be recorded in exactly the same way as the
original payments.
Booking the Trustee’s Report
Upon receipt of the trustee’s report on the handling of the fund, entries must be
made to bring a summary of the report onto the books. This report should cover a full
accounting of the funds turned over to the trustee, his investment of them, all expenses
of the trust, and any income received or accrued. The funds may be left for accretion
in a savings bank; they may be used to purchase high-grade securities; or with them
the very bonds which they are to redeem may be bought and canceled immediately, or
allowed to run, the interest accretions going into the fund also. Securities for
investment may be bought at a premium or a discount. Expenses will be incurred by
Page 382
way of commission or salary for the trustee, expenses of the trust, advertising,
brokers’ commission, etc.; and income will be received by the trustee from the
securities held and even from the unexpended balance of cash.
As to the purchase of securities at a premium or discount, the problem involved is
the proper handling of the premium or discount. Theoretically, whether in the hands of
a trustee or under own control, premiums and discounts on securities bought for long-
term investment should be amortized. The reader is referred to Chapter XV, page 267,
for the various methods of booking such investments. Oftentimes, however, the
premium is charged at once against the sinking fund income along with all other
expenses.
To book the investments of the trustee, the entries needed are:
(3) Sinking Fund Investments $.....
Sinking Fund Cash in Hands of Trustee $.....
(List here the securities purchased
and their price.)
(4) Sinking Fund Expenses .....
Sinking Fund Cash in Hands of Trustee .....
(Itemize here all expenses chargeable
against the fund or its income.)
(5) Sinking Fund Cash in Hands of Trustee $.....
Sinking Fund Income $.....
(Record here the income from interest on
unexpended cash balance and from securities,
with proper adjustments on account of
amortization of premium or discount.)
Treatment of Income and Expense
Practice varies as to the proper handling of the income and expense of the sinking
fund. Sometimes they are treated as affecting—i.e., increasing or decreasing—only
the sinking fund reserve and as having no place in the current profit and loss. That
seems a mistaken view; the fact that the investment is beyond the company’s control
none the less renders its income and expense a fact of current profit and loss, and it
should be so shown. Accordingly, the sinking fund expense and income accounts
above should be closed into profit and loss, after which their net result will be
brokers’ commission, etc.; and income will be received by the trustee from the
securities held and even from the unexpended balance of cash.
As to the purchase of securities at a premium or discount, the problem involved is
the proper handling of the premium or discount. Theoretically, whether in the hands of
a trustee or under own control, premiums and discounts on securities bought for long-
term investment should be amortized. The reader is referred to Chapter XV, page 267,
for the various methods of booking such investments. Oftentimes, however, the
premium is charged at once against the sinking fund income along with all other
expenses.
To book the investments of the trustee, the entries needed are:
(3) Sinking Fund Investments $.....
Sinking Fund Cash in Hands of Trustee $.....
(List here the securities purchased
and their price.)
(4) Sinking Fund Expenses .....
Sinking Fund Cash in Hands of Trustee .....
(Itemize here all expenses chargeable
against the fund or its income.)
(5) Sinking Fund Cash in Hands of Trustee $.....
Sinking Fund Income $.....
(Record here the income from interest on
unexpended cash balance and from securities,
with proper adjustments on account of
amortization of premium or discount.)
Treatment of Income and Expense
Practice varies as to the proper handling of the income and expense of the sinking
fund. Sometimes they are treated as affecting—i.e., increasing or decreasing—only
the sinking fund reserve and as having no place in the current profit and loss. That
seems a mistaken view; the fact that the investment is beyond the company’s control
none the less renders its income and expense a fact of current profit and loss, and it
should be so shown. Accordingly, the sinking fund expense and income accounts
above should be closed into profit and loss, after which their net result will be
Page 383
transferred from surplus to Sinking Fund Reserve, to show the net increment or
decrement as a result of the trustee’s operations. Thus:
(6) Sinking Fund Income $.....
Profit and Loss $.....
(7) Profit and Loss
Sinking Fund Expenses
(8) Profit and Loss
Surplus
Entry (8) is not strictly a sinking fund entry but transfers the entire balance of the
period’s profit and loss to surplus, out of which the net increment or decrement of the
sinking fund operations is transferred to Sinking Fund Reserve by entry (9):
(9) Surplus $.....
Sinking Fund Reserve $.....
An amount equal to the compound interest increment must always be transferred to
the reserve, if accurate results are desired.
Practically the same entries will serve if the investments are the company’s own
bonds. If the bonds are canceled, instead of entry (3) the following entry would be
made:
(10) First Mortgage 6% Bonds $.....
Sinking Fund Cash in Hands of Trustee $.....
Here the item of premium or discount is usually to be found and the question then
arises as to whether the item is not better handled as a charge or credit direct to
Sinking Fund Reserve rather than through the current profit and loss.
Final Disposition of Fund
There remain to be considered the entries recording the payment of the bonds at
maturity and the disposition of all sinking fund accounts. The securities of the trustee
must be reconverted into cash to be used for redeeming the bonds, often resulting in a
difference between the book value of securities and the actual amount realized
therefrom. This must be adjusted by charge or credit to the Sinking Fund Reserve.
After cancellation of all the bonds, any cash balance is turned back by the trustee to
the company. The entries on the books would be:
(11) Sinking Fund Cash in Hands of Trustee $.....
Sinking Fund Investments $.....
decrement as a result of the trustee’s operations. Thus:
(6) Sinking Fund Income $.....
Profit and Loss $.....
(7) Profit and Loss
Sinking Fund Expenses
(8) Profit and Loss
Surplus
Entry (8) is not strictly a sinking fund entry but transfers the entire balance of the
period’s profit and loss to surplus, out of which the net increment or decrement of the
sinking fund operations is transferred to Sinking Fund Reserve by entry (9):
(9) Surplus $.....
Sinking Fund Reserve $.....
An amount equal to the compound interest increment must always be transferred to
the reserve, if accurate results are desired.
Practically the same entries will serve if the investments are the company’s own
bonds. If the bonds are canceled, instead of entry (3) the following entry would be
made:
(10) First Mortgage 6% Bonds $.....
Sinking Fund Cash in Hands of Trustee $.....
Here the item of premium or discount is usually to be found and the question then
arises as to whether the item is not better handled as a charge or credit direct to
Sinking Fund Reserve rather than through the current profit and loss.
Final Disposition of Fund
There remain to be considered the entries recording the payment of the bonds at
maturity and the disposition of all sinking fund accounts. The securities of the trustee
must be reconverted into cash to be used for redeeming the bonds, often resulting in a
difference between the book value of securities and the actual amount realized
therefrom. This must be adjusted by charge or credit to the Sinking Fund Reserve.
After cancellation of all the bonds, any cash balance is turned back by the trustee to
the company. The entries on the books would be:
(11) Sinking Fund Cash in Hands of Trustee $.....
Sinking Fund Investments $.....
Page 384
To record sale of securities in
the sinking fund.
(12) Sinking Fund Reserve .....
Sinking Fund Investments .....
or
(13) Sinking Fund Investments .....
Sinking Fund Reserve .....
To adjust the difference between book
and realized values of the securities.
(14) First Mortgage 6% Bonds .....
Sinking Fund Cash in Hands of Trustee .....
To record redemption of all bonds.
(15) Cash .....
Sinking Fund Cash in Hands of Trustee .....
To record transfer to company of cash
balance in hands of trustee.
Treatment of Sinking Fund Reserve
Only the Sinking Fund Reserve account now remains on the books. Having served
its purpose of providing funds by retaining profits in the business for the redemption
of the bond issue, resulting in an addition to the net worth of the business, this reserve
is now free to be used as deemed best. It may be thrown into surplus and so become
available for dividend purposes; or it may be used as the basis for an increase in
capital stock and be distributed as a stock dividend, thus making the increase in net
worth permanent. The following entries respectively accomplish these ends:
(16) Sinking Fund Reserve $.....
Surplus $.....
(17) Surplus
Stock Dividend Payable
(18) Stock Dividend Payable
Capital Stock
Relation between Depreciation and Sinking Fund
the sinking fund.
(12) Sinking Fund Reserve .....
Sinking Fund Investments .....
or
(13) Sinking Fund Investments .....
Sinking Fund Reserve .....
To adjust the difference between book
and realized values of the securities.
(14) First Mortgage 6% Bonds .....
Sinking Fund Cash in Hands of Trustee .....
To record redemption of all bonds.
(15) Cash .....
Sinking Fund Cash in Hands of Trustee .....
To record transfer to company of cash
balance in hands of trustee.
Treatment of Sinking Fund Reserve
Only the Sinking Fund Reserve account now remains on the books. Having served
its purpose of providing funds by retaining profits in the business for the redemption
of the bond issue, resulting in an addition to the net worth of the business, this reserve
is now free to be used as deemed best. It may be thrown into surplus and so become
available for dividend purposes; or it may be used as the basis for an increase in
capital stock and be distributed as a stock dividend, thus making the increase in net
worth permanent. The following entries respectively accomplish these ends:
(16) Sinking Fund Reserve $.....
Surplus $.....
(17) Surplus
Stock Dividend Payable
(18) Stock Dividend Payable
Capital Stock
Relation between Depreciation and Sinking Fund
Page 385
A final problem deals with the relation between depreciation and the sinking fund.
If the trust agreement requires that a sinking fund reserve shall be created by charge
against profits, must provision be made also for the depreciation of the mortgaged
property held as security for the bonds? The fact of depreciation is omnipresent and
cannot be escaped. Also, the trust agreement must be lived up to. To carry out both
requirements simultaneously would manifestly result in a double charge. The charge
for depreciation is an expense charge which must be made before net profits can be
determined. The charge for the creation of the sinking fund reserve is against surplus,
i.e., it takes effect after the determination of net profits. Theoretically, therefore, the
provision for depreciation must be made, else true profits cannot be determined.
Equally certain must be the provision for the sinking fund reserve. Authorities seem to
agree that not only is there no need for provision for both but that to provide for both
places an unnecessary burden on the stockholders during the periods of the creation of
the sinking fund.
It is true that if the periodic amounts of the estimate for depreciation and the
sinking fund are practically the same, and if provision is made only for the sinking
fund reserve, there will be in that reserve a sufficient amount to care for the
depreciation. Assuming the life of the asset and the life of the bonds to be the same,
such a policy means simply that the asset, usually a fixed asset, has been converted by
use into current funds which have been applied to the liquidation of the bonds. There
has been no reservation of real profits for this purpose. Upon the complete
depreciation of the asset, the book value not having been written down in the
meantime because no depreciation has been booked for it, the asset must be charged
against the reserve, thereby mutually extinguishing each other. No principles of
accounting are necessarily violated.
Failure to book the depreciation as such results, however, in an inflated showing
of net profits. If the sinking fund reserve is charged against current profit and loss
instead of surplus, the showing of net profits is thus corrected but there has been no
real reservation of profits, the sinking fund reserve being in reality a valuation account
for the depreciating asset, and thus the letter of the trust agreement is violated. If the
intent of that agreement was to increase proprietorship, as discussed on page 456
above, this procedure will not accomplish that purpose.
Provision for both depreciation and the reserve does not effect a double charge
against profits. As pointed out above, the one is an expense charge without which true
profits cannot be shown, and the other is a charge against real profits, resulting in a
lessening of dividends. Where there is no trust agreement to compel the creation of a
sinking fund reserve, it is merely a matter of financial policy as to how the bonds shall
be redeemed, and there is no objection in theory to the conversion of the depreciating
asset to that purpose. Much more is this the case when the mortgaged asset is a
wasting asset, the exhaustion of which is inevitably bound up with the operation of the
business. Here there is no need either to increase proprietorship or even to maintain
If the trust agreement requires that a sinking fund reserve shall be created by charge
against profits, must provision be made also for the depreciation of the mortgaged
property held as security for the bonds? The fact of depreciation is omnipresent and
cannot be escaped. Also, the trust agreement must be lived up to. To carry out both
requirements simultaneously would manifestly result in a double charge. The charge
for depreciation is an expense charge which must be made before net profits can be
determined. The charge for the creation of the sinking fund reserve is against surplus,
i.e., it takes effect after the determination of net profits. Theoretically, therefore, the
provision for depreciation must be made, else true profits cannot be determined.
Equally certain must be the provision for the sinking fund reserve. Authorities seem to
agree that not only is there no need for provision for both but that to provide for both
places an unnecessary burden on the stockholders during the periods of the creation of
the sinking fund.
It is true that if the periodic amounts of the estimate for depreciation and the
sinking fund are practically the same, and if provision is made only for the sinking
fund reserve, there will be in that reserve a sufficient amount to care for the
depreciation. Assuming the life of the asset and the life of the bonds to be the same,
such a policy means simply that the asset, usually a fixed asset, has been converted by
use into current funds which have been applied to the liquidation of the bonds. There
has been no reservation of real profits for this purpose. Upon the complete
depreciation of the asset, the book value not having been written down in the
meantime because no depreciation has been booked for it, the asset must be charged
against the reserve, thereby mutually extinguishing each other. No principles of
accounting are necessarily violated.
Failure to book the depreciation as such results, however, in an inflated showing
of net profits. If the sinking fund reserve is charged against current profit and loss
instead of surplus, the showing of net profits is thus corrected but there has been no
real reservation of profits, the sinking fund reserve being in reality a valuation account
for the depreciating asset, and thus the letter of the trust agreement is violated. If the
intent of that agreement was to increase proprietorship, as discussed on page 456
above, this procedure will not accomplish that purpose.
Provision for both depreciation and the reserve does not effect a double charge
against profits. As pointed out above, the one is an expense charge without which true
profits cannot be shown, and the other is a charge against real profits, resulting in a
lessening of dividends. Where there is no trust agreement to compel the creation of a
sinking fund reserve, it is merely a matter of financial policy as to how the bonds shall
be redeemed, and there is no objection in theory to the conversion of the depreciating
asset to that purpose. Much more is this the case when the mortgaged asset is a
wasting asset, the exhaustion of which is inevitably bound up with the operation of the
business. Here there is no need either to increase proprietorship or even to maintain
Page 386
capital intact, and the conversion of the wasting asset, without providing for its
replacement, to the payment of the bond issue is legitimate and wholly
unobjectionable as a financial policy.
replacement, to the payment of the bond issue is legitimate and wholly
unobjectionable as a financial policy.
Page 387
CHAPTER XXVI
PROBLEMS IN CONNECTION WITH
THE PROFIT AND LOSS SUMMARY
Interrelation of Profit and Loss and Balance Sheet
Because of the supplemental character of the profit and loss summary to
the balance sheet, no study of the latter is complete or adequate, whether
viewed from the standpoint of valuation or from any other aspect, without
at least a consideration of the profit and loss summary in its larger bearings.
Some general features of the summary will here be considered, followed in
the next chapter by a discussion of its terminology, form, and content.
Every change in an asset which is not reflected among the other assets
or the liabilities relates to proprietorship; or, as stated from the profit and
loss point of view, every change in proprietorship, except it be merely a
transfer between proprietorship items, is reflected as a change in assets or
liabilities. The original contribution of capital is reflected among the assets.
Other items of vested or permanent proprietorship have been discussed in
Chapter XXIII, “Surplus and Reserves,” leaving for consideration here the
temporary proprietorship, i.e., the profit and loss items. Of these, every
income item results either in an increase of assets or a decrease of liability,
while every expense shows as a decrease of assets or increase of liabilities.
The relation of the profit and loss phase of an enterprise to the problem
of valuation is apparent—the majority of the changes in value of the assets
being connected with profit and loss activities. Thus sales result in cash or
claims against customers, and a valuation of these claims gives the amount
of bad debts expense. The valuation of fixed assets determines the amount
of depreciation expense. On the valuation of the stock-in-trade depends the
cost of goods sold and therefore the gross profit. Only those profit and loss
items which are realized or settled in cash are not dependent upon the
valuation of related assets, and even here, in so far as cash must under some
circumstances be valued, these may be, at least remotely, dependent upon
valuation. As, therefore, the balance sheet is primarily an expression of
PROBLEMS IN CONNECTION WITH
THE PROFIT AND LOSS SUMMARY
Interrelation of Profit and Loss and Balance Sheet
Because of the supplemental character of the profit and loss summary to
the balance sheet, no study of the latter is complete or adequate, whether
viewed from the standpoint of valuation or from any other aspect, without
at least a consideration of the profit and loss summary in its larger bearings.
Some general features of the summary will here be considered, followed in
the next chapter by a discussion of its terminology, form, and content.
Every change in an asset which is not reflected among the other assets
or the liabilities relates to proprietorship; or, as stated from the profit and
loss point of view, every change in proprietorship, except it be merely a
transfer between proprietorship items, is reflected as a change in assets or
liabilities. The original contribution of capital is reflected among the assets.
Other items of vested or permanent proprietorship have been discussed in
Chapter XXIII, “Surplus and Reserves,” leaving for consideration here the
temporary proprietorship, i.e., the profit and loss items. Of these, every
income item results either in an increase of assets or a decrease of liability,
while every expense shows as a decrease of assets or increase of liabilities.
The relation of the profit and loss phase of an enterprise to the problem
of valuation is apparent—the majority of the changes in value of the assets
being connected with profit and loss activities. Thus sales result in cash or
claims against customers, and a valuation of these claims gives the amount
of bad debts expense. The valuation of fixed assets determines the amount
of depreciation expense. On the valuation of the stock-in-trade depends the
cost of goods sold and therefore the gross profit. Only those profit and loss
items which are realized or settled in cash are not dependent upon the
valuation of related assets, and even here, in so far as cash must under some
circumstances be valued, these may be, at least remotely, dependent upon
valuation. As, therefore, the balance sheet is primarily an expression of
Page 388
opinion and judgment, rather than a statement of fact, so also in large
measure must the profit and loss summary be regarded as an expression of
opinion. The same factors which enter into appraisals and valuations
determine profits and losses.
Periodic Adjustments
In Chapter XXIII, on “Surplus and Reserves,” attention has been called
to the use of a statement of surplus for the purpose of showing the changes
which take place in surplus from period to period. These changes are due to
profits earned, dividends declared, extraordinary profit and loss items not
handled through the profit and loss summary, and adjustments in profit and
loss applicable to previous fiscal periods—such adjustments being
necessary because of errors in the profit and loss summaries of those
periods, due to insufficient information for making an accurate summary at
the time. The periodic profit and loss summary is limited in its purpose and
scope to the activities of the current period and to an equitable share of
those income and expense items running over a number of periods. Because
the adjustments just mentioned are frequently necessary, the periodic profit
and loss summary as it appears on the books is never an entirely accurate
reflection of the profit and loss activities for any period, but it is usually
sufficiently so to serve all current needs. When, however, the earning
capacity of a concern needs to be judged with great accuracy, over a number
of periods, it is not safe to depend entirely upon the periodic profit and loss
summaries. It may, for example, be necessary to judge earning capacity
because of a contemplated sale or merger. Here the basis for determining
value should be not the earnings of one period but the average of several
periods. It then becomes necessary to reconstruct the periodic profit and
loss summaries as carried on the books in the light of any additional
information that may have become available later.
The adjustments to be made in such cases comprise not only the most
obvious ones, caused by the oversight of accruals and deferred items of
various sorts, changes in inventory valuations due to an incorrect inclusion
or exclusion of some items, etc., but also changes in those items which in
the light of a longer experience are shown to be inaccurate. This latter class
of adjustments embraces particularly the estimated items the amounts of
which are not definitely determinable. As time passes, more complete
measure must the profit and loss summary be regarded as an expression of
opinion. The same factors which enter into appraisals and valuations
determine profits and losses.
Periodic Adjustments
In Chapter XXIII, on “Surplus and Reserves,” attention has been called
to the use of a statement of surplus for the purpose of showing the changes
which take place in surplus from period to period. These changes are due to
profits earned, dividends declared, extraordinary profit and loss items not
handled through the profit and loss summary, and adjustments in profit and
loss applicable to previous fiscal periods—such adjustments being
necessary because of errors in the profit and loss summaries of those
periods, due to insufficient information for making an accurate summary at
the time. The periodic profit and loss summary is limited in its purpose and
scope to the activities of the current period and to an equitable share of
those income and expense items running over a number of periods. Because
the adjustments just mentioned are frequently necessary, the periodic profit
and loss summary as it appears on the books is never an entirely accurate
reflection of the profit and loss activities for any period, but it is usually
sufficiently so to serve all current needs. When, however, the earning
capacity of a concern needs to be judged with great accuracy, over a number
of periods, it is not safe to depend entirely upon the periodic profit and loss
summaries. It may, for example, be necessary to judge earning capacity
because of a contemplated sale or merger. Here the basis for determining
value should be not the earnings of one period but the average of several
periods. It then becomes necessary to reconstruct the periodic profit and
loss summaries as carried on the books in the light of any additional
information that may have become available later.
The adjustments to be made in such cases comprise not only the most
obvious ones, caused by the oversight of accruals and deferred items of
various sorts, changes in inventory valuations due to an incorrect inclusion
or exclusion of some items, etc., but also changes in those items which in
the light of a longer experience are shown to be inaccurate. This latter class
of adjustments embraces particularly the estimated items the amounts of
which are not definitely determinable. As time passes, more complete
Page 389
knowledge may indicate insufficient or excessive estimates of such items as
depreciation, bad debts, provision for contingent liabilities, and similar
reserve items, the valuation of which must be corrected for an accurate
showing of earning capacity. Thus a distinction must be made between
summaries compiled to show the current profit and loss results and those
which give a true index of earning capacity over a longer period.
Interest as a Cost of Manufacture
A controversial point with a bearing on the profit and loss summary is
whether or not interest on invested capital should be included as an item of
manufacturing cost. One school of thought on the subject maintains, with a
considerable degree of argumentative warmth, that interest should be
included; while another school takes the opposite point of view. An attempt
will here be made to summarize the arguments for and against the treatment
of interest as an item of manufacturing cost. The one school bases its main
contention on the economic theory of profits; namely, that profits represent
the balance remaining after deducting the cost of land, capital, and labor.
The function of the entrepreneur, it is contended, does not in itself involve
the owning of capital. Profit is the reward for combining the other factors of
production and assuming the risk involved. Interest is a cost for the use of
capital and it does not matter who owns the capital.
It is further contended that, in order to bring a fair return on the capital
invested, the selling price must include interest on capital investment. While
this contention is true, the fact remains that no manufacturer would think of
fixing selling price as a matter of general policy at a figure which would not
return a fair rate of interest on his investment. But why that necessitates
taking into the books interest as an element of cost is not explained by this
theory.
It is also argued that to determine whether it is better to manufacture or
to buy goods in the open market, and whether it is better policy to
manufacture by means of expensive machinery and other equipment or by
manual labor, interest on investment must be considered. While these
arguments also are well taken, they again offer no satisfactory justification
for the showing of interest on the books. It is furthermore contended that
the cost of carrying the inventories for which the purchasing, stores, and
planning departments of a manufacturing concern are responsible, should
depreciation, bad debts, provision for contingent liabilities, and similar
reserve items, the valuation of which must be corrected for an accurate
showing of earning capacity. Thus a distinction must be made between
summaries compiled to show the current profit and loss results and those
which give a true index of earning capacity over a longer period.
Interest as a Cost of Manufacture
A controversial point with a bearing on the profit and loss summary is
whether or not interest on invested capital should be included as an item of
manufacturing cost. One school of thought on the subject maintains, with a
considerable degree of argumentative warmth, that interest should be
included; while another school takes the opposite point of view. An attempt
will here be made to summarize the arguments for and against the treatment
of interest as an item of manufacturing cost. The one school bases its main
contention on the economic theory of profits; namely, that profits represent
the balance remaining after deducting the cost of land, capital, and labor.
The function of the entrepreneur, it is contended, does not in itself involve
the owning of capital. Profit is the reward for combining the other factors of
production and assuming the risk involved. Interest is a cost for the use of
capital and it does not matter who owns the capital.
It is further contended that, in order to bring a fair return on the capital
invested, the selling price must include interest on capital investment. While
this contention is true, the fact remains that no manufacturer would think of
fixing selling price as a matter of general policy at a figure which would not
return a fair rate of interest on his investment. But why that necessitates
taking into the books interest as an element of cost is not explained by this
theory.
It is also argued that to determine whether it is better to manufacture or
to buy goods in the open market, and whether it is better policy to
manufacture by means of expensive machinery and other equipment or by
manual labor, interest on investment must be considered. While these
arguments also are well taken, they again offer no satisfactory justification
for the showing of interest on the books. It is furthermore contended that
the cost of carrying the inventories for which the purchasing, stores, and
planning departments of a manufacturing concern are responsible, should
Page 390
be shown with interest on the money invested in them taken into
consideration—this for the purpose of providing a check on the efficiency
of these departments. Where also both old and new machinery is used side
by side and it is desirable to compare their costs of production, the element
of interest should be considered.
Further argument for the inclusion of interest as an item of cost is the
fact that in numerous processes time is an important element. Thus, the
smelting of ore, the tanning of leather, the curing of tobacco, the seasoning
of lumber, etc., are examples of relatively lengthy processes the cost of
which should include interest on the capital invested. Interest on investment
is also a factor that may sometimes determine manufacturing and selling
policies, especially during slack periods when production is curtailed, part
of the plant stands idle, and the fixed charges on the unused manufacturing
capacity need to be taken into consideration. The same argument also
applies to the accumulation of a large inventory of raw materials or finished
stock during a period of low prices. The soundness of such a policy can
only be judged when the item of interest on the capital investment is
considered.
Arguments against the Inclusion of Interest
The majority of accountants are, however, opposed to the inclusion of
interest as an item of manufacturing cost. The chief objections raised to its
inclusion are:
1. The difficulty of determining the rate at which
interest should be charged.
2. Inasmuch as the amount of investment in current
assets is difficult to determine since it fluctuates
daily, is interest to be charged both on fixed
investment and on current investment, or only on
the fixed?
3. If interest is to be charged, how shall the offsetting
credit be handled on the books?
4. The introduction in production costs of a more or
less constant element tends to obscure fluctuations
in actual cost due to causes which may be
consideration—this for the purpose of providing a check on the efficiency
of these departments. Where also both old and new machinery is used side
by side and it is desirable to compare their costs of production, the element
of interest should be considered.
Further argument for the inclusion of interest as an item of cost is the
fact that in numerous processes time is an important element. Thus, the
smelting of ore, the tanning of leather, the curing of tobacco, the seasoning
of lumber, etc., are examples of relatively lengthy processes the cost of
which should include interest on the capital invested. Interest on investment
is also a factor that may sometimes determine manufacturing and selling
policies, especially during slack periods when production is curtailed, part
of the plant stands idle, and the fixed charges on the unused manufacturing
capacity need to be taken into consideration. The same argument also
applies to the accumulation of a large inventory of raw materials or finished
stock during a period of low prices. The soundness of such a policy can
only be judged when the item of interest on the capital investment is
considered.
Arguments against the Inclusion of Interest
The majority of accountants are, however, opposed to the inclusion of
interest as an item of manufacturing cost. The chief objections raised to its
inclusion are:
1. The difficulty of determining the rate at which
interest should be charged.
2. Inasmuch as the amount of investment in current
assets is difficult to determine since it fluctuates
daily, is interest to be charged both on fixed
investment and on current investment, or only on
the fixed?
3. If interest is to be charged, how shall the offsetting
credit be handled on the books?
4. The introduction in production costs of a more or
less constant element tends to obscure fluctuations
in actual cost due to causes which may be
Page 391
corrected, and thereby partly defeats the very
purpose of cost-keeping.
5. As the business world is accustomed to consider
interest and dividends as of the same nature,
namely, as a return on capital invested, to treat
interest as a cost of operation would produce
financial statements which are misleading.
With regard to the rate of interest, three different theoretical rates have
been suggested: (1) a so-called “pure” interest rate, i.e., one yielded by the
safest investment; (2) the rate at which money might be borrowed for the
particular type of industry; and (3) a rate sufficient to attract permanent
investment in the enterprise. From the practical standpoint of results there
are serious objections to all these suggestions. As it is beyond the scope of
this chapter to discuss this phase of the question, the interested student is
referred to the numerous writers who deal with the question.
Problem of Charging Interest on Books
Where interest is treated as a manufacturing cost, the booking of it
raises a perplexing accounting problem. The charge has to be made to some
factory expense account, while the credit must be carried over to possibly a
financial management income account. If the entire output of the factory
were sold out by the close of the fiscal period and no product was in process
of manufacture at that time, the result of booking interest in this way, so far
as net profit is concerned, would be nil. It would be like taking money out
of one pocket and putting it in another. This situation, however, is never met
at the close of the fiscal period. Almost invariably some finished stock is on
hand and goods are in process of manufacture. Where interest is added, the
result is to inflate the value at which the goods must be carried on the
inventory—a very undesirable procedure from an accounting and financial
viewpoint. By such means it is conceivable that a factory might be made to
show a handsome profit even before any of the product had been sold.
Considering both the ends to be attained by, and the defects and
disadvantages of, the inclusion of interest as an item of factory cost, its
exclusion seems best. In this connection it is to be noted that all government
contracts on a “cost-plus” basis do not allow the inclusion of interest as one
of the cost items. Furthermore, all the ends aimed at by its inclusion may be
purpose of cost-keeping.
5. As the business world is accustomed to consider
interest and dividends as of the same nature,
namely, as a return on capital invested, to treat
interest as a cost of operation would produce
financial statements which are misleading.
With regard to the rate of interest, three different theoretical rates have
been suggested: (1) a so-called “pure” interest rate, i.e., one yielded by the
safest investment; (2) the rate at which money might be borrowed for the
particular type of industry; and (3) a rate sufficient to attract permanent
investment in the enterprise. From the practical standpoint of results there
are serious objections to all these suggestions. As it is beyond the scope of
this chapter to discuss this phase of the question, the interested student is
referred to the numerous writers who deal with the question.
Problem of Charging Interest on Books
Where interest is treated as a manufacturing cost, the booking of it
raises a perplexing accounting problem. The charge has to be made to some
factory expense account, while the credit must be carried over to possibly a
financial management income account. If the entire output of the factory
were sold out by the close of the fiscal period and no product was in process
of manufacture at that time, the result of booking interest in this way, so far
as net profit is concerned, would be nil. It would be like taking money out
of one pocket and putting it in another. This situation, however, is never met
at the close of the fiscal period. Almost invariably some finished stock is on
hand and goods are in process of manufacture. Where interest is added, the
result is to inflate the value at which the goods must be carried on the
inventory—a very undesirable procedure from an accounting and financial
viewpoint. By such means it is conceivable that a factory might be made to
show a handsome profit even before any of the product had been sold.
Considering both the ends to be attained by, and the defects and
disadvantages of, the inclusion of interest as an item of factory cost, its
exclusion seems best. In this connection it is to be noted that all government
contracts on a “cost-plus” basis do not allow the inclusion of interest as one
of the cost items. Furthermore, all the ends aimed at by its inclusion may be
Page 392
secured almost if not equally as well by statistical records, thus eliminating
the objections to the bringing of interest as an item of cost onto the financial
records.
Unrealized Profits
A similar problem to the above is the practice of charging a
manufacturing profit to the selling department. The practice is prevalent in
some concerns, of transferring the output of the factory to the selling
department at a value above the cost to manufacture. The purpose of such a
transfer is to show on the books the profit arising from the policy of
manufacturing the product instead of buying it on the open market. The
value at which the product is transferred from the factory to the selling
department is usually the wholesale market value, though it may be at a
fixed per cent above the cost of manufacture. The effect of this is, of course,
to limit definitely the showing of factory profit. Where the compensation or
the efficiency of the factory management is measured by the savings
effected over the wholesale market price of the output, there is perhaps
some practical advantage in the allowance of a manufacturing profit.
The main objection to charging the factory output to the selling
department at any price other than cost is that such a policy introduces an
element of unrealized profit. This objection is not serious if, at the time the
books are closed for the purpose of showing results for the fiscal period, the
unrealized profit is eliminated from the stock-in-trade inventory. So far as
the profits on the portion of the output which has been sold are concerned,
the net result is the same. The effect is to diminish the profit of the selling
department by the amount of profit allowed to the factory. To bring assets
onto the books at inflated values is, however, always objectionable, both
because of the temptation to inflate profits by valuing the goods for the
inventory at an inflated figure, and also because of the ease with which the
adjustment of such items may be overlooked or forgotten at the close of the
fiscal period. Where the adjustment is made with care, correct results can be
shown as well by the one method as by the other. The adjustment needed
applies only to the inventory of goods remaining unsold at the close of the
period, which adjustment is usually shown by means of a valuation reserve
account, by means of which the book value of the inventory is brought
down to the factory cost value.
the objections to the bringing of interest as an item of cost onto the financial
records.
Unrealized Profits
A similar problem to the above is the practice of charging a
manufacturing profit to the selling department. The practice is prevalent in
some concerns, of transferring the output of the factory to the selling
department at a value above the cost to manufacture. The purpose of such a
transfer is to show on the books the profit arising from the policy of
manufacturing the product instead of buying it on the open market. The
value at which the product is transferred from the factory to the selling
department is usually the wholesale market value, though it may be at a
fixed per cent above the cost of manufacture. The effect of this is, of course,
to limit definitely the showing of factory profit. Where the compensation or
the efficiency of the factory management is measured by the savings
effected over the wholesale market price of the output, there is perhaps
some practical advantage in the allowance of a manufacturing profit.
The main objection to charging the factory output to the selling
department at any price other than cost is that such a policy introduces an
element of unrealized profit. This objection is not serious if, at the time the
books are closed for the purpose of showing results for the fiscal period, the
unrealized profit is eliminated from the stock-in-trade inventory. So far as
the profits on the portion of the output which has been sold are concerned,
the net result is the same. The effect is to diminish the profit of the selling
department by the amount of profit allowed to the factory. To bring assets
onto the books at inflated values is, however, always objectionable, both
because of the temptation to inflate profits by valuing the goods for the
inventory at an inflated figure, and also because of the ease with which the
adjustment of such items may be overlooked or forgotten at the close of the
fiscal period. Where the adjustment is made with care, correct results can be
shown as well by the one method as by the other. The adjustment needed
applies only to the inventory of goods remaining unsold at the close of the
period, which adjustment is usually shown by means of a valuation reserve
account, by means of which the book value of the inventory is brought
down to the factory cost value.
Page 393
The whole problem of profit between departments is one phase of the
larger problem of the intercompany profits of a holding company. In such a
case it usually happens that one of the subsidiaries with separate corporate
organization turns over its product to some other subsidiary company at a
price which returns a fair rate of profit. As the product passes through the
hands of the various subsidiaries, by the time it is ready for final
distribution to the public the accumulated profits represent those of all the
companies engaged in its production. If, now, all these subsidiaries belong
to the same parent company, the book value of the unsold product shows, at
the close of the fiscal period, a large unrealized profit which must be
adjusted in order not to show the stock-in-trade at an inflated value. This
problem is discussed more fully in Chapter XXXIV where the main
problems of the holding company are taken up.
Corporation Dividends
In addition to these general problems of the profit and loss summary,
some further questions arise at the time of closing the records of a
corporation for the fiscal period. Much more care must be taken in closing
the books of a company than is necessary in the case of either of the other
general types of business organization. Thus, the corporation authorized to
issue a number of different kinds of stock must see that the dividend
declaration is based only on the amounts of the various classes of stock
outstanding, and not on the stock unissued or brought back into the treasury.
It is customary to set up separate dividend accounts for each class of stock.
Oftentimes the terms of issue covering the various kinds of stock introduce
complexities in the calculation of the dividend. This is particularly true in
the case of stocks which have the privilege of participating in all dividends
over a certain amount. Some stocks are cumulative as to their dividend,
while others may be non-cumulative. All these conditions of issue must be
considered carefully at the time of the declaration of the dividend.
Discount on Bonds
Another problem requiring care is the treatment of discount or premium
on bonds as they are related to the bond interest charge. In Chapter XV
where bonds are discussed, the relation between the bond premium or
discount and the bond interest rate is brought out. This necessitates at the
time of the payment of the bond interest an entry to bring about the gradual
larger problem of the intercompany profits of a holding company. In such a
case it usually happens that one of the subsidiaries with separate corporate
organization turns over its product to some other subsidiary company at a
price which returns a fair rate of profit. As the product passes through the
hands of the various subsidiaries, by the time it is ready for final
distribution to the public the accumulated profits represent those of all the
companies engaged in its production. If, now, all these subsidiaries belong
to the same parent company, the book value of the unsold product shows, at
the close of the fiscal period, a large unrealized profit which must be
adjusted in order not to show the stock-in-trade at an inflated value. This
problem is discussed more fully in Chapter XXXIV where the main
problems of the holding company are taken up.
Corporation Dividends
In addition to these general problems of the profit and loss summary,
some further questions arise at the time of closing the records of a
corporation for the fiscal period. Much more care must be taken in closing
the books of a company than is necessary in the case of either of the other
general types of business organization. Thus, the corporation authorized to
issue a number of different kinds of stock must see that the dividend
declaration is based only on the amounts of the various classes of stock
outstanding, and not on the stock unissued or brought back into the treasury.
It is customary to set up separate dividend accounts for each class of stock.
Oftentimes the terms of issue covering the various kinds of stock introduce
complexities in the calculation of the dividend. This is particularly true in
the case of stocks which have the privilege of participating in all dividends
over a certain amount. Some stocks are cumulative as to their dividend,
while others may be non-cumulative. All these conditions of issue must be
considered carefully at the time of the declaration of the dividend.
Discount on Bonds
Another problem requiring care is the treatment of discount or premium
on bonds as they are related to the bond interest charge. In Chapter XV
where bonds are discussed, the relation between the bond premium or
discount and the bond interest rate is brought out. This necessitates at the
time of the payment of the bond interest an entry to bring about the gradual
Page 394
amortization of the bond premium or discount so that by the expiration of
the life of the bond issue the premium or discount is written off the books.
Where the interest period does not coincide with the close of the fiscal
period, for an absolutely accurate showing not only must the accrued bond
interest be taken into account but also the accrued amortization of bond
premium or discount.
Sinking Funds
A third problem at the time of closing the corporation’s books relates to
bringing the sinking fund transactions up to date. Where the sinking fund is
in the hands of a trustee, the corporation’s books can show the status of the
fund only upon the receipt of the report of the trustee showing the changes
in the fund for the current period. Care must be exercised to demand a
report from the trustee as on the date of the closing of the corporation’s
fiscal period. The character of the adjustments needed and the entries
necessary to book them have been explained in Chapter XXV.
Working Capital
A fourth problem which sometimes needs to be considered is that of
“working capital.” Technically the working capital of a business is
represented by the excess of current assets over current liabilities. As
pointed out in Chapter XXV, a credit account called “Sinking Fund
Reserve” is frequently set up to indicate the financial policy pursued in
making provision for the retirement of a bond issue at maturity. At the time
of the retirement of the bonds this reserve need no longer be shown as a
separate item to indicate financial policy and should therefore be closed out.
It may be thrown back into general surplus or it may be transferred—to
indicate that it is a part of the permanent capital of the corporation—to an
account entitled “Working Capital” or “Working Capital Surplus.” In all
cases where an item of surplus is created for a specific purpose, care must
be exercised to see that the conditions surrounding the creation of the item
are lived up to in its final disposition. In cases of surplus created by gift, as
in scholastic institutions or hospitals, this problem is particularly important.
A similar problem is also met at the time of the redemption of an issue
of preferred capital stock, inasmuch as such redemption is usually at a
figure above par.
the life of the bond issue the premium or discount is written off the books.
Where the interest period does not coincide with the close of the fiscal
period, for an absolutely accurate showing not only must the accrued bond
interest be taken into account but also the accrued amortization of bond
premium or discount.
Sinking Funds
A third problem at the time of closing the corporation’s books relates to
bringing the sinking fund transactions up to date. Where the sinking fund is
in the hands of a trustee, the corporation’s books can show the status of the
fund only upon the receipt of the report of the trustee showing the changes
in the fund for the current period. Care must be exercised to demand a
report from the trustee as on the date of the closing of the corporation’s
fiscal period. The character of the adjustments needed and the entries
necessary to book them have been explained in Chapter XXV.
Working Capital
A fourth problem which sometimes needs to be considered is that of
“working capital.” Technically the working capital of a business is
represented by the excess of current assets over current liabilities. As
pointed out in Chapter XXV, a credit account called “Sinking Fund
Reserve” is frequently set up to indicate the financial policy pursued in
making provision for the retirement of a bond issue at maturity. At the time
of the retirement of the bonds this reserve need no longer be shown as a
separate item to indicate financial policy and should therefore be closed out.
It may be thrown back into general surplus or it may be transferred—to
indicate that it is a part of the permanent capital of the corporation—to an
account entitled “Working Capital” or “Working Capital Surplus.” In all
cases where an item of surplus is created for a specific purpose, care must
be exercised to see that the conditions surrounding the creation of the item
are lived up to in its final disposition. In cases of surplus created by gift, as
in scholastic institutions or hospitals, this problem is particularly important.
A similar problem is also met at the time of the redemption of an issue
of preferred capital stock, inasmuch as such redemption is usually at a
figure above par.
Page 395
The Correction of Closing Errors
A final consideration has to do with the correcting of errors in the
closing work of previous periods. Any omissions and wrong valuations of
items in previous periods demand correction, but such correction must not
be allowed to affect the results of the current period. These corrections must
therefore be made either direct through surplus or by means of an entry in
the final section of the profit and loss account as will be indicated in the
next chapter. Sometimes where entries of this kind are numerous an account
called “Profit and Loss Adjustment” is opened as a clearing account through
which these items are carried net into surplus. The chief objection to this
procedure is that the adjustments are too easily lost sight of when only the
net results appear in surplus. These entries usually carry information of
value to shareholders and they should therefore be set forth as a part of the
statement of condition rendered at the close of each fiscal period.
A final consideration has to do with the correcting of errors in the
closing work of previous periods. Any omissions and wrong valuations of
items in previous periods demand correction, but such correction must not
be allowed to affect the results of the current period. These corrections must
therefore be made either direct through surplus or by means of an entry in
the final section of the profit and loss account as will be indicated in the
next chapter. Sometimes where entries of this kind are numerous an account
called “Profit and Loss Adjustment” is opened as a clearing account through
which these items are carried net into surplus. The chief objection to this
procedure is that the adjustments are too easily lost sight of when only the
net results appear in surplus. These entries usually carry information of
value to shareholders and they should therefore be set forth as a part of the
statement of condition rendered at the close of each fiscal period.
Page 396
CHAPTER XXVII
THE PROFIT AND LOSS SUMMARY—
FORM AND CONTENT
Standardization of Form
As stated in Chapter XXVI, the profit and loss summary is supplementary to the
balance sheet and should always accompany it whenever it is desirable to make a full
and comprehensive showing of condition. This summary is given various titles and is
shown in various forms, depending somewhat upon the general class of enterprise to
which it relates, the particular purpose for which it is compiled, and sometimes on the
predilection of the person who draws it up or for whom it is drawn. With the passage of
time the form of the summary, and to a less degree its content, tend to become
standardized. The regulations of various governmental bodies have given an impetus in
this direction. The Interstate Commerce Commission, the Comptroller of the Currency,
public service commissions of various states, superintendents of state banks and of
insurance—all require standardized reports from the concerns under their jurisdiction.
The Federal Reserve Board has recommended certain forms of statement of both balance
sheet and profit and loss to be submitted as the basis of credit by merchants and
manufacturers. Investigations made by the Federal Trade Commission point out the
desirability of a more uniform method of presenting the results of business activities than
now exists. These regulations and requirements as to standard forms of statement do not
interfere with the presentation of other forms of statement for other purposes than those
required by the regulatory bodies. As local conditions frequently give rise to problems
which are peculiar to individual concerns, standard forms of statement will not always
meet local needs. Flexibility to meet given conditions, and deviation from set forms must
always be permissible if the accounting department is to render the highest kind of
service of which it is capable.
Synonymous Terms
Various titles are used as synonyms for the profit and loss summary, among which
are the following: Statement of Profit and Loss, Loss and Gain, Outlay and Income,
Revenue, Revenue and Expenditures, Income, Income and Expenses, etc. Of these, the
term most generally used is “Profit and Loss.” “Business Statement” and “Statement of
Outlay and Income” are phrases seldom if ever employed nowadays, while “Loss and
Gain” finds little favor. Of the two terms, “Revenue” and “Income,” Revenue is used
more often in connection with non-profit-making concerns, particularly in connection
with state and municipal accounts. “Income and Expenses” is usually limited to the
profit and loss statement rendered by clubs, churches, libraries, hospitals, etc., although
the term “Revenue” is frequently used in this connection. “Income Statement” and
THE PROFIT AND LOSS SUMMARY—
FORM AND CONTENT
Standardization of Form
As stated in Chapter XXVI, the profit and loss summary is supplementary to the
balance sheet and should always accompany it whenever it is desirable to make a full
and comprehensive showing of condition. This summary is given various titles and is
shown in various forms, depending somewhat upon the general class of enterprise to
which it relates, the particular purpose for which it is compiled, and sometimes on the
predilection of the person who draws it up or for whom it is drawn. With the passage of
time the form of the summary, and to a less degree its content, tend to become
standardized. The regulations of various governmental bodies have given an impetus in
this direction. The Interstate Commerce Commission, the Comptroller of the Currency,
public service commissions of various states, superintendents of state banks and of
insurance—all require standardized reports from the concerns under their jurisdiction.
The Federal Reserve Board has recommended certain forms of statement of both balance
sheet and profit and loss to be submitted as the basis of credit by merchants and
manufacturers. Investigations made by the Federal Trade Commission point out the
desirability of a more uniform method of presenting the results of business activities than
now exists. These regulations and requirements as to standard forms of statement do not
interfere with the presentation of other forms of statement for other purposes than those
required by the regulatory bodies. As local conditions frequently give rise to problems
which are peculiar to individual concerns, standard forms of statement will not always
meet local needs. Flexibility to meet given conditions, and deviation from set forms must
always be permissible if the accounting department is to render the highest kind of
service of which it is capable.
Synonymous Terms
Various titles are used as synonyms for the profit and loss summary, among which
are the following: Statement of Profit and Loss, Loss and Gain, Outlay and Income,
Revenue, Revenue and Expenditures, Income, Income and Expenses, etc. Of these, the
term most generally used is “Profit and Loss.” “Business Statement” and “Statement of
Outlay and Income” are phrases seldom if ever employed nowadays, while “Loss and
Gain” finds little favor. Of the two terms, “Revenue” and “Income,” Revenue is used
more often in connection with non-profit-making concerns, particularly in connection
with state and municipal accounts. “Income and Expenses” is usually limited to the
profit and loss statement rendered by clubs, churches, libraries, hospitals, etc., although
the term “Revenue” is frequently used in this connection. “Income Statement” and
Page 397
“Account” are terms frequently applied to the profit and loss summary of trading,
industrial, and professional concerns; but except where custom has established certain
well-defined uses, as indicated above, the title “Profit and Loss” is all-sufficient; there is
no doubt as to its meaning or content, and its use for summarizing the temporary
proprietorship items is thereby established, particularly in connection with profit-making
concerns.
Cost of Goods Sold—Manufacturing Concern
Profit-making enterprises may be roughly divided into several groups as follows:
industrial or manufacturing selling, agency and commission, public carriers or
transportation, and financial. The profit and loss summary for these different groups is,
in the main, the same although, of course, the content of the summary depends
materially upon the nature of the business. In all cases the source of income is from sales
—whether of a commodity or of services makes little difference. The first deduction
from gross earnings under the title “Sales” or other similar title is the cost of sales. At
this point the first marked divergence among the various groups is met. In an industrial
enterprise the cost of sales is the cost of goods manufactured and sold as well as the cost
of any goods purchased for immediate resale. This latter cost is met only in enterprises
which combine manufacture with selling. This does not imply that manufacturing
concerns have no selling problem, but rather that in many cases they also purchase other
products for sale along with their own product, perhaps as side lines.
For a manufacturing concern which sells only its own product, the first deduction
from sales is the cost of the goods manufactured and sold. As stated in Chapter III, the
elements of the cost of manufacture are: (1) material, (2) labor, and (3) factory expense.
The cost of goods manufactured must be combined with any unsold output at the
beginning of the period and a similar output at the end of the period, in order to
determine the cost of the goods sold. Cost of manufacture corresponds roughly to the net
purchases of a trading business.
Cost of Goods Sold—Trading Concern
For a trading business, i.e., a business which buys its commodity for resale, the first
deduction from sales is likewise the cost of goods sold as determined by a “cost of goods
sold” formula as follows: To the goods on hand at the beginning of the period is added
the full cost of the net goods purchased, and from the sum of these two items is deducted
the cost of the goods on hand at the end of the period. In the case of both the industrial
and the trading enterprise, when the cost of the commodity sold is deducted from the
sales the result is the first significant figure as to profits known usually as “Gross Profit.”
Among public carriers the first deduction from sales is the “Cost of Services Sold or
Rendered”; this is usually carried under the title “Costs of Operation” or “Operating
Expenses,” giving the figure of net earnings.
For the other types of business mentioned—agency and commission concerns, and
financial enterprises of various sorts—the allocation of the direct costs of the service
industrial, and professional concerns; but except where custom has established certain
well-defined uses, as indicated above, the title “Profit and Loss” is all-sufficient; there is
no doubt as to its meaning or content, and its use for summarizing the temporary
proprietorship items is thereby established, particularly in connection with profit-making
concerns.
Cost of Goods Sold—Manufacturing Concern
Profit-making enterprises may be roughly divided into several groups as follows:
industrial or manufacturing selling, agency and commission, public carriers or
transportation, and financial. The profit and loss summary for these different groups is,
in the main, the same although, of course, the content of the summary depends
materially upon the nature of the business. In all cases the source of income is from sales
—whether of a commodity or of services makes little difference. The first deduction
from gross earnings under the title “Sales” or other similar title is the cost of sales. At
this point the first marked divergence among the various groups is met. In an industrial
enterprise the cost of sales is the cost of goods manufactured and sold as well as the cost
of any goods purchased for immediate resale. This latter cost is met only in enterprises
which combine manufacture with selling. This does not imply that manufacturing
concerns have no selling problem, but rather that in many cases they also purchase other
products for sale along with their own product, perhaps as side lines.
For a manufacturing concern which sells only its own product, the first deduction
from sales is the cost of the goods manufactured and sold. As stated in Chapter III, the
elements of the cost of manufacture are: (1) material, (2) labor, and (3) factory expense.
The cost of goods manufactured must be combined with any unsold output at the
beginning of the period and a similar output at the end of the period, in order to
determine the cost of the goods sold. Cost of manufacture corresponds roughly to the net
purchases of a trading business.
Cost of Goods Sold—Trading Concern
For a trading business, i.e., a business which buys its commodity for resale, the first
deduction from sales is likewise the cost of goods sold as determined by a “cost of goods
sold” formula as follows: To the goods on hand at the beginning of the period is added
the full cost of the net goods purchased, and from the sum of these two items is deducted
the cost of the goods on hand at the end of the period. In the case of both the industrial
and the trading enterprise, when the cost of the commodity sold is deducted from the
sales the result is the first significant figure as to profits known usually as “Gross Profit.”
Among public carriers the first deduction from sales is the “Cost of Services Sold or
Rendered”; this is usually carried under the title “Costs of Operation” or “Operating
Expenses,” giving the figure of net earnings.
For the other types of business mentioned—agency and commission concerns, and
financial enterprises of various sorts—the allocation of the direct costs of the service
Page 398
rendered is much more difficult and is seldom attempted. The so-called general and
administrative expense and the expense of selling are usually so inextricably merged
with the direct cost of rendering the service that a separate showing of the items is
seldom attempted. However, where any expenses are directly applicable to the service
rendered, they should be deducted first, before the general administrative and selling
expense.
Further Differentiation of Terms
Before going into a detailed explanation of the elements of the profit and loss
summary, it may be wise to make a further differentiation of terms sometimes employed,
such as: Income and Expenditures, Receipts and Disbursements, Receipts and Payments,
etc. All three terms are often met and are frequently misused as titles for the profit and
loss summary. Their proper use should limit them to cash transactions or activities only.
It is true that in some instances the profit and loss summary is mistakenly made up on a
so-called cash basis, cognizance being taken of the income and expense items only when
realized in cash. It would hardly seem necessary to convince the modern business man
that sales made on credit and not yet realized in cash are part of his income as much as
the items of income realized in cash, the chief difference being that provision must be
made in the one case for uncollectible items, while in the other case no such provision is
necessary. Yet even today it is sometimes difficult to convince the proprietor of a small
business of the necessity, from the standpoint of accurate accounting, of taking
cognizance of accrued and deferred expense items. Instances may sometimes, though
rarely, arise in which all income has been received in cash at the end of the fiscal period
and all expenses applicable to that period have been met in cash and that no deferred
items need to be taken into account. Where such is the case, a statement of cash receipts
and disbursements might give a fair indication of the profit and loss for the period. In the
case of clubs, churches, and other institutions, practically all that is required of the
managing officers in accounting for their trusteeship is a statement of trusteeship of cash,
i.e., a statement of receipts and disbursements. The point of this discussion is merely that
the terms, “Receipts and Disbursements,” “Receipts and Payments,” and, to a less extent,
“Income and Expenditure,” should be limited to a statement of cash activities and never
applied to the profit and loss summary.
Desirability of Uniformity in Terms Used
So far as the standardization of the sections of the profit and loss summary is
concerned, much the same remarks are applicable as to the general title of the
“Temporary Proprietorship Summary.” Such terms as Gross and Net Profit, Gross
Revenue or Income, Net Revenue or Income, Gross Trading Profit, Net Trading Profit,
Net Profit or Profit from Operation, or simply Business Profit, are used with little
uniformity by the business world at large and even by the accounting profession. While
it is never desirable to lay down many hard and fast rules or definitions because any
statement or method of showing results should always be flexible and adapted to the
conditions met, still the use of the same terms for different purposes and the use of
administrative expense and the expense of selling are usually so inextricably merged
with the direct cost of rendering the service that a separate showing of the items is
seldom attempted. However, where any expenses are directly applicable to the service
rendered, they should be deducted first, before the general administrative and selling
expense.
Further Differentiation of Terms
Before going into a detailed explanation of the elements of the profit and loss
summary, it may be wise to make a further differentiation of terms sometimes employed,
such as: Income and Expenditures, Receipts and Disbursements, Receipts and Payments,
etc. All three terms are often met and are frequently misused as titles for the profit and
loss summary. Their proper use should limit them to cash transactions or activities only.
It is true that in some instances the profit and loss summary is mistakenly made up on a
so-called cash basis, cognizance being taken of the income and expense items only when
realized in cash. It would hardly seem necessary to convince the modern business man
that sales made on credit and not yet realized in cash are part of his income as much as
the items of income realized in cash, the chief difference being that provision must be
made in the one case for uncollectible items, while in the other case no such provision is
necessary. Yet even today it is sometimes difficult to convince the proprietor of a small
business of the necessity, from the standpoint of accurate accounting, of taking
cognizance of accrued and deferred expense items. Instances may sometimes, though
rarely, arise in which all income has been received in cash at the end of the fiscal period
and all expenses applicable to that period have been met in cash and that no deferred
items need to be taken into account. Where such is the case, a statement of cash receipts
and disbursements might give a fair indication of the profit and loss for the period. In the
case of clubs, churches, and other institutions, practically all that is required of the
managing officers in accounting for their trusteeship is a statement of trusteeship of cash,
i.e., a statement of receipts and disbursements. The point of this discussion is merely that
the terms, “Receipts and Disbursements,” “Receipts and Payments,” and, to a less extent,
“Income and Expenditure,” should be limited to a statement of cash activities and never
applied to the profit and loss summary.
Desirability of Uniformity in Terms Used
So far as the standardization of the sections of the profit and loss summary is
concerned, much the same remarks are applicable as to the general title of the
“Temporary Proprietorship Summary.” Such terms as Gross and Net Profit, Gross
Revenue or Income, Net Revenue or Income, Gross Trading Profit, Net Trading Profit,
Net Profit or Profit from Operation, or simply Business Profit, are used with little
uniformity by the business world at large and even by the accounting profession. While
it is never desirable to lay down many hard and fast rules or definitions because any
statement or method of showing results should always be flexible and adapted to the
conditions met, still the use of the same terms for different purposes and the use of
Page 399
different terms for the same purpose or section of a statement are, to say the least,
confusing to the student. The committee of the Federal Reserve Board which drew up
tentative forms for the profit and loss account and balance sheet, has done a good work
in the interest of uniformity in accounting terminology. Their suggested form is
applicable, however, only to the business of a manufacturer or merchant. In the case of
public carriers the regulation of their accounting systems by the Interstate Commerce
Commission has brought about a very desirable uniformity of terminology. Other
regulating bodies in various states have performed a similar service in the case of public
utility concerns, although because of divided authority their rulings lack uniformity.
Profit and Method of Showing
In general it may be said that the term “Gross Profit” is properly applicable to what is
left after deducting from the main income the cost of that income. In a merchandising
concern this figure is sometimes called “Gross Trading Profit,” though the term “Gross
Profit” serves the purpose equally well and does not introduce a confusing adjective.
When, from this gross profit, the two groups of selling expense and general
administrative expense are deducted, there remains what is termed “Profit from
Operation” or “Net Operating Profit.” One occasionally finds the group of selling
expenses deducted by itself from the figure of gross profit, leaving what is termed the
“Net Trading Profit.” Such a method of presentation serves no useful purpose and shows
a figure which has little or no significance. The net trading profit merely represents what
is left after deducting one group of expenses, and gives no essential information which
the total of selling expenses would not give equally as well.
There is some difference of opinion as to whether the figure of net operating profit
should be arrived at before considering any of the items of financial management, i.e., as
to whether such items as interest income and expense, cash discount items, bad debts,
etc., which are more or less common to every business, should be included before
determining net operating profit or should be set up separately after its determination.
The best practice seems to be to use the term “Net Operating Profit” as indicated above,
and to show the financial management items in a separate section. In public service
utility statements and also in those of some manufacturing concerns, such terms as
“Gross and Net Earnings” and “Gross and Net Income” are met. Where these terms are
used the gross earnings correspond approximately to sales and indicate the amount of the
main income before any deductions are made. After the deduction of the direct cost of
securing this income, the item is frequently called “Net Earnings.” Alternative terms for
these two are “Total Operating Revenue” and “Total Net Revenue.” When, to the item of
the net earnings or net revenue, income from other sources is added, the figure of total
Gross Income is arrived at. When, from this figure of total income the “Charges Against
Income” are subtracted, which are roughly the financial management expenses, we arrive
at the figure of net income which corresponds to the figure of net profit. The use of the
terms “Earnings” and “Income” in this restricted way is illogical, and must be regarded
as the outgrowth of custom—a custom which is, as stated above, fairly uniform in the
case of public utilities.
confusing to the student. The committee of the Federal Reserve Board which drew up
tentative forms for the profit and loss account and balance sheet, has done a good work
in the interest of uniformity in accounting terminology. Their suggested form is
applicable, however, only to the business of a manufacturer or merchant. In the case of
public carriers the regulation of their accounting systems by the Interstate Commerce
Commission has brought about a very desirable uniformity of terminology. Other
regulating bodies in various states have performed a similar service in the case of public
utility concerns, although because of divided authority their rulings lack uniformity.
Profit and Method of Showing
In general it may be said that the term “Gross Profit” is properly applicable to what is
left after deducting from the main income the cost of that income. In a merchandising
concern this figure is sometimes called “Gross Trading Profit,” though the term “Gross
Profit” serves the purpose equally well and does not introduce a confusing adjective.
When, from this gross profit, the two groups of selling expense and general
administrative expense are deducted, there remains what is termed “Profit from
Operation” or “Net Operating Profit.” One occasionally finds the group of selling
expenses deducted by itself from the figure of gross profit, leaving what is termed the
“Net Trading Profit.” Such a method of presentation serves no useful purpose and shows
a figure which has little or no significance. The net trading profit merely represents what
is left after deducting one group of expenses, and gives no essential information which
the total of selling expenses would not give equally as well.
There is some difference of opinion as to whether the figure of net operating profit
should be arrived at before considering any of the items of financial management, i.e., as
to whether such items as interest income and expense, cash discount items, bad debts,
etc., which are more or less common to every business, should be included before
determining net operating profit or should be set up separately after its determination.
The best practice seems to be to use the term “Net Operating Profit” as indicated above,
and to show the financial management items in a separate section. In public service
utility statements and also in those of some manufacturing concerns, such terms as
“Gross and Net Earnings” and “Gross and Net Income” are met. Where these terms are
used the gross earnings correspond approximately to sales and indicate the amount of the
main income before any deductions are made. After the deduction of the direct cost of
securing this income, the item is frequently called “Net Earnings.” Alternative terms for
these two are “Total Operating Revenue” and “Total Net Revenue.” When, to the item of
the net earnings or net revenue, income from other sources is added, the figure of total
Gross Income is arrived at. When, from this figure of total income the “Charges Against
Income” are subtracted, which are roughly the financial management expenses, we arrive
at the figure of net income which corresponds to the figure of net profit. The use of the
terms “Earnings” and “Income” in this restricted way is illogical, and must be regarded
as the outgrowth of custom—a custom which is, as stated above, fairly uniform in the
case of public utilities.
Page 400
Form of Presentation—Account Form
As to the form of the profit and loss summary, in the main, two types are met. One is
known as the account form because the items of income and expense are set up like
credits and debits in an account. The other is known as the statement or report form. This
is sometimes referred to as the non-technical method of presentation because the items
are set up in running form without regard to a debit or credit terminology, the order of
arrangement being dictated by the logic of the ordinary business man. In the case of the
account form the sales or main items of income are placed in juxtaposition on the one
side with the direct costs of that income on the other side, the balance of the two sides
being brought down as the gross profit. Against this are set up the groups of selling and
general administrative expenses. The difference between the two sides is again brought
down as the figure of net operating profit to which are added other items of income. The
charges against that income, i.e., the expenses incurred in financing the business, are
then shown. The balance at this stage is the net profit for the fiscal period and opposite
this appears its disposition, showing the portion appropriated to dividend purposes, to
reserves of various sorts, and finally to surplus of the portion remaining unappropriated
to other uses.
Non-Technical or Report Form
When the profit and loss summary is set up in non-technical form, the figure of sales
is first shown. Beneath this rather than in juxtaposition as in the other case, the cost of
sales is given, which cost deducted from sales gives the figure of gross profit. Below this
appear the groups of selling and general administrative expenses, the deduction of which
from the gross profit figure gives the figure of net operating profit or, as sometimes
stated, the figure of “Net Profit on Sales.” To the net profit on sales are added the other
items of income, and from the sum of these are subtracted the expenses of financial
management, leaving, as in the other case, the net profit for the period.
Examples of Forms of Presentation
It is impossible and undesirable, as stated above, to lay down any hard and fast form
which must be rigidly followed, because a basic principle of all accounting is that it must
adapt itself to the needs and requirements of particular conditions. Therefore, only the
bare skeleton of a form can be set up with any hope of its being applicable to all
conditions. In other words, the form of arrangement and method of showing the
statement to be presented at the close of the fiscal period must be flexible, depending
upon the use to which the statement is to be put and also depending upon the information
which it is desired to set forth.
The skeleton form given below which is suggested by A. Lowes Dickinson[68]
follows the general lines laid down in this chapter. It is designed to serve as a framework
for all uses.
As to the form of the profit and loss summary, in the main, two types are met. One is
known as the account form because the items of income and expense are set up like
credits and debits in an account. The other is known as the statement or report form. This
is sometimes referred to as the non-technical method of presentation because the items
are set up in running form without regard to a debit or credit terminology, the order of
arrangement being dictated by the logic of the ordinary business man. In the case of the
account form the sales or main items of income are placed in juxtaposition on the one
side with the direct costs of that income on the other side, the balance of the two sides
being brought down as the gross profit. Against this are set up the groups of selling and
general administrative expenses. The difference between the two sides is again brought
down as the figure of net operating profit to which are added other items of income. The
charges against that income, i.e., the expenses incurred in financing the business, are
then shown. The balance at this stage is the net profit for the fiscal period and opposite
this appears its disposition, showing the portion appropriated to dividend purposes, to
reserves of various sorts, and finally to surplus of the portion remaining unappropriated
to other uses.
Non-Technical or Report Form
When the profit and loss summary is set up in non-technical form, the figure of sales
is first shown. Beneath this rather than in juxtaposition as in the other case, the cost of
sales is given, which cost deducted from sales gives the figure of gross profit. Below this
appear the groups of selling and general administrative expenses, the deduction of which
from the gross profit figure gives the figure of net operating profit or, as sometimes
stated, the figure of “Net Profit on Sales.” To the net profit on sales are added the other
items of income, and from the sum of these are subtracted the expenses of financial
management, leaving, as in the other case, the net profit for the period.
Examples of Forms of Presentation
It is impossible and undesirable, as stated above, to lay down any hard and fast form
which must be rigidly followed, because a basic principle of all accounting is that it must
adapt itself to the needs and requirements of particular conditions. Therefore, only the
bare skeleton of a form can be set up with any hope of its being applicable to all
conditions. In other words, the form of arrangement and method of showing the
statement to be presented at the close of the fiscal period must be flexible, depending
upon the use to which the statement is to be put and also depending upon the information
which it is desired to set forth.
The skeleton form given below which is suggested by A. Lowes Dickinson[68]
follows the general lines laid down in this chapter. It is designed to serve as a framework
for all uses.
Page 401
Manufacturing and Merchandising:
Gross Earnings from Sales $.....
Less—Returns, Allowances, and Discount .....
Net Earnings from Sales $.....
Deduct—Cost of Production or Service .....
Gross Profit $.....
Deduct—Cost of Selling $.....
Expenses of Management ..... .....
Net Profit from Operations $.....
Agency and Commission:
Commissions Earned $.....
Deduct—Expenses of Management $.....
Cost of Guarantees ..... .....
Net Profit from Operations $.....
Transportation:
Earnings from Operations $.....
Deduct—Operating Expenses $.....
Taxes ..... .....
Net Profit from Operations or Operating Income $.....
Banking:
Earnings from:
Interest $.....
Commissions .....
Other Profits ..... $.....
Deduct—Expenses of Operation and Management .....
Net Profit from Operations $.....
Professional:
Gross Earnings from Fees $.....
Less—Out-of-Pocket Expenses included therein .....
Net Earnings from Fees $.....
Gross Earnings from Sales $.....
Less—Returns, Allowances, and Discount .....
Net Earnings from Sales $.....
Deduct—Cost of Production or Service .....
Gross Profit $.....
Deduct—Cost of Selling $.....
Expenses of Management ..... .....
Net Profit from Operations $.....
Agency and Commission:
Commissions Earned $.....
Deduct—Expenses of Management $.....
Cost of Guarantees ..... .....
Net Profit from Operations $.....
Transportation:
Earnings from Operations $.....
Deduct—Operating Expenses $.....
Taxes ..... .....
Net Profit from Operations or Operating Income $.....
Banking:
Earnings from:
Interest $.....
Commissions .....
Other Profits ..... $.....
Deduct—Expenses of Operation and Management .....
Net Profit from Operations $.....
Professional:
Gross Earnings from Fees $.....
Less—Out-of-Pocket Expenses included therein .....
Net Earnings from Fees $.....
Page 402
Deduct—Expenses of Operation and Management .....
Net Profit from Operations $.....
(The form for the remainder of the statement will be the same in all cases, viz.:)
Net Profit from Operations $.....
Other Income ..... .....
Deduct—Interest on Bonds $.....
Other Fixed Charges ..... .....
Surplus for the year $.....
Extraordinary Profits (detailed) .....
Surplus brought forward from preceding year .....
$.....
Deduct—Extraordinary Charges .....
Total Surplus available $.....
Dividends on Stocks .....
Surplus carried forward $.....
Form for Manufacturers and Merchants
The form suggested by the Federal Reserve Board as suitable for manufacturers and
merchants is presented below. It is shown as a comparative statement of several years,
but the same content and order of arrangement of items would, of course, be followed
for any individual year. When presenting a single year’s activities, the money columns
should be so used as better to present significant figures and their interrelations. The use
of one column for items and another for totals accomplishes this. The form shown
presents, after the figure of Net Income—Profit and Loss, a statement of extraordinary
charges and credits to profit and loss tied up with the former balance of surplus, an
appropriation made of profit and surplus at the end of this period, giving as a final figure
the new surplus at its close—which is the figure carried on the balance sheet. This last
portion of the statement is often shown as a separate statement of surplus. The items
which are best handled as charges direct to surplus so as not to affect the profit and loss
showing for the current period, have been discussed in Chapter XXIII on “Reserves and
Surplus.” There the illegitimate use of surplus as a dumping ground for items which it is
desired to conceal was mentioned. To prevent this misuse of surplus the final section of
the profit and loss statement is often shown as set forth above. Where, however, a
separate statement of the surplus is included as a part of the exhibit of the condition for
the fiscal period, the statement of profit and loss will, of course, end with the figure of
net profit, if that profit is transferred to surplus, out of which all appropriations of profit
to its various uses are made. If, however, appropriations of this period’s profits, as
Net Profit from Operations $.....
(The form for the remainder of the statement will be the same in all cases, viz.:)
Net Profit from Operations $.....
Other Income ..... .....
Deduct—Interest on Bonds $.....
Other Fixed Charges ..... .....
Surplus for the year $.....
Extraordinary Profits (detailed) .....
Surplus brought forward from preceding year .....
$.....
Deduct—Extraordinary Charges .....
Total Surplus available $.....
Dividends on Stocks .....
Surplus carried forward $.....
Form for Manufacturers and Merchants
The form suggested by the Federal Reserve Board as suitable for manufacturers and
merchants is presented below. It is shown as a comparative statement of several years,
but the same content and order of arrangement of items would, of course, be followed
for any individual year. When presenting a single year’s activities, the money columns
should be so used as better to present significant figures and their interrelations. The use
of one column for items and another for totals accomplishes this. The form shown
presents, after the figure of Net Income—Profit and Loss, a statement of extraordinary
charges and credits to profit and loss tied up with the former balance of surplus, an
appropriation made of profit and surplus at the end of this period, giving as a final figure
the new surplus at its close—which is the figure carried on the balance sheet. This last
portion of the statement is often shown as a separate statement of surplus. The items
which are best handled as charges direct to surplus so as not to affect the profit and loss
showing for the current period, have been discussed in Chapter XXIII on “Reserves and
Surplus.” There the illegitimate use of surplus as a dumping ground for items which it is
desired to conceal was mentioned. To prevent this misuse of surplus the final section of
the profit and loss statement is often shown as set forth above. Where, however, a
separate statement of the surplus is included as a part of the exhibit of the condition for
the fiscal period, the statement of profit and loss will, of course, end with the figure of
net profit, if that profit is transferred to surplus, out of which all appropriations of profit
to its various uses are made. If, however, appropriations of this period’s profits, as
Page 403
distinguished from the accumulated profits of other periods, are to be made for specific
purposes, their disposition is best shown in a final appropriation section as a part of the
current statement of profit and loss.
Comparative Statement of Profit and Loss
Year Year Year
Ended Ended Ended
19— 19— 19—
Gross Sales $. . . . . . $. . . . . . $. . . . . .
Less Outward Freight, Allowances, and Returns ...... ...... ......
Net Sales $. . . . . . $. . . . . . $. . . . . .
Inventory beginning of year $. . . . . . $. . . . . . $. . . . . .
Purchases, Net ...... ...... ......
$. . . . . . $. . . . . . $. . . . . .
Less Inventory end of year ...... ...... ......
Cost of Sales $. . . . . . $. . . . . . $. . . . . .
Gross Profit on Sales $. . . . . . $. . . . . . $. . . . . .
Selling Expenses (itemized to correspond
with ledger accounts kept) $. . . . . . $. . . . . . $. . . . . .
Total Selling Expense $. . . . . . $. . . . . . $. . . . . .
General Expenses (itemized to correspond
with ledger accounts kept) $. . . . . . $. . . . . . $. . . . . .
Total General Expense $. . . . . . $. . . . . . $. . . . . .
Administrative Expenses (itemized to correspond
with ledger accounts kept) $. . . . . . $. . . . . . $. . . . . .
Total Administrative Expense $. . . . . . $. . . . . . $. . . . . .
Net Profit on Sales $. . . . . . $. . . . . . $. . . . . .
Other Income:
Income from Investments $. . . . . . $. . . . . . $. . . . . .
Interest on Notes Receivable, etc. ...... ...... ......
Gross Income $. . . . . . $. . . . . . $. . . . . .
Deductions from Income:
Interest on Bonded Debt $. . . . . . $. . . . . . $. . . . . .
purposes, their disposition is best shown in a final appropriation section as a part of the
current statement of profit and loss.
Comparative Statement of Profit and Loss
Year Year Year
Ended Ended Ended
19— 19— 19—
Gross Sales $. . . . . . $. . . . . . $. . . . . .
Less Outward Freight, Allowances, and Returns ...... ...... ......
Net Sales $. . . . . . $. . . . . . $. . . . . .
Inventory beginning of year $. . . . . . $. . . . . . $. . . . . .
Purchases, Net ...... ...... ......
$. . . . . . $. . . . . . $. . . . . .
Less Inventory end of year ...... ...... ......
Cost of Sales $. . . . . . $. . . . . . $. . . . . .
Gross Profit on Sales $. . . . . . $. . . . . . $. . . . . .
Selling Expenses (itemized to correspond
with ledger accounts kept) $. . . . . . $. . . . . . $. . . . . .
Total Selling Expense $. . . . . . $. . . . . . $. . . . . .
General Expenses (itemized to correspond
with ledger accounts kept) $. . . . . . $. . . . . . $. . . . . .
Total General Expense $. . . . . . $. . . . . . $. . . . . .
Administrative Expenses (itemized to correspond
with ledger accounts kept) $. . . . . . $. . . . . . $. . . . . .
Total Administrative Expense $. . . . . . $. . . . . . $. . . . . .
Net Profit on Sales $. . . . . . $. . . . . . $. . . . . .
Other Income:
Income from Investments $. . . . . . $. . . . . . $. . . . . .
Interest on Notes Receivable, etc. ...... ...... ......
Gross Income $. . . . . . $. . . . . . $. . . . . .
Deductions from Income:
Interest on Bonded Debt $. . . . . . $. . . . . . $. . . . . .
Page 404
Year Year Year
Ended Ended Ended
19— 19— 19—
Interest on Notes Payable ...... ...... ......
Total Deductions $. . . . . . $. . . . . . $. . . . . .
Net Income—Profit and Loss $. . . . . . $. . . . . . $. . . . . .
Add special credits to Profit and Loss ...... ...... ......
Deduct special charges to Profit and Loss ...... ...... ......
Profit and Loss for period $. . . . . . $. . . . . . $. . . . . .
Surplus beginning of period ...... ...... ......
$. . . . . . $. . . . . . $. . . . . .
Dividends Paid ...... ...... ......
Surplus ending of period $. . . . . . $. . . . . . $. . . . . .
Content and Manner of Showing
Some problems in connection with the content of the various sections of the profit
and loss summary and also with the manner of showing the content will now be taken
up. The first item to be considered is the handling of the deductions from sales. On the
Federal Reserve form of statement not only are sales returns and allowances deducted
but also outfreight charges and, in some instances, other expenses which are regarded as
direct selling costs as distinguished from the indirect costs shown in the group of selling
expenses. Practice is not at all uniform in this regard. It should be stated that where the
policy of the business is to sell goods f.o.b. destination, the outfreight charges may be
regarded as a proper deduction from the figure of gross sales, as otherwise that figure is
inflated by the item of freight, the cost of which is no part of the business organization
nor is it under its control. Where, however, goods are only sold occasionally f.o.b.
destination, the outward freight is more properly treated as a cost of making the sale in
the same way as advertising. It should therefore be included in the group of selling
expenses rather than be treated as a direct deduction from sales.
Supporting Schedules
With the object of presenting a bird’s-eye view of the profit and loss activities for the
year, it is desirable that as little detail be shown on the face of the statement as may be
necessary to furnish the information desired. The profit and loss statement under this
method of treatment must be supported as to its detailed content by schedules giving the
full information which may at times be valuable to proprietor or manager. The first
supporting schedule may well be headed “Cost of Goods Sold.” Therein should be
shown the statement of inventory on hand at the beginning of the period, goods
purchased during the year, inward freight and carriage costs, purchase returns and
Ended Ended Ended
19— 19— 19—
Interest on Notes Payable ...... ...... ......
Total Deductions $. . . . . . $. . . . . . $. . . . . .
Net Income—Profit and Loss $. . . . . . $. . . . . . $. . . . . .
Add special credits to Profit and Loss ...... ...... ......
Deduct special charges to Profit and Loss ...... ...... ......
Profit and Loss for period $. . . . . . $. . . . . . $. . . . . .
Surplus beginning of period ...... ...... ......
$. . . . . . $. . . . . . $. . . . . .
Dividends Paid ...... ...... ......
Surplus ending of period $. . . . . . $. . . . . . $. . . . . .
Content and Manner of Showing
Some problems in connection with the content of the various sections of the profit
and loss summary and also with the manner of showing the content will now be taken
up. The first item to be considered is the handling of the deductions from sales. On the
Federal Reserve form of statement not only are sales returns and allowances deducted
but also outfreight charges and, in some instances, other expenses which are regarded as
direct selling costs as distinguished from the indirect costs shown in the group of selling
expenses. Practice is not at all uniform in this regard. It should be stated that where the
policy of the business is to sell goods f.o.b. destination, the outfreight charges may be
regarded as a proper deduction from the figure of gross sales, as otherwise that figure is
inflated by the item of freight, the cost of which is no part of the business organization
nor is it under its control. Where, however, goods are only sold occasionally f.o.b.
destination, the outward freight is more properly treated as a cost of making the sale in
the same way as advertising. It should therefore be included in the group of selling
expenses rather than be treated as a direct deduction from sales.
Supporting Schedules
With the object of presenting a bird’s-eye view of the profit and loss activities for the
year, it is desirable that as little detail be shown on the face of the statement as may be
necessary to furnish the information desired. The profit and loss statement under this
method of treatment must be supported as to its detailed content by schedules giving the
full information which may at times be valuable to proprietor or manager. The first
supporting schedule may well be headed “Cost of Goods Sold.” Therein should be
shown the statement of inventory on hand at the beginning of the period, goods
purchased during the year, inward freight and carriage costs, purchase returns and
Page 405
allowances, and goods on hand at the close of the year, the result being the figure carried
on the profit and loss summary. Where manufacturing is also carried on, this cost of
goods schedule should include a statement of manufacturing activities, set up in the
following order: raw materials used in manufacture which will be derived from a
statement of raw materials inventory at the beginning, purchases, inward freight,
purchase returns, and raw materials on hand at the close of the period. To this figure of
raw materials consumed in manufacture should be added the direct labor costs for the
period, the sum of the two giving the significant figure of prime costs. The addition to
this of the factory expense set up in detail gives the cost of manufacture for the period.
Adjustment of Inventories
An adjustment should be made somewhere in this manufacturing section of the
inventories of goods in process at the beginning and end of the period. This adjustment is
usually made at the end of the manufacturing statement, but the position depends largely
on the cost system in use and therefore the cost elements which make up the value of
goods in process. If these values include raw materials, direct labor, and factory expense,
and a separation of these elements is difficult or impossible, the adjustment is perhaps
best made at the close of the manufacturing statement. Where, however, the elements
referred to are easily separable, the difference between the cost of materials in the
opening inventory of goods in process and the closing inventory should be added to the
materials used in manufacture during this period or subtracted from them, as the case
may be. Likewise, the difference between the labor items in the two inventories should
be added to, or subtracted from, the direct labor cost for the current period. This makes
possible an exact showing of the prime cost for the period.
The element of factory expense in goods in process should then be handled in the
factory expense section, in this way doing away with the adjustment at the end of the
statement as in the other case. While this method is more difficult and complicated, it is
usually to be preferred. The cost of the finished product turned out during the period, as
shown by the manufacturing section, must be added to the inventory of the finished
product on hand at the beginning of the period, and from the sum of these two items
must be deducted the finished product on hand at the close of the period in order to
develop the cost of the manufactured product sold during the period. If, now, other
commodities are bought and sold in addition to those manufactured, the cost of the
goods bought and sold should be shown as for a trading business.
Selling Expense and Administrative Schedules
The second schedule to be shown in support of the profit and loss statement will be
the selling expense schedule. Herein will be included all the customary selling expense
items, the total of which is carried on the face of the profit and loss statement. It may be
desirable in some instances to omit advertising costs from this group and show them on
the face of the statement as a separate item. This is a particularly desirable policy either
where advertising is a large item, or where results are to be shown during an advertising
campaign.
on the profit and loss summary. Where manufacturing is also carried on, this cost of
goods schedule should include a statement of manufacturing activities, set up in the
following order: raw materials used in manufacture which will be derived from a
statement of raw materials inventory at the beginning, purchases, inward freight,
purchase returns, and raw materials on hand at the close of the period. To this figure of
raw materials consumed in manufacture should be added the direct labor costs for the
period, the sum of the two giving the significant figure of prime costs. The addition to
this of the factory expense set up in detail gives the cost of manufacture for the period.
Adjustment of Inventories
An adjustment should be made somewhere in this manufacturing section of the
inventories of goods in process at the beginning and end of the period. This adjustment is
usually made at the end of the manufacturing statement, but the position depends largely
on the cost system in use and therefore the cost elements which make up the value of
goods in process. If these values include raw materials, direct labor, and factory expense,
and a separation of these elements is difficult or impossible, the adjustment is perhaps
best made at the close of the manufacturing statement. Where, however, the elements
referred to are easily separable, the difference between the cost of materials in the
opening inventory of goods in process and the closing inventory should be added to the
materials used in manufacture during this period or subtracted from them, as the case
may be. Likewise, the difference between the labor items in the two inventories should
be added to, or subtracted from, the direct labor cost for the current period. This makes
possible an exact showing of the prime cost for the period.
The element of factory expense in goods in process should then be handled in the
factory expense section, in this way doing away with the adjustment at the end of the
statement as in the other case. While this method is more difficult and complicated, it is
usually to be preferred. The cost of the finished product turned out during the period, as
shown by the manufacturing section, must be added to the inventory of the finished
product on hand at the beginning of the period, and from the sum of these two items
must be deducted the finished product on hand at the close of the period in order to
develop the cost of the manufactured product sold during the period. If, now, other
commodities are bought and sold in addition to those manufactured, the cost of the
goods bought and sold should be shown as for a trading business.
Selling Expense and Administrative Schedules
The second schedule to be shown in support of the profit and loss statement will be
the selling expense schedule. Herein will be included all the customary selling expense
items, the total of which is carried on the face of the profit and loss statement. It may be
desirable in some instances to omit advertising costs from this group and show them on
the face of the statement as a separate item. This is a particularly desirable policy either
where advertising is a large item, or where results are to be shown during an advertising
campaign.
Page 406
The third schedule is the general administrative items. It seems hardly worth while to
attempt a separation of so-called general expense items from those of administration, as
any basis of separation must necessarily be arbitrary.
The fourth schedule will show the financial management expense and income items.
These are the items which are shown on the statement under the heads of “Other
Income” and “Deductions from Income.”
These are the customary schedules presented. When the statement of surplus is made
a part of the profit and loss statement, as is sometimes the case, and there are many
detailed entries during the period direct to surplus, a final schedule should present these
charges and credits to surplus during the period.
Schedules for Special Needs
It frequently happens that it is desirable to carry additional schedules to those
explained, in order to show an analysis of certain earnings or operations which may be of
special interest to the individual concern. Thus, it might be desirable to show an analysis
of sales by departments, by geographical districts, or by branches. Similarly, expenses
might be analyzed on the same basis. A branch organization, for example, might show all
its activities, including the net operating profit by branches, the sum of the branch
operating profits being taken into the combined profit and loss statement, after which
appear the items of financial management expense and income. As heretofore stated, all
these are problems concerning which no arbitrary ruling can be made, the organization
of the business and the information desired being always the determining factor.
The problem of valuation as related to the commercial balance sheet has now been
completed. Some miscellaneous matters of corporation accounting and finance follow
and these complete the second year’s course of study.
attempt a separation of so-called general expense items from those of administration, as
any basis of separation must necessarily be arbitrary.
The fourth schedule will show the financial management expense and income items.
These are the items which are shown on the statement under the heads of “Other
Income” and “Deductions from Income.”
These are the customary schedules presented. When the statement of surplus is made
a part of the profit and loss statement, as is sometimes the case, and there are many
detailed entries during the period direct to surplus, a final schedule should present these
charges and credits to surplus during the period.
Schedules for Special Needs
It frequently happens that it is desirable to carry additional schedules to those
explained, in order to show an analysis of certain earnings or operations which may be of
special interest to the individual concern. Thus, it might be desirable to show an analysis
of sales by departments, by geographical districts, or by branches. Similarly, expenses
might be analyzed on the same basis. A branch organization, for example, might show all
its activities, including the net operating profit by branches, the sum of the branch
operating profits being taken into the combined profit and loss statement, after which
appear the items of financial management expense and income. As heretofore stated, all
these are problems concerning which no arbitrary ruling can be made, the organization
of the business and the information desired being always the determining factor.
The problem of valuation as related to the commercial balance sheet has now been
completed. Some miscellaneous matters of corporation accounting and finance follow
and these complete the second year’s course of study.
Page 407
CHAPTER XXVIII
LIQUIDATION OF A CORPORATION
Reasons for Liquidating—Partial and Complete Liquidation
There are a number of ways in which a corporation may cease to exist
and a liquidation take place. The charter, if created for a fixed number of
years, may expire. The state may see fit to repeal the charter in accordance
with the right reserved at the time it was granted. The corporation may of its
own accord surrender its charter; or the courts may decide that the
corporation has forfeited its charter rights by reason of non-performance or
because of some wrongful act. Failure to pay taxes due the state is an
instance. The liquidation of a corporation may take place because of a
consolidation resulting in loss of its original identity. In the case of a merger
the merged corporation ceases to exist under the terms of the agreement
made which may call for a more or less complete liquidation. Sometimes a
reorganization effects the liquidation of an insolvent corporation. If the new
corporation obtains the assets of the previous corporation under a forced
sale, the money received would be applied to the satisfaction of the old
creditors’ claims.
Insolvency is the most usual reason for liquidating a corporation.
Insolvency may be either actual or legal. By the National Bankruptcy Act
insolvency is defined as the condition in which the assets of a person, firm,
or corporation are less than the debts. This definition emphasizes the
economic point of view. A corporation is legally insolvent when the cash
assets are not sufficient to pay debts when they become due. Either of these
conditions may exist without necessarily disastrous results, though it
generally leads to disaster sooner or later. However, the fact that these
conditions do exist indicates that the business in question is not well
managed. It is well, therefore, to bring out the more prevalent causes
leading to insolvency.
Current Assets Transferred into Fixed Assets
LIQUIDATION OF A CORPORATION
Reasons for Liquidating—Partial and Complete Liquidation
There are a number of ways in which a corporation may cease to exist
and a liquidation take place. The charter, if created for a fixed number of
years, may expire. The state may see fit to repeal the charter in accordance
with the right reserved at the time it was granted. The corporation may of its
own accord surrender its charter; or the courts may decide that the
corporation has forfeited its charter rights by reason of non-performance or
because of some wrongful act. Failure to pay taxes due the state is an
instance. The liquidation of a corporation may take place because of a
consolidation resulting in loss of its original identity. In the case of a merger
the merged corporation ceases to exist under the terms of the agreement
made which may call for a more or less complete liquidation. Sometimes a
reorganization effects the liquidation of an insolvent corporation. If the new
corporation obtains the assets of the previous corporation under a forced
sale, the money received would be applied to the satisfaction of the old
creditors’ claims.
Insolvency is the most usual reason for liquidating a corporation.
Insolvency may be either actual or legal. By the National Bankruptcy Act
insolvency is defined as the condition in which the assets of a person, firm,
or corporation are less than the debts. This definition emphasizes the
economic point of view. A corporation is legally insolvent when the cash
assets are not sufficient to pay debts when they become due. Either of these
conditions may exist without necessarily disastrous results, though it
generally leads to disaster sooner or later. However, the fact that these
conditions do exist indicates that the business in question is not well
managed. It is well, therefore, to bring out the more prevalent causes
leading to insolvency.
Current Assets Transferred into Fixed Assets
Page 408
A common cause of insolvency is the tying up of current assets in plant
and equipment. While this may be the actual cause, the post-mortem assigns
the cause generally to lack of “working capital.” When a business expands
and orders are coming in in excess of the facilities at hand, there is a great
temptation to put a large part of the incoming funds into plant in order to
take full advantage of the opportunities in sight. The result is that eventually
the point is reached where it is impossible to get the cash necessary to meet
maturing obligations. While the need for plant and equipment may justify
the outlay, they cannot readily be converted into cash for they are usually of
such a special nature as to be of small value without the organization.
Tying up Cash in Stocks of Material
The conversion of the cash resources of a company into stocks of
material is another cause of insolvency, especially if the turnover is slow or
the business is of such a nature as to require large sums invested in
materials. Though capital in this form is generally being converted into cash
or other forms of working capital, the fact that large sums are invested in
material does not always mean that its cash value measures the amount of
working capital. On the liability side of the balance sheet there may be
items such as short-time loans or accounts payable which must be deducted
in order to determine the net working capital. If the stock carried is
disproportionate to requirements, it is a sign of poor management. When
this state of affairs is allowed to continue for some time, the chances are
that stocks will become obsolete or deteriorate, resulting in a loss. This will
eventually result in the accumulation of current liabilities or floating debts
and so bring about a condition of insolvency.
Unwise Use of Cash for Paying Dividends
Dividends are sometimes paid at a rate entirely out of proportion to
average earnings, or a rate is maintained that is at variance with current
earnings. Profits depend to a large extent upon economic and financial
conditions. Business does not move on an even level throughout the years.
The rule with conservative corporations is that dividends must not be
allowed to rise, even in most prosperous periods, above a conservative
estimate of the average earnings. In periods of prosperity the demand on the
cash resources of a business increases as the prices of material, labor, and
money rise. The result is that while a company may make large profits it
and equipment. While this may be the actual cause, the post-mortem assigns
the cause generally to lack of “working capital.” When a business expands
and orders are coming in in excess of the facilities at hand, there is a great
temptation to put a large part of the incoming funds into plant in order to
take full advantage of the opportunities in sight. The result is that eventually
the point is reached where it is impossible to get the cash necessary to meet
maturing obligations. While the need for plant and equipment may justify
the outlay, they cannot readily be converted into cash for they are usually of
such a special nature as to be of small value without the organization.
Tying up Cash in Stocks of Material
The conversion of the cash resources of a company into stocks of
material is another cause of insolvency, especially if the turnover is slow or
the business is of such a nature as to require large sums invested in
materials. Though capital in this form is generally being converted into cash
or other forms of working capital, the fact that large sums are invested in
material does not always mean that its cash value measures the amount of
working capital. On the liability side of the balance sheet there may be
items such as short-time loans or accounts payable which must be deducted
in order to determine the net working capital. If the stock carried is
disproportionate to requirements, it is a sign of poor management. When
this state of affairs is allowed to continue for some time, the chances are
that stocks will become obsolete or deteriorate, resulting in a loss. This will
eventually result in the accumulation of current liabilities or floating debts
and so bring about a condition of insolvency.
Unwise Use of Cash for Paying Dividends
Dividends are sometimes paid at a rate entirely out of proportion to
average earnings, or a rate is maintained that is at variance with current
earnings. Profits depend to a large extent upon economic and financial
conditions. Business does not move on an even level throughout the years.
The rule with conservative corporations is that dividends must not be
allowed to rise, even in most prosperous periods, above a conservative
estimate of the average earnings. In periods of prosperity the demand on the
cash resources of a business increases as the prices of material, labor, and
money rise. The result is that while a company may make large profits it
Page 409
may not be in a position to pay more than the usual rate of dividends. Many
a corporation after paying big dividends in prosperous times has ended by
placing its affairs in the hands of its creditors. Dividend payments are
dependent not only upon profits but to a greater extent upon the concern’s
cash position. To endeavor to do a large volume of business with a small
working capital is generally a sure and a quick way of landing in
bankruptcy. The prudent way is to withhold dividends until in the normal
course of events cash is accumulated beyond the requirements of the
business. The book surplus must be reinforced by a satisfactory cash
balance as a basis for the declaration of cash dividends.
Sometimes corporations may find it sound practice to pay dividends
with the proceeds of temporary bank loans. This is not open to objection
under certain circumstances. For example, the company’s business may be
subject to wide seasonal fluctuations’ or it may be of such a nature that it
nominally operates with a small working capital. Even in these cases the
assumption must be that the loans can be repaid when due without any
undue strain or effort. There is some question regarding the soundness of
the practice, sometimes resorted to, of issuing long-term obligations or of
selling additional stock for the purpose of obtaining cash to pay dividends.
If the profits are extraordinarily large and the probabilities are that they will
remain so, then the increased capitalization may not be a serious handicap
in itself. However, where the surplus shown on the books is fictitious or
when a legitimate showing of profits cannot be made, then such a
transaction would clearly be fraudulent.
Inability to Secure Cash for Refunding Operations
Corporations sometimes issue bonds because of the fact that a larger
return is gained to the stockholders than if more stock were sold. The
interest rate on bonds is generally much less than the rate of profits and
even less than on short-term loans or notes. The distinction between bonds
and notes is mainly that of time. The proceeds from the bonds are
commonly used for permanent improvements, while the notes are issued to
bridge over the changing of some form of quick assets into cash. Generally
the bonds are issued during a period of easy money but they may mature
when the money market is hard. If a sinking fund has been provided, all that
is necessary is to convert the securities in which the funds have been
a corporation after paying big dividends in prosperous times has ended by
placing its affairs in the hands of its creditors. Dividend payments are
dependent not only upon profits but to a greater extent upon the concern’s
cash position. To endeavor to do a large volume of business with a small
working capital is generally a sure and a quick way of landing in
bankruptcy. The prudent way is to withhold dividends until in the normal
course of events cash is accumulated beyond the requirements of the
business. The book surplus must be reinforced by a satisfactory cash
balance as a basis for the declaration of cash dividends.
Sometimes corporations may find it sound practice to pay dividends
with the proceeds of temporary bank loans. This is not open to objection
under certain circumstances. For example, the company’s business may be
subject to wide seasonal fluctuations’ or it may be of such a nature that it
nominally operates with a small working capital. Even in these cases the
assumption must be that the loans can be repaid when due without any
undue strain or effort. There is some question regarding the soundness of
the practice, sometimes resorted to, of issuing long-term obligations or of
selling additional stock for the purpose of obtaining cash to pay dividends.
If the profits are extraordinarily large and the probabilities are that they will
remain so, then the increased capitalization may not be a serious handicap
in itself. However, where the surplus shown on the books is fictitious or
when a legitimate showing of profits cannot be made, then such a
transaction would clearly be fraudulent.
Inability to Secure Cash for Refunding Operations
Corporations sometimes issue bonds because of the fact that a larger
return is gained to the stockholders than if more stock were sold. The
interest rate on bonds is generally much less than the rate of profits and
even less than on short-term loans or notes. The distinction between bonds
and notes is mainly that of time. The proceeds from the bonds are
commonly used for permanent improvements, while the notes are issued to
bridge over the changing of some form of quick assets into cash. Generally
the bonds are issued during a period of easy money but they may mature
when the money market is hard. If a sinking fund has been provided, all that
is necessary is to convert the securities in which the funds have been
Page 410
invested into cash and take up the bonds. But the fact that the returns on the
securities in the sinking fund are as a rule much less than can be realized by
placing the money in betterments, operates against its use.
When, therefore, the bond issue becomes due in a period of financial
stringency, or even during normal times if the business has not been highly
successful or if its credit has been impaired, the company may be unable to
liquidate its assets and pay it off. The consequence is that a foreclosure of
the mortgaged property is made.
Excessive Borrowing on Short-Term Securities
A frequent cause of insolvency is excessive borrowing by means of
short-term securities in the form of accounts payable, acceptances, and
notes. The notes may be classified into: (1) notes discounted at some bank;
(2) notes sold to the public; and (3) merchandise notes. There are three
legitimate uses to which they may be put, namely: (1) to take care of a
temporary lack of funds; (2) to extend further credit to customers; and (3) to
increase the stock of easily marketable goods on hand. Definite provision
must be made to meet the notes at maturity, which in the case of bank loans
run from 30 days to six months—generally 60 to 90 days. The use made of
funds obtained in this manner is a matter of importance to bankers when
extending loans.
To use any one of these forms of borrowing for the purpose of financing
betterments and additions is dangerous and essentially unsound. Such
obligations are generally contracted during a period of prosperity and
expanding business for the purpose of taking care of temporary needs. They
frequently become a source of embarrassment when a period of money
stringency sets in. If the borrowings are in excess of the quick assets, the
policy is unsound at all times. Conservative managers make provision for
meeting their notes at maturity before they issue them.
The short-term notes sold to the public usually are for longer periods
than those discounted at the banks—the period ranging from one to five
years. When the time is not appropriate for a bond issue and it is desirable
to defer it, short-term notes are generally issued and marketed through note
brokers, often throughout the country. This is an effective means of
deferring a bond issue until money is easier and better terms can be
obtained for the larger issue. When the bonds are sold the notes are retired
securities in the sinking fund are as a rule much less than can be realized by
placing the money in betterments, operates against its use.
When, therefore, the bond issue becomes due in a period of financial
stringency, or even during normal times if the business has not been highly
successful or if its credit has been impaired, the company may be unable to
liquidate its assets and pay it off. The consequence is that a foreclosure of
the mortgaged property is made.
Excessive Borrowing on Short-Term Securities
A frequent cause of insolvency is excessive borrowing by means of
short-term securities in the form of accounts payable, acceptances, and
notes. The notes may be classified into: (1) notes discounted at some bank;
(2) notes sold to the public; and (3) merchandise notes. There are three
legitimate uses to which they may be put, namely: (1) to take care of a
temporary lack of funds; (2) to extend further credit to customers; and (3) to
increase the stock of easily marketable goods on hand. Definite provision
must be made to meet the notes at maturity, which in the case of bank loans
run from 30 days to six months—generally 60 to 90 days. The use made of
funds obtained in this manner is a matter of importance to bankers when
extending loans.
To use any one of these forms of borrowing for the purpose of financing
betterments and additions is dangerous and essentially unsound. Such
obligations are generally contracted during a period of prosperity and
expanding business for the purpose of taking care of temporary needs. They
frequently become a source of embarrassment when a period of money
stringency sets in. If the borrowings are in excess of the quick assets, the
policy is unsound at all times. Conservative managers make provision for
meeting their notes at maturity before they issue them.
The short-term notes sold to the public usually are for longer periods
than those discounted at the banks—the period ranging from one to five
years. When the time is not appropriate for a bond issue and it is desirable
to defer it, short-term notes are generally issued and marketed through note
brokers, often throughout the country. This is an effective means of
deferring a bond issue until money is easier and better terms can be
obtained for the larger issue. When the bonds are sold the notes are retired
Page 411
with a part of the proceeds. The danger of this financial practice is that the
notes may mature before the bonds can be marketed, as would probably be
the case if a period of depression ensued. This would involve disaster if
provision for refunding had not been made, especially as the proceeds of
such notes, like the proceeds of a bond issue, are generally used for
betterments and additions.
Losses in Conducting the Business
A business, through defects of management, does not always fulfill the
expectation of its promoters. The price of the product may be set without
regard to true costs, and losses pile up with or without the knowledge of the
management. Competitive conditions may have to be met and efficiency of
management be an absolute requisite if profits are to be made. An
organization is of slow growth and the price paid for experience may eat up
all the profits. Poor workmanship, duplication of effort, poor planning in the
factory, resulting in a high unit cost—these are all factors which may bring
disaster if not detected and remedied in time. The promoters may have been
unusually optimistic in regard to the business that could be done, with the
consequence that a plant is constructed much in excess of actual market
possibilities. Losses of a serious nature then result from the poor utilization
of fixed assets. “Lack of ability” is the phrase commonly used in describing
this cause of insolvency. The usual symptom of the malady is a reduction in
current assets and greater difficulty in obtaining credit.
Loss through Fraud, Theft, or Unavoidable Causes
The corporate form of business lends itself to exploitations of many
kinds. The public is usually victimized, but sometimes the stockholders
suffer through a breach of trust on the part of officers—as for example, the
granting of contracts or the payment of exorbitant salaries to the detriment
of the large body of stockholders. Another form of exploitation is the
diversion of profitable business to some other corporation controlled by the
untrustworthy officers. Then again the officers may buy up unprofitable
ventures and sell them to the corporation at a large profit. The juggling of
accounts may cover up fraud and exploitation. The profits may be sacrificed
for the purpose of squeezing out the minority stockholders, or contracts
may be made with a subsidiary whereby it takes most of the profits, or the
profitable features of the corporation may be sold to a new company. These
notes may mature before the bonds can be marketed, as would probably be
the case if a period of depression ensued. This would involve disaster if
provision for refunding had not been made, especially as the proceeds of
such notes, like the proceeds of a bond issue, are generally used for
betterments and additions.
Losses in Conducting the Business
A business, through defects of management, does not always fulfill the
expectation of its promoters. The price of the product may be set without
regard to true costs, and losses pile up with or without the knowledge of the
management. Competitive conditions may have to be met and efficiency of
management be an absolute requisite if profits are to be made. An
organization is of slow growth and the price paid for experience may eat up
all the profits. Poor workmanship, duplication of effort, poor planning in the
factory, resulting in a high unit cost—these are all factors which may bring
disaster if not detected and remedied in time. The promoters may have been
unusually optimistic in regard to the business that could be done, with the
consequence that a plant is constructed much in excess of actual market
possibilities. Losses of a serious nature then result from the poor utilization
of fixed assets. “Lack of ability” is the phrase commonly used in describing
this cause of insolvency. The usual symptom of the malady is a reduction in
current assets and greater difficulty in obtaining credit.
Loss through Fraud, Theft, or Unavoidable Causes
The corporate form of business lends itself to exploitations of many
kinds. The public is usually victimized, but sometimes the stockholders
suffer through a breach of trust on the part of officers—as for example, the
granting of contracts or the payment of exorbitant salaries to the detriment
of the large body of stockholders. Another form of exploitation is the
diversion of profitable business to some other corporation controlled by the
untrustworthy officers. Then again the officers may buy up unprofitable
ventures and sell them to the corporation at a large profit. The juggling of
accounts may cover up fraud and exploitation. The profits may be sacrificed
for the purpose of squeezing out the minority stockholders, or contracts
may be made with a subsidiary whereby it takes most of the profits, or the
profitable features of the corporation may be sold to a new company. These
Page 412
modes of freezing out the minority are naturally promoted by the majority
stockholders. Whatever may be the means used, these various methods of
exploitation may lead to insolvency, their ultimate effect depending upon
the condition of the company and the extent to which they are carried on.
Unavoidable causes which may lead to the impairment or complete loss
of a corporation’s assets are the disruption of the organization and its
earning capacity through fire or earthquakes or other natural causes; or new
inventions may kill the demand for its product; or improvements in
machinery and equipment may render obsolete a large capital investment.
Methods of Liquidation
There are several forms of procedure in case liquidation is found
advisable or necessary, and in general there are three courses open, viz.:
bankruptcy, voluntary dissolution, and receivership.
Bankruptcy. This perhaps is the most common method. It is of two kinds
—voluntary and involuntary. If voluntary bankruptcy is contemplated, the
debtor files a petition in the federal court for his district, stating the number
and amount of his debts and the amount of his assets. Creditors are then
served with the notice and copies of the petition. Further proceedings are
similar to those in involuntary bankruptcy. Involuntary bankruptcy
proceedings may be brought if the debts are not less than $1,000 and an act
of bankruptcy has been committed.
The following are legal acts of bankruptcy:
1. To convey, transfer, conceal, or remove, or to permit
to be concealed or removed, any part of the
debtor’s property with intent to hinder, delay, or
defraud his creditors.
2. To transfer while insolvent any portion of the
property to one or more creditors with intent to
give preference to them.
3. To make a general assignment for the benefit of
creditors, or being insolvent to apply for a receiver
or trustee for the property.
stockholders. Whatever may be the means used, these various methods of
exploitation may lead to insolvency, their ultimate effect depending upon
the condition of the company and the extent to which they are carried on.
Unavoidable causes which may lead to the impairment or complete loss
of a corporation’s assets are the disruption of the organization and its
earning capacity through fire or earthquakes or other natural causes; or new
inventions may kill the demand for its product; or improvements in
machinery and equipment may render obsolete a large capital investment.
Methods of Liquidation
There are several forms of procedure in case liquidation is found
advisable or necessary, and in general there are three courses open, viz.:
bankruptcy, voluntary dissolution, and receivership.
Bankruptcy. This perhaps is the most common method. It is of two kinds
—voluntary and involuntary. If voluntary bankruptcy is contemplated, the
debtor files a petition in the federal court for his district, stating the number
and amount of his debts and the amount of his assets. Creditors are then
served with the notice and copies of the petition. Further proceedings are
similar to those in involuntary bankruptcy. Involuntary bankruptcy
proceedings may be brought if the debts are not less than $1,000 and an act
of bankruptcy has been committed.
The following are legal acts of bankruptcy:
1. To convey, transfer, conceal, or remove, or to permit
to be concealed or removed, any part of the
debtor’s property with intent to hinder, delay, or
defraud his creditors.
2. To transfer while insolvent any portion of the
property to one or more creditors with intent to
give preference to them.
3. To make a general assignment for the benefit of
creditors, or being insolvent to apply for a receiver
or trustee for the property.
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4. For the debtor to admit in writing his inability to
pay his debts and his willingness to be adjudged a
bankrupt on that ground.
5. To suffer or permit, while insolvent, any creditor to
obtain preference through legal proceedings and
not have vacated such preference at least five days
before the sale or final disposition of the property
affected by such preference.
After the petition has been presented the next step is the appointment of
a receiver or trustee for the purpose of protecting the creditors, and also in
the case of the individual to secure the application of his property to the
settlement of his debts so far as possible and so secure for him a discharge
from further liability.
Bankruptcy proceedings are regulated by the National Bankruptcy Act
of 1898. The courts of the Federal Government have jurisdiction in these
proceedings. Under the National Bankruptcy Act, a person is insolvent
“when the aggregate of his property, exclusive of any property that he has
conveyed, transferred, concealed or removed, or permitted to be removed
with intent to hinder, delay or defraud his creditors, is not, at a fair
valuation, sufficient in amount to pay his debts.”
Voluntary Dissolution. A corporation may or may not be insolvent when
making a voluntary dissolution. The reasons for the decision on the part of
the stockholders to take this step may be various. Perhaps business is falling
off and further profitable use cannot be made of the capital, or the company
while solvent is losing money and drawing on its surplus. Again the cause
may be due to legal complications, especially when concerns are adjudged
combinations in restraint of trade. Voluntary dissolution in general is due to
the fact that the condition of affairs seems to be unprofitable and the near
future promises nothing better.
Receivership. One method of liquidating an insolvent corporation is by
means of a receivership. The appointment of a receiver in equity is different
in purpose from that of a receiver in bankruptcy. The function of the
receiver in equity is to continue the business until it is wound up. In
bankruptcy proceedings a receiver is appointed temporarily to preserve the
property until a trustee can be elected. He does not conduct the business,
pay his debts and his willingness to be adjudged a
bankrupt on that ground.
5. To suffer or permit, while insolvent, any creditor to
obtain preference through legal proceedings and
not have vacated such preference at least five days
before the sale or final disposition of the property
affected by such preference.
After the petition has been presented the next step is the appointment of
a receiver or trustee for the purpose of protecting the creditors, and also in
the case of the individual to secure the application of his property to the
settlement of his debts so far as possible and so secure for him a discharge
from further liability.
Bankruptcy proceedings are regulated by the National Bankruptcy Act
of 1898. The courts of the Federal Government have jurisdiction in these
proceedings. Under the National Bankruptcy Act, a person is insolvent
“when the aggregate of his property, exclusive of any property that he has
conveyed, transferred, concealed or removed, or permitted to be removed
with intent to hinder, delay or defraud his creditors, is not, at a fair
valuation, sufficient in amount to pay his debts.”
Voluntary Dissolution. A corporation may or may not be insolvent when
making a voluntary dissolution. The reasons for the decision on the part of
the stockholders to take this step may be various. Perhaps business is falling
off and further profitable use cannot be made of the capital, or the company
while solvent is losing money and drawing on its surplus. Again the cause
may be due to legal complications, especially when concerns are adjudged
combinations in restraint of trade. Voluntary dissolution in general is due to
the fact that the condition of affairs seems to be unprofitable and the near
future promises nothing better.
Receivership. One method of liquidating an insolvent corporation is by
means of a receivership. The appointment of a receiver in equity is different
in purpose from that of a receiver in bankruptcy. The function of the
receiver in equity is to continue the business until it is wound up. In
bankruptcy proceedings a receiver is appointed temporarily to preserve the
property until a trustee can be elected. He does not conduct the business,
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but merely takes care of the goods, and pays taxes and dues, until the
election of the trustee. A receivership in equity is frequently a preliminary
step to reorganization. While the concern is technically insolvent in that the
quick assets are not sufficient to meet maturing obligations, the total assets
really exceed the total liabilities. Were the fixed assets sold, only a small
fraction of their value might be realized. Under these circumstances the
appointment of a receiver in equity is a valuable measure, giving time to
provide for permanent remedies.
Liquidation under Bankruptcy
In involuntary bankruptcy proceedings the creditors file a petition in the
federal courts located in the judicial district where the bankrupt has his
place of business or in which his property is located. A copy of the petition
is served on the bankrupt. The petition generally asks for the appointment
of a receiver to protect the property until a trustee can be elected. The
receiver is appointed by the court and is given charge of all property of the
bankrupt until the first meeting of the creditors. The proceedings are
generally conducted before a referee in bankruptcy appointed by the court.
After the expiration of 20 days, during which the bankrupt is allowed to
make his reply, he is required to file a list of all claims against him. A
meeting of all creditors whose claims have been allowed by the court is
then called and, if the petition is granted, a trustee is elected. Creditors who
have some security for their claims are not allowed to vote for the trustee
unless the security is insufficient to cover their claims, in which case they
may vote on the amount of claim which is unsecured.
As soon as the trustee has been elected the creditors should file their
claims with him together with the proof of the claims. This may consist of
an affidavit stating the nature and amount of the claim, and the security
held, if any. The bankruptcy proceedings are carried through unless the
creditors and debtor agree to compromise.
The trustee’s first duty on his appointment is to collect all the property
and any debts owing to the bankrupt, and to turn everything into cash in as
short time as possible without unduly sacrificing the assets. As a general
rule it is necessary to keep the business going for some time in order to get
the most out of it. From the receipts the trustee pays taxes, filing fees, court
costs, attorney’s fee and wages due, and then the creditors. Servants and
election of the trustee. A receivership in equity is frequently a preliminary
step to reorganization. While the concern is technically insolvent in that the
quick assets are not sufficient to meet maturing obligations, the total assets
really exceed the total liabilities. Were the fixed assets sold, only a small
fraction of their value might be realized. Under these circumstances the
appointment of a receiver in equity is a valuable measure, giving time to
provide for permanent remedies.
Liquidation under Bankruptcy
In involuntary bankruptcy proceedings the creditors file a petition in the
federal courts located in the judicial district where the bankrupt has his
place of business or in which his property is located. A copy of the petition
is served on the bankrupt. The petition generally asks for the appointment
of a receiver to protect the property until a trustee can be elected. The
receiver is appointed by the court and is given charge of all property of the
bankrupt until the first meeting of the creditors. The proceedings are
generally conducted before a referee in bankruptcy appointed by the court.
After the expiration of 20 days, during which the bankrupt is allowed to
make his reply, he is required to file a list of all claims against him. A
meeting of all creditors whose claims have been allowed by the court is
then called and, if the petition is granted, a trustee is elected. Creditors who
have some security for their claims are not allowed to vote for the trustee
unless the security is insufficient to cover their claims, in which case they
may vote on the amount of claim which is unsecured.
As soon as the trustee has been elected the creditors should file their
claims with him together with the proof of the claims. This may consist of
an affidavit stating the nature and amount of the claim, and the security
held, if any. The bankruptcy proceedings are carried through unless the
creditors and debtor agree to compromise.
The trustee’s first duty on his appointment is to collect all the property
and any debts owing to the bankrupt, and to turn everything into cash in as
short time as possible without unduly sacrificing the assets. As a general
rule it is necessary to keep the business going for some time in order to get
the most out of it. From the receipts the trustee pays taxes, filing fees, court
costs, attorney’s fee and wages due, and then the creditors. Servants and
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persons employed for three months prior to the bankruptcy proceedings are
entitled to be paid before any other claims are settled. After that the secured
debts are discharged to the value of the security. When these items have
been paid, if there remains enough to pay 5% of the total amount of all
other claims, the creditors are entitled to have a dividend declared within 30
days after the debtor has been adjudged a bankrupt. If not, they must wait
until the trustee has collected a sufficient amount. Afterwards the creditors
are entitled to dividends from time to time until the entire amount in the
hands of the trustee has been paid out. When the final dividend has been
paid the trustee makes up his accounts, presents them at court, and asks for
a discharge. He then is entitled to his fee based on the value of the funds
that have gone through his hands.
Liquidation under Voluntary Dissolution
A corporation may be dissolved and its affairs wound up by the proper
procedure if all its stockholders consent. In some states a majority is
sufficient, and in certain cases even less. Statutory provisions prescribe the
procedure in most of the states. The process of voluntary dissolution
consists simply of gradually closing down the business by realizing on the
assets, and distributing the funds among the creditors and stockholders. This
usually involves a vast amount of detail work, such as the transfer of
contracts, the sale of parts of the business, the taking of inventories, the
making of appraisals, and so on.
Liquidation under Receivership
The receivership in bankruptcy is only a step in the chain leading to the
appointment of a trustee under whom the process of liquidation takes place.
As already stated, the receivership in equity is sometimes not a process of
liquidation but a means of carrying on the business pending reorganization.
In case the assets are greater than the liabilities, it may be advisable to
effect some sort of reorganization to continue the business. The receiver can
continue the business in whatever way the court will permit. Any of its
unprofitable and unessential parts may be sold and in this way a partial
liquidation may be effected.
With permission of the court the receiver may issue receiver’s
certificates to meet immediate and necessary running expenses. The
entitled to be paid before any other claims are settled. After that the secured
debts are discharged to the value of the security. When these items have
been paid, if there remains enough to pay 5% of the total amount of all
other claims, the creditors are entitled to have a dividend declared within 30
days after the debtor has been adjudged a bankrupt. If not, they must wait
until the trustee has collected a sufficient amount. Afterwards the creditors
are entitled to dividends from time to time until the entire amount in the
hands of the trustee has been paid out. When the final dividend has been
paid the trustee makes up his accounts, presents them at court, and asks for
a discharge. He then is entitled to his fee based on the value of the funds
that have gone through his hands.
Liquidation under Voluntary Dissolution
A corporation may be dissolved and its affairs wound up by the proper
procedure if all its stockholders consent. In some states a majority is
sufficient, and in certain cases even less. Statutory provisions prescribe the
procedure in most of the states. The process of voluntary dissolution
consists simply of gradually closing down the business by realizing on the
assets, and distributing the funds among the creditors and stockholders. This
usually involves a vast amount of detail work, such as the transfer of
contracts, the sale of parts of the business, the taking of inventories, the
making of appraisals, and so on.
Liquidation under Receivership
The receivership in bankruptcy is only a step in the chain leading to the
appointment of a trustee under whom the process of liquidation takes place.
As already stated, the receivership in equity is sometimes not a process of
liquidation but a means of carrying on the business pending reorganization.
In case the assets are greater than the liabilities, it may be advisable to
effect some sort of reorganization to continue the business. The receiver can
continue the business in whatever way the court will permit. Any of its
unprofitable and unessential parts may be sold and in this way a partial
liquidation may be effected.
With permission of the court the receiver may issue receiver’s
certificates to meet immediate and necessary running expenses. The
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certificates usually have the first claim on the assets. It seldom happens that
these remedies are sufficient to put the company on its feet and the receiver
in the end will wind up the business by disposing of the assets and
distributing the proceeds as instructed by the court.
A receiver is an officer of the court and acts under its instructions. In all
dubious matters he can protect himself from liability by procuring an order
of court or by refusing to act until authorized by an order of court.
Status of Creditors in Liquidation
Creditors may be divided into two groups—secured and unsecured.
Those that have a lien upon some specific part of the assets, such as
buildings, machinery, or materials, and holders of bonds are among those
whose claims are secured. Trade credits and bank loans often have no other
security than the standing of the firm.
If the business has been in a receiver’s hands and receiver’s certificates,
have been issued, these may be given priority over all debts except those for
taxes. The bondholders are usually given the opportunity to appear and
present their arguments for or against the issuance of receiver’s certificates.
The court directs the issuance at its discretion.
Preferred and common stockholders receive what is left after everyone
else has been paid. If the preferred stock is preferred as to assets, it takes
priority over the common stock. Often, however, the preference is only as to
earnings, in which case the two stock issues share equally in the liquidation.
Directors are prohibited by law from declaring dividends except out of
earnings. If it should appear that dividends have been paid out of capital
and not out of earnings, the stockholders are liable for any amounts thus
paid out to them. If the stock issued is only partly paid, the stockholders are
liable up to the amount which remains unpaid.
Accounting for Liquidation
Accounting for liquidation may be simple or complex, depending upon
circumstances, but it involves practically nothing new in principle. The
main bookkeeping features for a liquidation which takes place because of
bankruptcy or receivership are treated in Chapter XXXV where some
specialized forms of statement are discussed and illustrated. Here it is
these remedies are sufficient to put the company on its feet and the receiver
in the end will wind up the business by disposing of the assets and
distributing the proceeds as instructed by the court.
A receiver is an officer of the court and acts under its instructions. In all
dubious matters he can protect himself from liability by procuring an order
of court or by refusing to act until authorized by an order of court.
Status of Creditors in Liquidation
Creditors may be divided into two groups—secured and unsecured.
Those that have a lien upon some specific part of the assets, such as
buildings, machinery, or materials, and holders of bonds are among those
whose claims are secured. Trade credits and bank loans often have no other
security than the standing of the firm.
If the business has been in a receiver’s hands and receiver’s certificates,
have been issued, these may be given priority over all debts except those for
taxes. The bondholders are usually given the opportunity to appear and
present their arguments for or against the issuance of receiver’s certificates.
The court directs the issuance at its discretion.
Preferred and common stockholders receive what is left after everyone
else has been paid. If the preferred stock is preferred as to assets, it takes
priority over the common stock. Often, however, the preference is only as to
earnings, in which case the two stock issues share equally in the liquidation.
Directors are prohibited by law from declaring dividends except out of
earnings. If it should appear that dividends have been paid out of capital
and not out of earnings, the stockholders are liable for any amounts thus
paid out to them. If the stock issued is only partly paid, the stockholders are
liable up to the amount which remains unpaid.
Accounting for Liquidation
Accounting for liquidation may be simple or complex, depending upon
circumstances, but it involves practically nothing new in principle. The
main bookkeeping features for a liquidation which takes place because of
bankruptcy or receivership are treated in Chapter XXXV where some
specialized forms of statement are discussed and illustrated. Here it is
Page 417
purposed merely to point out the accounting procedure necessary in the case
of a voluntary dissolution. Under a voluntary liquidation the same books of
account are used as for the regular record of business transactions, and the
procedure is merely a matter of recording the conversion of assets into cash.
This involves taking into consideration, in the case of depreciating assets,
the adjustment between the asset account, the depreciation reserve, and the
loss or gain realized upon the final disposal of the asset. It may be desirable
to separate these losses and gains on the sale of fixed properties from the
losses and gains of the stock-in-trade, particularly if operations are
continued up to the point of the final disposal of the merchandise stock on
hand through the regular channels of trade. If, however, the sale of the
whole property, including stock-in-trade, is effected, there is no occasion
for the separation of the results of the liquidation of the two types of assets.
But if this is desirable a separate clearing account, sometimes called
“Liquidation Profit and Loss,” may be opened to summarize the losses and
gains on fixed assets before transferring the net result of both into surplus.
As the assets are sold and converted into cash the liabilities will be
liquidated in due course, the accounting features here being the same as
during the period of regular operation. After all assets have been converted
into cash and all liabilities liquidated, only the cash and net worth accounts
will remain on the books of the corporation. If the net result of the
liquidation has been to encroach upon the original capital, the net worth
accounts will consist of a deficit account and one or more capital stock
accounts. If, however, a profit has resulted or if the resulting deficit is not
sufficient to wipe out any previously accumulated surplus, the net worth
accounts will consist of a surplus account and the various capital stock
accounts.
The final step in liquidation will be the declaration of a liquidating
dividend of the amount of cash on hand; this will be apportioned, just as all
other dividends, on the basis of the stockholdings of the various
shareholders. The books will be finally closed by charging the dividend and
deficit, if any, to the various capital stock accounts in the one case; or by
charging the dividend against the various capital stock accounts and surplus
in the other case. In practice the closing of all accounts on the books is
seldom carried out, the bookkeeping ceasing with the declaration of the
liquidating dividend which disposes of the cash. Except as a matter of
complete record, nothing is to be gained by closing off the accounts.
of a voluntary dissolution. Under a voluntary liquidation the same books of
account are used as for the regular record of business transactions, and the
procedure is merely a matter of recording the conversion of assets into cash.
This involves taking into consideration, in the case of depreciating assets,
the adjustment between the asset account, the depreciation reserve, and the
loss or gain realized upon the final disposal of the asset. It may be desirable
to separate these losses and gains on the sale of fixed properties from the
losses and gains of the stock-in-trade, particularly if operations are
continued up to the point of the final disposal of the merchandise stock on
hand through the regular channels of trade. If, however, the sale of the
whole property, including stock-in-trade, is effected, there is no occasion
for the separation of the results of the liquidation of the two types of assets.
But if this is desirable a separate clearing account, sometimes called
“Liquidation Profit and Loss,” may be opened to summarize the losses and
gains on fixed assets before transferring the net result of both into surplus.
As the assets are sold and converted into cash the liabilities will be
liquidated in due course, the accounting features here being the same as
during the period of regular operation. After all assets have been converted
into cash and all liabilities liquidated, only the cash and net worth accounts
will remain on the books of the corporation. If the net result of the
liquidation has been to encroach upon the original capital, the net worth
accounts will consist of a deficit account and one or more capital stock
accounts. If, however, a profit has resulted or if the resulting deficit is not
sufficient to wipe out any previously accumulated surplus, the net worth
accounts will consist of a surplus account and the various capital stock
accounts.
The final step in liquidation will be the declaration of a liquidating
dividend of the amount of cash on hand; this will be apportioned, just as all
other dividends, on the basis of the stockholdings of the various
shareholders. The books will be finally closed by charging the dividend and
deficit, if any, to the various capital stock accounts in the one case; or by
charging the dividend against the various capital stock accounts and surplus
in the other case. In practice the closing of all accounts on the books is
seldom carried out, the bookkeeping ceasing with the declaration of the
liquidating dividend which disposes of the cash. Except as a matter of
complete record, nothing is to be gained by closing off the accounts.
Page 418
CHAPTER XXIX
COMBINATIONS AND CONSOLIDATIONS
Reasons for Combination
The primary purpose of the formation of a combination or a
consolidation of two or more corporations, or of the taking over of a
partnership business by a corporation, is to secure greater profits through
unity of control. To this end the various parties to the consolidation agree to
subordinate their own interests if the effectiveness of the larger unit is
thereby increased. The main object in view is the control of any external or
internal factors that affect earnings. Profit may be increased by economy of
operation resulting from large-scale production, by economies in use of by-
products, by the standardization of product and improvement of quality, and
by the elimination of duplicate effort; or the control of sources of supplies
or of a marketing organization, or greater ease in obtaining capital, or
greater facility in dealing with labor, may be among the advantages
obtained. In the past the most important of all factors has been the
elimination of competition by the control of selling prices, thus securing a
greater hold on the market and reducing selling expense. A consolidated
enterprise enjoys the advantage of adding to its plant facilities and rounding
out the scope of its activities without the expenditure of new construction or
capital purchases entailing the raising of large sums of money.
Types of Consolidation
In the popular mind the terms, combination, trust, holding company,
consolidation, and merger stand very much for one and the same thing. The
end sought is generally the same, namely, the power to control in some
degree the conditions surrounding a particular industry. The means used are
dictated by the actual conditions governing the situation, such as the
possibility of coming to an agreement, legal aspects, financial factors, etc.
Where the elimination of competition was the main consideration, the
end sought was most easily achieved by arrangements variously termed a
“gentleman’s agreement,” an “interlocking directorate,” a “community of
COMBINATIONS AND CONSOLIDATIONS
Reasons for Combination
The primary purpose of the formation of a combination or a
consolidation of two or more corporations, or of the taking over of a
partnership business by a corporation, is to secure greater profits through
unity of control. To this end the various parties to the consolidation agree to
subordinate their own interests if the effectiveness of the larger unit is
thereby increased. The main object in view is the control of any external or
internal factors that affect earnings. Profit may be increased by economy of
operation resulting from large-scale production, by economies in use of by-
products, by the standardization of product and improvement of quality, and
by the elimination of duplicate effort; or the control of sources of supplies
or of a marketing organization, or greater ease in obtaining capital, or
greater facility in dealing with labor, may be among the advantages
obtained. In the past the most important of all factors has been the
elimination of competition by the control of selling prices, thus securing a
greater hold on the market and reducing selling expense. A consolidated
enterprise enjoys the advantage of adding to its plant facilities and rounding
out the scope of its activities without the expenditure of new construction or
capital purchases entailing the raising of large sums of money.
Types of Consolidation
In the popular mind the terms, combination, trust, holding company,
consolidation, and merger stand very much for one and the same thing. The
end sought is generally the same, namely, the power to control in some
degree the conditions surrounding a particular industry. The means used are
dictated by the actual conditions governing the situation, such as the
possibility of coming to an agreement, legal aspects, financial factors, etc.
Where the elimination of competition was the main consideration, the
end sought was most easily achieved by arrangements variously termed a
“gentleman’s agreement,” an “interlocking directorate,” a “community of
Page 419
interest,” a “pool,” or a “voting trust”—the results of which were generally
referred to as “combinations.” Like the earlier form of the holding
company, the “trust,” they are known in the federal courts as “combinations
in restraint of trade,” are illegal, and are no longer entered into.
The trust derived its name from the fact that it was controlled by a board
of trustees who issued trust certificates in lieu of the stock of the
participating companies. Popular aversion to this form of control has led to
the formation of another and better type of organization known as the
“holding company.” While the holding company is generally classed among
the combinations in restraint of trade and in a number of instances, like its
predecessor, has come to grief through the enforcement of the anti-trust
laws, its legality is recognized in those states where ownership of the stock
of other corporations is allowed by law and where no restraint of trade or
interference with competition is effected. A holding company organized in
one state may control corporations organized under the laws of other states.
The holding corporation can itself be controlled by the ownership of 50 or
51 per cent of its stock, and the control of its subsidiaries is obtained with
stock ownership in the same ratio. Thus a relatively small capital
investment may exercise a far-reaching control.
A holding company as a rule buys up the controlling stock interest of
the companies in which it is interested, and elects its own men on the board
of directors of the subsidiaries. Frequently the larger stockholders of
competing corporations get together and form the holding company. In this
case very little difficulty is experienced so far as financing is concerned,
which is usually a matter of exchanging the stock of the various companies
for the stock of the holding company.
One of the advantages accruing to the holding company, aside from the
favorable financial and legal aspects of the enterprise, is that the
subsidiaries remain as operating and business units. This is often desirable
because of the value of the good-will accruing to the constituent companies
from years of business dealing with their customers. The advantages of the
close consolidation may be often obtained by stimulating rivalry between
the various plants of the same industry and by exchanging information as to
successful methods of operation.
referred to as “combinations.” Like the earlier form of the holding
company, the “trust,” they are known in the federal courts as “combinations
in restraint of trade,” are illegal, and are no longer entered into.
The trust derived its name from the fact that it was controlled by a board
of trustees who issued trust certificates in lieu of the stock of the
participating companies. Popular aversion to this form of control has led to
the formation of another and better type of organization known as the
“holding company.” While the holding company is generally classed among
the combinations in restraint of trade and in a number of instances, like its
predecessor, has come to grief through the enforcement of the anti-trust
laws, its legality is recognized in those states where ownership of the stock
of other corporations is allowed by law and where no restraint of trade or
interference with competition is effected. A holding company organized in
one state may control corporations organized under the laws of other states.
The holding corporation can itself be controlled by the ownership of 50 or
51 per cent of its stock, and the control of its subsidiaries is obtained with
stock ownership in the same ratio. Thus a relatively small capital
investment may exercise a far-reaching control.
A holding company as a rule buys up the controlling stock interest of
the companies in which it is interested, and elects its own men on the board
of directors of the subsidiaries. Frequently the larger stockholders of
competing corporations get together and form the holding company. In this
case very little difficulty is experienced so far as financing is concerned,
which is usually a matter of exchanging the stock of the various companies
for the stock of the holding company.
One of the advantages accruing to the holding company, aside from the
favorable financial and legal aspects of the enterprise, is that the
subsidiaries remain as operating and business units. This is often desirable
because of the value of the good-will accruing to the constituent companies
from years of business dealing with their customers. The advantages of the
close consolidation may be often obtained by stimulating rivalry between
the various plants of the same industry and by exchanging information as to
successful methods of operation.
Page 420
A holding company does not generally own all the stock of the
subsidiary. Often, however, this is necessary because of the trouble that a
small minority of the stockholders can create if the interests of the
subsidiary and the holding company clash; such as might be the case if, for
reasons of efficiency, the plant of the subsidiary were closed down. It would
naturally be a gain to the holding company but a loss to the minority
stockholders of the subsidiary if the productive capacity of another plant
could be utilized to better advantage.
Accounting for the Holding Company
In Chapter XV where the principles of valuation of permanent
investments were discussed, reference was made to the method of valuing
the holdings of the stock of subsidiaries as carried on the books of the
holding company. A distinction was there made between the accounting
procedure in showing the holdings of the subsidiary stocks when the parent
company has complete ownership, and when its ownership is only partial—
though usually a controlling—ownership. If the ownership is complete, as
there pointed out, to show the consolidated balance sheet and profit and loss
summaries is the best and only intelligible presentation of condition. Where
ownership is not complete the balance sheet of the holding company must
carry the stock of the subsidiary at a valuation which varies in accordance
with the earnings and dividend policy of the subsidiary. In addition to the
method of showing the valuation of the holdings in the subsidiary, it may
for certain purposes and particularly for internal use, be desirable to append
to the statements of the holding company financial statements of each of the
subsidiaries so as to give an intelligent view of the condition of the
properties of all the companies. These appended statements are, of course,
not an integral part of the financial statements of the holding company but
are necessary as furnishing information which the officers of the holding
company may need in their direction of the policy of the subsidiary. For a
detailed discussion of the consolidated balance sheet and profit and loss
summaries the student is referred to Chapter XXXIV.
Aside from the financial statements, no special accounting problems or
peculiarities arise in accounting for the holding company. Where, as is
usual, accounts with the subsidiaries appear on the books of the holding
company other than stock accounts showing the investment, the chief
subsidiary. Often, however, this is necessary because of the trouble that a
small minority of the stockholders can create if the interests of the
subsidiary and the holding company clash; such as might be the case if, for
reasons of efficiency, the plant of the subsidiary were closed down. It would
naturally be a gain to the holding company but a loss to the minority
stockholders of the subsidiary if the productive capacity of another plant
could be utilized to better advantage.
Accounting for the Holding Company
In Chapter XV where the principles of valuation of permanent
investments were discussed, reference was made to the method of valuing
the holdings of the stock of subsidiaries as carried on the books of the
holding company. A distinction was there made between the accounting
procedure in showing the holdings of the subsidiary stocks when the parent
company has complete ownership, and when its ownership is only partial—
though usually a controlling—ownership. If the ownership is complete, as
there pointed out, to show the consolidated balance sheet and profit and loss
summaries is the best and only intelligible presentation of condition. Where
ownership is not complete the balance sheet of the holding company must
carry the stock of the subsidiary at a valuation which varies in accordance
with the earnings and dividend policy of the subsidiary. In addition to the
method of showing the valuation of the holdings in the subsidiary, it may
for certain purposes and particularly for internal use, be desirable to append
to the statements of the holding company financial statements of each of the
subsidiaries so as to give an intelligent view of the condition of the
properties of all the companies. These appended statements are, of course,
not an integral part of the financial statements of the holding company but
are necessary as furnishing information which the officers of the holding
company may need in their direction of the policy of the subsidiary. For a
detailed discussion of the consolidated balance sheet and profit and loss
summaries the student is referred to Chapter XXXIV.
Aside from the financial statements, no special accounting problems or
peculiarities arise in accounting for the holding company. Where, as is
usual, accounts with the subsidiaries appear on the books of the holding
company other than stock accounts showing the investment, the chief
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problem lies in the valuation of these accounts. That feature was also
discussed in Chapter XV to which the student is referred.
Distinction between Consolidation and Merger
Consolidation, in the legal sense, refers to the complete union of two or
more enterprises. It is a fusion whereby each company loses its identity in
the larger unit of the new corporation. The prior corporations are dissolved
and cease to exist. The stock of the old corporation is exchanged for that of
the new corporation upon an agreed ratio. The usual procedure for statutory
consolidation is as follows:
1. Agreement by the directors of the various
companies as to terms, etc.
2. Assent of the stockholders of each company to the
directors’ agreement.
3. Filing of certified copies of the agreement, with the
vote in its favor, in the same offices in which the
certificates of incorporation of each corporation
were originally filed.
4. The exchange and issuance of new stock for the old
stock of the constituent companies.
The merger of a number of corporations is generally held to be a
method of consolidating. The difference is that a consolidation is a fusion
while a merger is rather an absorption. The constituent companies are
merged into an existing one and no new corporation is formed. The rights,
franchises, and interest are deemed to be transferred to, and vested in, the
corporation into which the various companies have been merged without
any deed or transfer, and the liabilities follow the rights.
Formation of Consolidation and Merger
In the formation of a consolidation or a merger the services of a
promoter may be necessary. This is especially true if the various companies
are direct competitors and deep-rooted jealousies exist. Under the
circumstances an outsider has the best chance of effecting an agreement
between the parties. The difficulty encountered in all consolidations and
mergers is the exaggerated idea of officials regarding the importance and
discussed in Chapter XV to which the student is referred.
Distinction between Consolidation and Merger
Consolidation, in the legal sense, refers to the complete union of two or
more enterprises. It is a fusion whereby each company loses its identity in
the larger unit of the new corporation. The prior corporations are dissolved
and cease to exist. The stock of the old corporation is exchanged for that of
the new corporation upon an agreed ratio. The usual procedure for statutory
consolidation is as follows:
1. Agreement by the directors of the various
companies as to terms, etc.
2. Assent of the stockholders of each company to the
directors’ agreement.
3. Filing of certified copies of the agreement, with the
vote in its favor, in the same offices in which the
certificates of incorporation of each corporation
were originally filed.
4. The exchange and issuance of new stock for the old
stock of the constituent companies.
The merger of a number of corporations is generally held to be a
method of consolidating. The difference is that a consolidation is a fusion
while a merger is rather an absorption. The constituent companies are
merged into an existing one and no new corporation is formed. The rights,
franchises, and interest are deemed to be transferred to, and vested in, the
corporation into which the various companies have been merged without
any deed or transfer, and the liabilities follow the rights.
Formation of Consolidation and Merger
In the formation of a consolidation or a merger the services of a
promoter may be necessary. This is especially true if the various companies
are direct competitors and deep-rooted jealousies exist. Under the
circumstances an outsider has the best chance of effecting an agreement
between the parties. The difficulty encountered in all consolidations and
mergers is the exaggerated idea of officials regarding the importance and
Page 422
value of their own plant and organization as related to the rest. This
difficulty is accentuated in effecting a merger because of the irrevocable
nature of the compact and the almost complete disappearance of lines of
demarcation as to the tangible and intangible assets of the various units.
These difficulties are overcome in many instances by the promoter’s
keeping the terms arrived at with each company a secret. Direct dealing is
possible in the case of a merger when the various companies are
supplementary to each other, such as would be the case where a selling
organization is merged into a manufacturing corporation the product of
which it distributes.
Principles of Valuation of the Constituent Companies
In all the foregoing cases the question at once arises as to the principles
which should govern in arriving at a valuation. Should the value of the net
assets comprising plant, equipment, etc., or the earnings for a number of
years serve as a basis in arriving at the ratio of exchange in cash or stock?
What relative weight should be given to the various items? A concern with
large assets when not running its plant to full capacity would be averse to
having the apportionments based on earnings. The corporation with
relatively small assets but with large earnings on the capital invested would
not want the value computed on net assets.
If the net assets are an important factor of valuation, an appraisal should
be made either through a committee or by independent appraisers. If such
an appraisal cannot be made, the books should be examined to see that the
valuation of each plant and equipment is correct. Great care should be
exercised to see that capital additions represent actual additions to the plant
or serve to increase its capacity or lower its cost of production. The method
of handling improvement expenditures should be uniform. It is necessary to
determine that proper entries have been made in respect of property
abandoned or equipment removed from service. Another point requiring
careful investigation is the provision of ample reserves for depreciation, and
the same method of calculation and consideration of the different elements
of depreciation and the conditions under which they are operative must be
taken into account in all the companies.
The main problem in using earnings as the basis for valuation is the
determination of the number of years’ profits to be averaged. Care must be
difficulty is accentuated in effecting a merger because of the irrevocable
nature of the compact and the almost complete disappearance of lines of
demarcation as to the tangible and intangible assets of the various units.
These difficulties are overcome in many instances by the promoter’s
keeping the terms arrived at with each company a secret. Direct dealing is
possible in the case of a merger when the various companies are
supplementary to each other, such as would be the case where a selling
organization is merged into a manufacturing corporation the product of
which it distributes.
Principles of Valuation of the Constituent Companies
In all the foregoing cases the question at once arises as to the principles
which should govern in arriving at a valuation. Should the value of the net
assets comprising plant, equipment, etc., or the earnings for a number of
years serve as a basis in arriving at the ratio of exchange in cash or stock?
What relative weight should be given to the various items? A concern with
large assets when not running its plant to full capacity would be averse to
having the apportionments based on earnings. The corporation with
relatively small assets but with large earnings on the capital invested would
not want the value computed on net assets.
If the net assets are an important factor of valuation, an appraisal should
be made either through a committee or by independent appraisers. If such
an appraisal cannot be made, the books should be examined to see that the
valuation of each plant and equipment is correct. Great care should be
exercised to see that capital additions represent actual additions to the plant
or serve to increase its capacity or lower its cost of production. The method
of handling improvement expenditures should be uniform. It is necessary to
determine that proper entries have been made in respect of property
abandoned or equipment removed from service. Another point requiring
careful investigation is the provision of ample reserves for depreciation, and
the same method of calculation and consideration of the different elements
of depreciation and the conditions under which they are operative must be
taken into account in all the companies.
The main problem in using earnings as the basis for valuation is the
determination of the number of years’ profits to be averaged. Care must be
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exercised to handle uniformly the earnings and expenses of the various
companies.
Fundamental Principle of Equalization of Conditions
Before an intelligent estimate or computation can be made of the
relative value of each unit in the proposed consolidation or merger, the
various items that make up the assets and earnings of each company should
be examined from the same point of view. Accounting systems and methods
are so varied that a common basis of computation must be constructed or
agreed upon before a comparison can be made. In general, the following
points should be considered:
1. A uniform accounting system for all the companies
to be merged, in order to have the same basis in
arriving at the results.
2. The reserves for depreciation should be based on an
analogous system of calculation.
3. Costs should be determined in the same way if the
companies carry on the same industry; if the
industries are not similar the cost should be
reduced to the same basis.
4. The apportionment of labor, factory expense, and
factory overhead should be uniform.
5. Only real items of cost should be included under the
head of cost of plant and all income charges
should be eliminated so as to give a basis for
comparing manufacturing items.
6. The same methods of inventory-taking, both of
working assets and fixed capital, should be used.
Proper valuation of accounts receivable should be
made. The accounts payable should be properly
shown.
7. The amount of orders on hand should be
considered. The past year may have been poor and
the books may not reflect the true state of affairs.
companies.
Fundamental Principle of Equalization of Conditions
Before an intelligent estimate or computation can be made of the
relative value of each unit in the proposed consolidation or merger, the
various items that make up the assets and earnings of each company should
be examined from the same point of view. Accounting systems and methods
are so varied that a common basis of computation must be constructed or
agreed upon before a comparison can be made. In general, the following
points should be considered:
1. A uniform accounting system for all the companies
to be merged, in order to have the same basis in
arriving at the results.
2. The reserves for depreciation should be based on an
analogous system of calculation.
3. Costs should be determined in the same way if the
companies carry on the same industry; if the
industries are not similar the cost should be
reduced to the same basis.
4. The apportionment of labor, factory expense, and
factory overhead should be uniform.
5. Only real items of cost should be included under the
head of cost of plant and all income charges
should be eliminated so as to give a basis for
comparing manufacturing items.
6. The same methods of inventory-taking, both of
working assets and fixed capital, should be used.
Proper valuation of accounts receivable should be
made. The accounts payable should be properly
shown.
7. The amount of orders on hand should be
considered. The past year may have been poor and
the books may not reflect the true state of affairs.
Page 424
Valuation of Partnership
Where, as frequently happens, a partnership is a party to the merger, it is
necessary to consider the method of handling certain items in the
partnership accounting which differs from their handling under the
corporate form, so that the valuation of the assets and earnings of all the
properties can be placed on an equitable basis. Such items are partners’
salaries and drawings, and the interest on capital and drawings for the
purpose of adjusting the various partners’ interests. In partnership
accounting the proper treatment of partners’ salaries, drawings, and interest
on capital and drawings requires that these appropriations of profits be
shown in the profit and loss summary; i.e., the figure of net profits for a
partnership is determined before taking into consideration the items
mentioned. However, one occasionally finds partners’ salaries and
adjustments on account of interest handled as expenses of the business. To
place the earning capacity of the partnership on an equitable basis for
comparison with the earnings of a corporation, a reasonable figure for the
salaries of the partners as managers of the business must be agreed upon
and treated as an expense chargeable to operations before the determination
of net profits. Partners’ drawings and interest adjustments on account of
capital and drawings should not be taken into account in the determination
of earning capacity. In determining the amounts of partners’ salaries, that
which would be appropriate for similar capacities in a corporation should be
allowed as deductions from earnings. All the items mentioned above in
connection with placing the properties of the several corporations on an
equitable basis for valuation apply with equal force to the properties of any
partnerships which may become parties to the merger.
Earning Capacity
Any extraordinary profits or losses not due to the ordinary operations of
the business should be eliminated when computing profits. Interest on
borrowed money should not be included. The charges to operating expense
on account of repairs should be adequate, and care must be taken to see that
charges to the repair accounts do not show a sudden falling off toward the
close of the period under review. The reserve for depreciation should be
credited with the proper amounts. Sales, effected for a subsequent period,
are not to be considered in the accounts of the current period as this would
Where, as frequently happens, a partnership is a party to the merger, it is
necessary to consider the method of handling certain items in the
partnership accounting which differs from their handling under the
corporate form, so that the valuation of the assets and earnings of all the
properties can be placed on an equitable basis. Such items are partners’
salaries and drawings, and the interest on capital and drawings for the
purpose of adjusting the various partners’ interests. In partnership
accounting the proper treatment of partners’ salaries, drawings, and interest
on capital and drawings requires that these appropriations of profits be
shown in the profit and loss summary; i.e., the figure of net profits for a
partnership is determined before taking into consideration the items
mentioned. However, one occasionally finds partners’ salaries and
adjustments on account of interest handled as expenses of the business. To
place the earning capacity of the partnership on an equitable basis for
comparison with the earnings of a corporation, a reasonable figure for the
salaries of the partners as managers of the business must be agreed upon
and treated as an expense chargeable to operations before the determination
of net profits. Partners’ drawings and interest adjustments on account of
capital and drawings should not be taken into account in the determination
of earning capacity. In determining the amounts of partners’ salaries, that
which would be appropriate for similar capacities in a corporation should be
allowed as deductions from earnings. All the items mentioned above in
connection with placing the properties of the several corporations on an
equitable basis for valuation apply with equal force to the properties of any
partnerships which may become parties to the merger.
Earning Capacity
Any extraordinary profits or losses not due to the ordinary operations of
the business should be eliminated when computing profits. Interest on
borrowed money should not be included. The charges to operating expense
on account of repairs should be adequate, and care must be taken to see that
charges to the repair accounts do not show a sudden falling off toward the
close of the period under review. The reserve for depreciation should be
credited with the proper amounts. Sales, effected for a subsequent period,
are not to be considered in the accounts of the current period as this would
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tend to inflate the profits. Shipments made to branch offices or on
consignment account should not be regarded as sales. Ample provisions
should be made for all liabilities for expenditures incurred during the period
under review and outstanding at the close thereof. The inventories should be
checked over carefully and certified by the parties taking them. Allowance
for old or obsolete material should be made.
Good-Will
The determination of the value of good-will is generally a delicate
proposition unless the parties to the consolidation or merger first agree as to
the basis on which it is to be computed. This is generally anything that the
interested parties choose to make it.
The two methods commonly used for estimating the value of good-will
have already been discussed in Chapter XVIII.
Capitalization of a Consolidation or a Merger
The capitalization of a corporation, in a legal sense, is the sum total of
the par value of the authorized capital stock. From an investment or
economic point of view it is the sum total of all the stock and bonds issued
or outstanding.
There are three different bases of capitalization: (1) cost of property
plus accumulated surplus value; (2) cost of reproducing the property; and
(3) earning power. According to legal theory the investment or the cost plus
surplus is the proper basis. This idea has been fostered by the fact that
shares have been assigned a definite face value. While at the beginning of a
new enterprise investment value and capitalization may closely correspond
generally, they soon diverge widely—due to smaller or greater earnings
than were estimated or to depreciation or accretion in the value of the
assets. When the potential earning power of the business begins to be
realized, conditions begin to change and the value of the tangible and
intangible assets fluctuates. The basis of capitalization changes with these
fluctuations and the laws regulating it are in practice only complied with
nominally. The custom is to adjust the value of the assets to harmonize with
the capitalization rather than vice versa. Such a policy is to be deprecated.
consignment account should not be regarded as sales. Ample provisions
should be made for all liabilities for expenditures incurred during the period
under review and outstanding at the close thereof. The inventories should be
checked over carefully and certified by the parties taking them. Allowance
for old or obsolete material should be made.
Good-Will
The determination of the value of good-will is generally a delicate
proposition unless the parties to the consolidation or merger first agree as to
the basis on which it is to be computed. This is generally anything that the
interested parties choose to make it.
The two methods commonly used for estimating the value of good-will
have already been discussed in Chapter XVIII.
Capitalization of a Consolidation or a Merger
The capitalization of a corporation, in a legal sense, is the sum total of
the par value of the authorized capital stock. From an investment or
economic point of view it is the sum total of all the stock and bonds issued
or outstanding.
There are three different bases of capitalization: (1) cost of property
plus accumulated surplus value; (2) cost of reproducing the property; and
(3) earning power. According to legal theory the investment or the cost plus
surplus is the proper basis. This idea has been fostered by the fact that
shares have been assigned a definite face value. While at the beginning of a
new enterprise investment value and capitalization may closely correspond
generally, they soon diverge widely—due to smaller or greater earnings
than were estimated or to depreciation or accretion in the value of the
assets. When the potential earning power of the business begins to be
realized, conditions begin to change and the value of the tangible and
intangible assets fluctuates. The basis of capitalization changes with these
fluctuations and the laws regulating it are in practice only complied with
nominally. The custom is to adjust the value of the assets to harmonize with
the capitalization rather than vice versa. Such a policy is to be deprecated.
Page 426
The cost of reproducing the property as a basis of capitalization is as yet
only seriously considered in theory. It is very doubtful if the method will
ever be used in actual practice.
Earnings, past or potential, perhaps form the basis for capitalization
most frequently used. Investment value closely corresponds to the rate
earned and the degree of permanency of the earning power. To secure an
income is the motive of all investment. In practically all consolidations and
mergers the estimated increase in earnings due to the application of better
methods of operation plays an important part not only in the promotion and
formation of the new company, but also in deciding upon the capitalization.
While the plant value and the past earnings of each of the companies may
be considered in allotting them their respective interests, these are not a safe
guide as to future earnings. In the case of partnerships especially and often
in the case of corporations, there is a loss of valuable good-will. It is
generally held that the benefits of consolidation greatly overbalance these
disadvantages. The savings due to the elimination of duplicate work in
factory and office, the cutting down of the item of rent, the saving in the
cost of selling, the greater effectiveness of advertising, etc.—all are reasons
held out as warranting this or that capitalization.
Payment of Amalgamated Interests
In a consolidation or a merger the usual practice is to pay the various
interests in the companies which are amalgamated with bonds, preferred
and common stock, and in some instances with cash. The proportion and
kind of payment will depend upon the conditions surrounding each case.
The prevalent custom is to pay for the net assets in preferred stock and to
issue common stock for good-will. Often, however, bonds are used to pay
for the tangible assets; preferred stock is issued for the intangible assets;
and common stock represents the additional profits that are expected to
accrue to the corporation through the consolidation or merger. The issue of
bonds to cover all the tangible assets is generally a dangerous procedure
because of the high fixed charges resulting therefrom—though
advantageous when the difference between the fixed charges and the net
earnings is large. Bonds generally carry relatively small interest because of
their safety, whereas the use of preferred stock entails a smaller equity for
the common. The bondholder is not concerned with the capitalization or
only seriously considered in theory. It is very doubtful if the method will
ever be used in actual practice.
Earnings, past or potential, perhaps form the basis for capitalization
most frequently used. Investment value closely corresponds to the rate
earned and the degree of permanency of the earning power. To secure an
income is the motive of all investment. In practically all consolidations and
mergers the estimated increase in earnings due to the application of better
methods of operation plays an important part not only in the promotion and
formation of the new company, but also in deciding upon the capitalization.
While the plant value and the past earnings of each of the companies may
be considered in allotting them their respective interests, these are not a safe
guide as to future earnings. In the case of partnerships especially and often
in the case of corporations, there is a loss of valuable good-will. It is
generally held that the benefits of consolidation greatly overbalance these
disadvantages. The savings due to the elimination of duplicate work in
factory and office, the cutting down of the item of rent, the saving in the
cost of selling, the greater effectiveness of advertising, etc.—all are reasons
held out as warranting this or that capitalization.
Payment of Amalgamated Interests
In a consolidation or a merger the usual practice is to pay the various
interests in the companies which are amalgamated with bonds, preferred
and common stock, and in some instances with cash. The proportion and
kind of payment will depend upon the conditions surrounding each case.
The prevalent custom is to pay for the net assets in preferred stock and to
issue common stock for good-will. Often, however, bonds are used to pay
for the tangible assets; preferred stock is issued for the intangible assets;
and common stock represents the additional profits that are expected to
accrue to the corporation through the consolidation or merger. The issue of
bonds to cover all the tangible assets is generally a dangerous procedure
because of the high fixed charges resulting therefrom—though
advantageous when the difference between the fixed charges and the net
earnings is large. Bonds generally carry relatively small interest because of
their safety, whereas the use of preferred stock entails a smaller equity for
the common. The bondholder is not concerned with the capitalization or
Page 427
nature of the issues over which he takes precedence. For the same reason it
is not usual for the preferred stockholder to complain about
overcapitalization through the use of common stock. The business risk
involved depends upon the nature of the business and the ability of the
management. No financial arrangements should be made that do not take
into consideration the fluctuations that are inherent in the business and their
effect upon net income.
Another apportionment sometimes made is to issue bonds for the fixed
assets; preferred stock for the working capital; and common stock in
proportion to the prospective earnings of the consolidation or merger. New
bonds are exchanged for the old bonds or preferred stock of the constituent
companies, while the common is exchanged for the corresponding issues in
the merged corporations. The balance is used for the purpose of paying
organization expenses and the fees of the promoters, and to provide
working capital for the consolidation. The ratio and the medium will depend
to a great extent upon the nature of the business, the attitude of those who
are interested in the merger corporations, and the optimism or hopes of the
promoters.
Closing the Books of the Merged Concerns
Closing the books of the merged concerns presents the problems of
accounting for the sale of the subsidiary companies. This may be effected in
two ways. Where the sale is made at the book values as carried on the
records of the subsidiary, no adjustments whatever become necessary.
Where, however, the price received is less or greater than the book value of
the concern, it becomes necessary to show the difference between book and
sale valuation. In taking account of these differences two methods are
employed. Under the one an adjustment is made of all the detailed
valuations of the items of property as taken over. It becomes necessary,
therefore, to adjust each property account through its depreciation reserve
or through surplus, in order to bring it to the value at which it is taken over.
This may, and frequently does, necessitate setting up a good-will account on
the books of the vendor company. After the books are thus brought into
accord with the sale agreement, the closing of the accounts follows the
procedure laid down in Chapter XXVIII for the liquidation of a company.
is not usual for the preferred stockholder to complain about
overcapitalization through the use of common stock. The business risk
involved depends upon the nature of the business and the ability of the
management. No financial arrangements should be made that do not take
into consideration the fluctuations that are inherent in the business and their
effect upon net income.
Another apportionment sometimes made is to issue bonds for the fixed
assets; preferred stock for the working capital; and common stock in
proportion to the prospective earnings of the consolidation or merger. New
bonds are exchanged for the old bonds or preferred stock of the constituent
companies, while the common is exchanged for the corresponding issues in
the merged corporations. The balance is used for the purpose of paying
organization expenses and the fees of the promoters, and to provide
working capital for the consolidation. The ratio and the medium will depend
to a great extent upon the nature of the business, the attitude of those who
are interested in the merger corporations, and the optimism or hopes of the
promoters.
Closing the Books of the Merged Concerns
Closing the books of the merged concerns presents the problems of
accounting for the sale of the subsidiary companies. This may be effected in
two ways. Where the sale is made at the book values as carried on the
records of the subsidiary, no adjustments whatever become necessary.
Where, however, the price received is less or greater than the book value of
the concern, it becomes necessary to show the difference between book and
sale valuation. In taking account of these differences two methods are
employed. Under the one an adjustment is made of all the detailed
valuations of the items of property as taken over. It becomes necessary,
therefore, to adjust each property account through its depreciation reserve
or through surplus, in order to bring it to the value at which it is taken over.
This may, and frequently does, necessitate setting up a good-will account on
the books of the vendor company. After the books are thus brought into
accord with the sale agreement, the closing of the accounts follows the
procedure laid down in Chapter XXVIII for the liquidation of a company.
Page 428
Under the second and more common method, no attempt is made to
adjust the individual items of properties sold in accordance with the
appraisal committee’s report, but all differences are cleared in a lump sum
through the surplus or deficit accounts. If the sale is made for cash, the
amount received is then disbursed as a liquidating dividend to the
shareholders. If the property is sold for stock and bonds in the merged
company, either this stock is handed over en bloc, in which case it is
likewise distributed as a liquidating dividend, or the merger company may
issue the stock and bonds as a liquidating dividend for the vendor company
on the basis of the report of the shares belonging to each stockholder. Upon
notice that such stock and bonds have been issued to its shareholders, the
vendor company closes up its records completely by cancelling its
proprietorship accounts against the charge account set up against the merger
company until the stock is issued.
Opening the Books of the Merger
As a merger is a corporation, the opening of its records follows the same
lines as that of any other corporation, excepting that when payment of
subscriptions for capital stock is to be recorded, cognizance must be taken
of the manner of payment. The subscription contract, in so far as it relates to
the various subsidiaries, is usually canceled by turning over the properties
of the subsidiaries. The assets are taken over at an appraised price which
becomes the basis for the amount of subscription to the stock of the merger
by each subsidiary. In Chapter I, where mention was made of the payment
of stock subscriptions in property, it was pointed out that it may be
desirable to bring onto the books the lump sum representing the appraised
purchase price paid for the subsidiary some time before the appraisal
committee has submitted its report on the detailed valuation of the various
items of property taken over from the subsidiary. The customary method of
handling the situation on the books of the merger was there shown. The
bookkeeper is not concerned with the valuation of any of the items taken
over, but must make his entries in accordance with the valuation report
turned in by the appraisal committee. The main problem in the merger, then,
is one of valuation and not of accounting. As stated above, payment to the
subsidiaries may be made by the merger in either of two ways. An entire
block of stock may be turned over to the subsidiary company and be
distributed by it as liquidating dividends to its stockholders, or the merger
adjust the individual items of properties sold in accordance with the
appraisal committee’s report, but all differences are cleared in a lump sum
through the surplus or deficit accounts. If the sale is made for cash, the
amount received is then disbursed as a liquidating dividend to the
shareholders. If the property is sold for stock and bonds in the merged
company, either this stock is handed over en bloc, in which case it is
likewise distributed as a liquidating dividend, or the merger company may
issue the stock and bonds as a liquidating dividend for the vendor company
on the basis of the report of the shares belonging to each stockholder. Upon
notice that such stock and bonds have been issued to its shareholders, the
vendor company closes up its records completely by cancelling its
proprietorship accounts against the charge account set up against the merger
company until the stock is issued.
Opening the Books of the Merger
As a merger is a corporation, the opening of its records follows the same
lines as that of any other corporation, excepting that when payment of
subscriptions for capital stock is to be recorded, cognizance must be taken
of the manner of payment. The subscription contract, in so far as it relates to
the various subsidiaries, is usually canceled by turning over the properties
of the subsidiaries. The assets are taken over at an appraised price which
becomes the basis for the amount of subscription to the stock of the merger
by each subsidiary. In Chapter I, where mention was made of the payment
of stock subscriptions in property, it was pointed out that it may be
desirable to bring onto the books the lump sum representing the appraised
purchase price paid for the subsidiary some time before the appraisal
committee has submitted its report on the detailed valuation of the various
items of property taken over from the subsidiary. The customary method of
handling the situation on the books of the merger was there shown. The
bookkeeper is not concerned with the valuation of any of the items taken
over, but must make his entries in accordance with the valuation report
turned in by the appraisal committee. The main problem in the merger, then,
is one of valuation and not of accounting. As stated above, payment to the
subsidiaries may be made by the merger in either of two ways. An entire
block of stock may be turned over to the subsidiary company and be
distributed by it as liquidating dividends to its stockholders, or the merger
Page 429
may issue shares to the individual stockholders of the subsidiaries in
accordance with information furnished by the subsidiary.
accordance with information furnished by the subsidiary.
Page 430
CHAPTER XXX
BRANCH HOUSE ACCOUNTING
Advantages of Branch and Agency System
The branch and agency forms of increasing sales in large enterprises are an outgrowth of
the policy of “service” combined with economy of management which dominates all
present-day capitalistic enterprises. The tendency of a successful business is to absorb other
businesses in the same line through combinations and amalgamations, and thus the policies
of apparently independent units in a single district or throughout the entire country may be
controlled by the central management at a head office.
Where a business serves consumers direct by means of retail stores, as for instance, the
chain tea stores, the chain cigar stores, the 5c and 10c stores, the system offers one of the
best means of bringing the business into close personal touch with customers. It gives
customers an opportunity to examine the wares at their convenience, and at the same time it
gives the local branch manager an opportunity to build up good-will for the distant
proprietor.
By these means also, stocks of merchandise can be better selected for local needs, and
the buying power of each territory and the quantities carried on hand can be better adjusted
to secure the greatest possible turnover of stock during an operating year.
There is no doubt that a campaign of education to introduce new goods or appliances can
be more successfully conducted through local branches or by personal visits of local agents
residing in the territory. Illustrations of this are the present methods of selling sewing
machines, phonographs, pianos, electric and gas appliances, etc. When branches are given
authority to sell on credit and collect their own accounts, credits can be more intelligently
extended and collections can be more carefully watched by a local branch manager.
Agency and Branch Differentiated
There is a great deal of difference between the organization and management of agencies
and of branch houses. An agency simply acts as a local salesman for a certain territory. It
secures orders and forwards them to the head office. The head office passes on the credit of
the purchaser and assumes the risk of refusing or accepting the order. If it accepts the order it
also collects the account when it is due. Naturally it must keep a memorandum of sales,
either to pay a commission to the agent, or to ascertain whether or not the agency is a paying
venture, or for both reasons. A branch, on the other hand, has a much higher degree of self-
management. It may receive at least the greater part of its stock of merchandise from the
head office, but it usually makes its own sales. It may pass on its own credits and may collect
its own accounts receivable; and sometimes it pays all its own expenses.
There are many modifications of the self-management of branches, especially in the
matter of financial control. Some branches deposit all their receipts to the credit of the head
BRANCH HOUSE ACCOUNTING
Advantages of Branch and Agency System
The branch and agency forms of increasing sales in large enterprises are an outgrowth of
the policy of “service” combined with economy of management which dominates all
present-day capitalistic enterprises. The tendency of a successful business is to absorb other
businesses in the same line through combinations and amalgamations, and thus the policies
of apparently independent units in a single district or throughout the entire country may be
controlled by the central management at a head office.
Where a business serves consumers direct by means of retail stores, as for instance, the
chain tea stores, the chain cigar stores, the 5c and 10c stores, the system offers one of the
best means of bringing the business into close personal touch with customers. It gives
customers an opportunity to examine the wares at their convenience, and at the same time it
gives the local branch manager an opportunity to build up good-will for the distant
proprietor.
By these means also, stocks of merchandise can be better selected for local needs, and
the buying power of each territory and the quantities carried on hand can be better adjusted
to secure the greatest possible turnover of stock during an operating year.
There is no doubt that a campaign of education to introduce new goods or appliances can
be more successfully conducted through local branches or by personal visits of local agents
residing in the territory. Illustrations of this are the present methods of selling sewing
machines, phonographs, pianos, electric and gas appliances, etc. When branches are given
authority to sell on credit and collect their own accounts, credits can be more intelligently
extended and collections can be more carefully watched by a local branch manager.
Agency and Branch Differentiated
There is a great deal of difference between the organization and management of agencies
and of branch houses. An agency simply acts as a local salesman for a certain territory. It
secures orders and forwards them to the head office. The head office passes on the credit of
the purchaser and assumes the risk of refusing or accepting the order. If it accepts the order it
also collects the account when it is due. Naturally it must keep a memorandum of sales,
either to pay a commission to the agent, or to ascertain whether or not the agency is a paying
venture, or for both reasons. A branch, on the other hand, has a much higher degree of self-
management. It may receive at least the greater part of its stock of merchandise from the
head office, but it usually makes its own sales. It may pass on its own credits and may collect
its own accounts receivable; and sometimes it pays all its own expenses.
There are many modifications of the self-management of branches, especially in the
matter of financial control. Some branches deposit all their receipts to the credit of the head
Page 431
office and have no authority to withdraw money for any purpose. In such cases the branch is
supplied with a separate petty cash fund kept at a fixed sum on the imprest cash system.
Other branches receive and pay money and simply make periodic remittances of surplus
amounts to the head office as if they were entirely independent units. Various policies of
control have been formulated to suit the nature of the business and the degree of self-
management granted to the local branches.
Degree of Control Desired
The question of the particular kind of branch or the size of the agency or branch which it
is desired to establish depends entirely on the peculiar needs of the business under
consideration, and the degree of head office control which is necessary to secure the
maximum results with the minimum of expense. An agency by its very nature is completely
under the control of the central office. The agent has no powers other than those granted by
his principal.
If the business is such that a large stock of merchandise is necessary, and a high degree
of discretion and executive ability must be exercised, or if it is desirable to establish
practically independent units with only central executive control over the entire purchasing
and financial systems, branch stores may best serve the purpose.
The same system, however, will not meet the needs of every business, or even of every
branch in the same business. Changes must be made for diversified local conditions which
are peculiar to each establishment.
Factors of Successful Management
Certain points must be watched in all systems and under all conditions. Since the total
net profits or losses are determined largely by the average turnover of circulating capital
invested in the merchandise, the control of the quantity of merchandise, as well as the price,
is a question which must have very careful attention and intelligent supervision. The stock on
hand must be that quantity which will insure a supply adequate at all times to meet the
demands of the trade, and which at the same time will be the minimum necessary to
accomplish such a result. Each article turns in accordance with certain fixed principles.
Certain goods turn faster than others, but there is a general relation between the rate of
turnover and the profit per turn which should be carefully watched.
In the last analysis the success of every branch store system depends upon three things:
1. A fair gross profit on sales, augmented by
2. A proper rate of turnover on the merchandise carried, and
3. Economical management.
Since expenses are a more or less fixed item, their relation to the total volume of
business transacted must have the constant attention of the manager. Statistical charts made
up from the reports sent in by the various branches, with summaries of total results,
compared either by territories or by branches or by product will show to the manager the past
supplied with a separate petty cash fund kept at a fixed sum on the imprest cash system.
Other branches receive and pay money and simply make periodic remittances of surplus
amounts to the head office as if they were entirely independent units. Various policies of
control have been formulated to suit the nature of the business and the degree of self-
management granted to the local branches.
Degree of Control Desired
The question of the particular kind of branch or the size of the agency or branch which it
is desired to establish depends entirely on the peculiar needs of the business under
consideration, and the degree of head office control which is necessary to secure the
maximum results with the minimum of expense. An agency by its very nature is completely
under the control of the central office. The agent has no powers other than those granted by
his principal.
If the business is such that a large stock of merchandise is necessary, and a high degree
of discretion and executive ability must be exercised, or if it is desirable to establish
practically independent units with only central executive control over the entire purchasing
and financial systems, branch stores may best serve the purpose.
The same system, however, will not meet the needs of every business, or even of every
branch in the same business. Changes must be made for diversified local conditions which
are peculiar to each establishment.
Factors of Successful Management
Certain points must be watched in all systems and under all conditions. Since the total
net profits or losses are determined largely by the average turnover of circulating capital
invested in the merchandise, the control of the quantity of merchandise, as well as the price,
is a question which must have very careful attention and intelligent supervision. The stock on
hand must be that quantity which will insure a supply adequate at all times to meet the
demands of the trade, and which at the same time will be the minimum necessary to
accomplish such a result. Each article turns in accordance with certain fixed principles.
Certain goods turn faster than others, but there is a general relation between the rate of
turnover and the profit per turn which should be carefully watched.
In the last analysis the success of every branch store system depends upon three things:
1. A fair gross profit on sales, augmented by
2. A proper rate of turnover on the merchandise carried, and
3. Economical management.
Since expenses are a more or less fixed item, their relation to the total volume of
business transacted must have the constant attention of the manager. Statistical charts made
up from the reports sent in by the various branches, with summaries of total results,
compared either by territories or by branches or by product will show to the manager the past
Page 432
history and also the present trend of the business as a whole or in parts. From these charts he
is able to form an intelligent basis for inaugurating future policies of control.
Main Principles of Branch Accounting
The underlying principles upon which branch store accounting is based are very simple,
but the superstructure will be simple or complex according to the nature of the business and
the information which the head office requires for its accounts and records.
The main points to be kept in view in installing a system of accounts are to insure:
1. Control or supervision by the head office.
2. Separate results for the trading of each branch.
3. Facilities for centralizing and comparing such separate results.
In discussing the question of branch accounting any treatment of the problems peculiar to
it is so dependent on the particular system employed that only a very general statement of
principles can be made unless the comment is confined to a particular system and this might
not be relevant to all systems. There are, however, certain principles which apply
fundamentally to all systems. The question of the degree of control desired by the head
office and the resulting information which must be given by the branch to the head office
governs largely the detailed ramifications of general principles which will be necessary. Also
the amount of information as to the results of the business done at each branch which it is
desirable for the branch management to know has an important bearing on the manner of
keeping the accounts. Sometimes it is not desirable that the branch manager should know the
amount of profit which his branch is earning. While, of course, it is impossible to keep a
shrewd manager in entire ignorance of the results of his management, yet the exact figure of
profit earned by his branch can be kept from him if the books are handled properly. It is
purposed here to develop by statement and illustration most of the problems which are
peculiar to branch and agency accounting.
Agency Accounts
What has been said with regard to the difficulty of presenting a widely applicable
statement of branch accounts is equally true of agency accounts. There is no well-marked
line of distinction between agency and branch organization. What may be termed an agency
by one concern will be looked upon as a branch by another concern. For the purpose of this
discussion, however, the distinction stated above between these two forms of organization
will be adhered to. Where, therefore, the agency is for the most part simply a sales agency,
practically nothing in the way of accounts and accounting control is necessary other than
what must always be used in connection with traveling salesmen. The agency must be
furnished with an expense fund and must, of course, send in to the head office all its orders
and sales. The expense fund is best operated under the imprest system. To keep track of the
results of the various agencies it will be necessary on the head office books to keep the
records of the activities of each branch separate from one another and from those of the head
office. At the close of the fiscal period a comparison of agency sales with the direct costs of
making those sales and with the expenses of maintaining the agency will develop the net
is able to form an intelligent basis for inaugurating future policies of control.
Main Principles of Branch Accounting
The underlying principles upon which branch store accounting is based are very simple,
but the superstructure will be simple or complex according to the nature of the business and
the information which the head office requires for its accounts and records.
The main points to be kept in view in installing a system of accounts are to insure:
1. Control or supervision by the head office.
2. Separate results for the trading of each branch.
3. Facilities for centralizing and comparing such separate results.
In discussing the question of branch accounting any treatment of the problems peculiar to
it is so dependent on the particular system employed that only a very general statement of
principles can be made unless the comment is confined to a particular system and this might
not be relevant to all systems. There are, however, certain principles which apply
fundamentally to all systems. The question of the degree of control desired by the head
office and the resulting information which must be given by the branch to the head office
governs largely the detailed ramifications of general principles which will be necessary. Also
the amount of information as to the results of the business done at each branch which it is
desirable for the branch management to know has an important bearing on the manner of
keeping the accounts. Sometimes it is not desirable that the branch manager should know the
amount of profit which his branch is earning. While, of course, it is impossible to keep a
shrewd manager in entire ignorance of the results of his management, yet the exact figure of
profit earned by his branch can be kept from him if the books are handled properly. It is
purposed here to develop by statement and illustration most of the problems which are
peculiar to branch and agency accounting.
Agency Accounts
What has been said with regard to the difficulty of presenting a widely applicable
statement of branch accounts is equally true of agency accounts. There is no well-marked
line of distinction between agency and branch organization. What may be termed an agency
by one concern will be looked upon as a branch by another concern. For the purpose of this
discussion, however, the distinction stated above between these two forms of organization
will be adhered to. Where, therefore, the agency is for the most part simply a sales agency,
practically nothing in the way of accounts and accounting control is necessary other than
what must always be used in connection with traveling salesmen. The agency must be
furnished with an expense fund and must, of course, send in to the head office all its orders
and sales. The expense fund is best operated under the imprest system. To keep track of the
results of the various agencies it will be necessary on the head office books to keep the
records of the activities of each branch separate from one another and from those of the head
office. At the close of the fiscal period a comparison of agency sales with the direct costs of
making those sales and with the expenses of maintaining the agency will develop the net
Page 433
result of the agency’s activities. The problem, therefore, of agency accounting is simply one
phase of the general problem of accounting, viz., furnishing, by means of whatever analysis
may be necessary, the information which will be of greatest advantage, to the management of
the business.
Branch Accounting Records
The accounting records of the branch will be simple or complex according to the
conditions to secure control over which they must give information. Sometimes a very
simple set of records will furnish all the data needed. In other cases just as elaborate detailed
records as are employed at the head office may be required to secure the information desired.
Sometimes it may appear best for the branch to keep but few records, and for the head office
to keep all the main accounting records by means of duplicate reports of all branch
transactions. Again, to exercise proper control over the branch, even where it keeps a full set
of records, it may be advisable to require periodic reports of all branch activities. Sometimes
these are required daily, but more often a weekly or monthly summary of activities serves the
purpose equally well.
Illustration of Simple Branch Accounts
The simplest method of keeping the branch and head office accounts can be illustrated by
a short problem in summarized form. In the illustration given it is assumed that the head
office furnishes the cash necessary to inaugurate the branch, and that all stock-in-trade is
supplied by the head office. It is further assumed that the branch keeps a complete set of
records which will furnish information as to profits and losses at the close of the fiscal
period. On the branch books it will be necessary to open accounts with Merchandise (here,
for the sake of brevity, carried under one title rather than as usually shown), with Cash, with
Expenses (again, for the sake of brevity, carried under one head), with the Head Office, and
with Profit and Loss. These accounts present no peculiarities excepting the Head Office
account which stands on the branch books as the net worth or proprietorship account. It is
credited with all values received from the head office and charged with all values returned to
the head office or expended on head office account. The net profit for the period is closed
from the Profit and Loss account into the Head Office account in order to show the present
net worth or proprietorship with which the branch enters the new fiscal period.
On the head office books there need be carried only an account with each branch by
name or number. The charges and credits in this account are the exact reverse of those in the
Head Office account carried on the branch books. At the close of the fiscal period it is
necessary to receive the report of the branch profit or loss before that can be incorporated in
the branch account on the head office books. The following problem will show the manner in
which these accounts are kept.
Problem. The head office sends to the branch during the year $5,000
cash and $50,000 worth of merchandise. The branch makes sales to
customers on account amounting to $45,000 and cash sales of $10,000. It
incurs expenses of $7,500. Its collections from customers on account
amount to $25,000. It remits $37,000 to the head office. The inventory of
merchandise at the close of the year is found to be $12,500.
phase of the general problem of accounting, viz., furnishing, by means of whatever analysis
may be necessary, the information which will be of greatest advantage, to the management of
the business.
Branch Accounting Records
The accounting records of the branch will be simple or complex according to the
conditions to secure control over which they must give information. Sometimes a very
simple set of records will furnish all the data needed. In other cases just as elaborate detailed
records as are employed at the head office may be required to secure the information desired.
Sometimes it may appear best for the branch to keep but few records, and for the head office
to keep all the main accounting records by means of duplicate reports of all branch
transactions. Again, to exercise proper control over the branch, even where it keeps a full set
of records, it may be advisable to require periodic reports of all branch activities. Sometimes
these are required daily, but more often a weekly or monthly summary of activities serves the
purpose equally well.
Illustration of Simple Branch Accounts
The simplest method of keeping the branch and head office accounts can be illustrated by
a short problem in summarized form. In the illustration given it is assumed that the head
office furnishes the cash necessary to inaugurate the branch, and that all stock-in-trade is
supplied by the head office. It is further assumed that the branch keeps a complete set of
records which will furnish information as to profits and losses at the close of the fiscal
period. On the branch books it will be necessary to open accounts with Merchandise (here,
for the sake of brevity, carried under one title rather than as usually shown), with Cash, with
Expenses (again, for the sake of brevity, carried under one head), with the Head Office, and
with Profit and Loss. These accounts present no peculiarities excepting the Head Office
account which stands on the branch books as the net worth or proprietorship account. It is
credited with all values received from the head office and charged with all values returned to
the head office or expended on head office account. The net profit for the period is closed
from the Profit and Loss account into the Head Office account in order to show the present
net worth or proprietorship with which the branch enters the new fiscal period.
On the head office books there need be carried only an account with each branch by
name or number. The charges and credits in this account are the exact reverse of those in the
Head Office account carried on the branch books. At the close of the fiscal period it is
necessary to receive the report of the branch profit or loss before that can be incorporated in
the branch account on the head office books. The following problem will show the manner in
which these accounts are kept.
Problem. The head office sends to the branch during the year $5,000
cash and $50,000 worth of merchandise. The branch makes sales to
customers on account amounting to $45,000 and cash sales of $10,000. It
incurs expenses of $7,500. Its collections from customers on account
amount to $25,000. It remits $37,000 to the head office. The inventory of
merchandise at the close of the year is found to be $12,500.
Page 434
Solution
Branch Books
Cash $ 5,000.00
Head Office $ 5,000.00
Merchandise 50,000.00
Head Office 50,000.00
Customers 45,000.00
Merchandise 45,000.00
Cash 10,000.00
Merchandise 10,000.00
Expense 7,500.00
Cash 7,500.00
Cash 25,000.00
Customers 25,000.00
Head Office 37,000.00
Cash 37,000.00
Merchandise (Inventory) 12,500.00
Merchandise 12,500.00
Merchandise 17,500.00
Profit and Loss 17,500.00
Profit and Loss 7,500.00
Expense 7,500.00
Profit and Loss 10,000.00
Head Office 10,000.00
Head Office Books
Branch $55,000.00
Cash $ 5,000.00
Merchandise $50,000.00
Branch 10,000.00
Branch Profit and Loss 10,000.00
In making up the head office balance sheet, the Branch account as carried on the head
office books will be an asset representing the property of the head office invested in the
Branch Books
Cash $ 5,000.00
Head Office $ 5,000.00
Merchandise 50,000.00
Head Office 50,000.00
Customers 45,000.00
Merchandise 45,000.00
Cash 10,000.00
Merchandise 10,000.00
Expense 7,500.00
Cash 7,500.00
Cash 25,000.00
Customers 25,000.00
Head Office 37,000.00
Cash 37,000.00
Merchandise (Inventory) 12,500.00
Merchandise 12,500.00
Merchandise 17,500.00
Profit and Loss 17,500.00
Profit and Loss 7,500.00
Expense 7,500.00
Profit and Loss 10,000.00
Head Office 10,000.00
Head Office Books
Branch $55,000.00
Cash $ 5,000.00
Merchandise $50,000.00
Branch 10,000.00
Branch Profit and Loss 10,000.00
In making up the head office balance sheet, the Branch account as carried on the head
office books will be an asset representing the property of the head office invested in the
Page 435
branch. Instead of carrying this property under the title “Branch,” it is sometimes desirable to
include all branch values with similar values at the head office. This results in a balance
sheet which is similar to the consolidated balance sheet explained in Chapter XXXIV.
Illustration of More Complex Branch Accounts
As an illustration of a somewhat more complex method of keeping the books, a problem
is appended illustrating the sending of goods to the branch at a nominal figure or at sales
price. Here it is not desired that the branch management be able to determine the profit and
loss of its activities; consequently the goods from the head office are not charged to the
branch at cost but at some fictitious value. Where this is done it is best to open two accounts,
the one to record the merchandising transactions between the branch and the head office, and
the other to record all other interactivities.
Problem. The head office sends to the branch during the year $10,000 cash and $77,000
worth of merchandise as billed at a conventional price. The branch makes sales to customers
on account, of $60,000, and for cash $25,000. The expenses of the branch are $10,000.
Collections from customers amount to $45,000 and remittances to head office amount to
$66,000. The inventory of the stock-in-trade at the close of the year is $14,000, this valuation
being on the same basis as the original charge, i.e., at the conventional figure.
Solution
Branch Books
On the branch books two accounts are opened with the head office, one entitled “Head
Office General,” and the other “Head Office Merchandise.” Neither one of these accounts
represents the full proprietorship of the head office in the branch, nor do both of them
together represent the true proprietorship because of the fact that the merchandise is priced to
the branch at a fictitious figure. The branch books cannot show the true status of relations
with the head office so long as the policy, of billing goods in this way is maintained. That is
the chief reason why it is best to set up the two accounts, in one of which appear the
merchandise transactions at the fictitious figure, while in the other appear all other
transactions correctly valued. This Head Office Merchandise account is more in the nature of
a memorandum or consignment account and is offset by an account called “Purchases from
Head Office.” On the branch books appear also accounts with Customers, Branch Sales, and
Expenses—as in the other case. There is no Profit and Loss account because it is impossible
to determine on the branch books the correct profit and loss for the period. All expense and
income accounts are closed directly into Head Office General. The entries necessary to book
properly the activities as set forth in the illustrative problem are as follows:
Cash $10,000.00
Head Office General $10,000.00
Purchases from Head Office 77,000.00
Head Office Merchandise 77,000.00
Customers 60,000.00
Cash 25,000.00
include all branch values with similar values at the head office. This results in a balance
sheet which is similar to the consolidated balance sheet explained in Chapter XXXIV.
Illustration of More Complex Branch Accounts
As an illustration of a somewhat more complex method of keeping the books, a problem
is appended illustrating the sending of goods to the branch at a nominal figure or at sales
price. Here it is not desired that the branch management be able to determine the profit and
loss of its activities; consequently the goods from the head office are not charged to the
branch at cost but at some fictitious value. Where this is done it is best to open two accounts,
the one to record the merchandising transactions between the branch and the head office, and
the other to record all other interactivities.
Problem. The head office sends to the branch during the year $10,000 cash and $77,000
worth of merchandise as billed at a conventional price. The branch makes sales to customers
on account, of $60,000, and for cash $25,000. The expenses of the branch are $10,000.
Collections from customers amount to $45,000 and remittances to head office amount to
$66,000. The inventory of the stock-in-trade at the close of the year is $14,000, this valuation
being on the same basis as the original charge, i.e., at the conventional figure.
Solution
Branch Books
On the branch books two accounts are opened with the head office, one entitled “Head
Office General,” and the other “Head Office Merchandise.” Neither one of these accounts
represents the full proprietorship of the head office in the branch, nor do both of them
together represent the true proprietorship because of the fact that the merchandise is priced to
the branch at a fictitious figure. The branch books cannot show the true status of relations
with the head office so long as the policy, of billing goods in this way is maintained. That is
the chief reason why it is best to set up the two accounts, in one of which appear the
merchandise transactions at the fictitious figure, while in the other appear all other
transactions correctly valued. This Head Office Merchandise account is more in the nature of
a memorandum or consignment account and is offset by an account called “Purchases from
Head Office.” On the branch books appear also accounts with Customers, Branch Sales, and
Expenses—as in the other case. There is no Profit and Loss account because it is impossible
to determine on the branch books the correct profit and loss for the period. All expense and
income accounts are closed directly into Head Office General. The entries necessary to book
properly the activities as set forth in the illustrative problem are as follows:
Cash $10,000.00
Head Office General $10,000.00
Purchases from Head Office 77,000.00
Head Office Merchandise 77,000.00
Customers 60,000.00
Cash 25,000.00
Page 436
Sales 85,000.00
Expense 10,000.00
Cash 10,000.00
Cash 45,000.00
Customers 45,000.00
Head Office General 66,000.00
Cash 66,000.00
In closing the branch books the inventory is brought into the Purchases from Head Office
account which by its balance shows at billed price the goods disposed of by sale. The latter
figure is taken into the Head Office Merchandise account so that its balance will also be the
amount of goods still on hand as shown by the inventory. Purchases from Head Office and
Head Office Merchandise are memorandum accounts calling attention to the fact that the
merchandise on hand at the branch is not carried at its correct valuation but must be adjusted
before incorporation with the head office accounts. The entries to effect this adjustment on
account of the inventory and to close the branch books are as follows:
Purchases from Head Office (Inventory)$14,000.00
Purchases from Head Office $14,000.00
Head Office Merchandise 63,000.00
Purchases from Head Office 63,000.00
Sales 85,000.00
Head Office General 85,000.00
Head Office General 10,000.00
Expense 10,000.00
These entries close the books of the branch so far as is possible in view of the fact that
accurate results as to profit and loss cannot be shown from the way in which merchandise is
billed to the branch. There is perhaps no objection to using a Profit and Loss account as a
summary account for income and expense items rather than the Head Office General account
as shown here; though a Profit and Loss account is somewhat of a misnomer since profits
and losses cannot be determined. In the problem given all expenses are grouped under one
Expense account. This is done for the sake of brevity, and it is to be understood that as
detailed an expense record will be kept on the books of the branch as may be necessary to
give the information desired.
Head Office Books
Where the head office bills merchandise to the branch at any other figure than cost, the
record of such shipments is best made in much the same way as with consignments.
Memorandum accounts are set up to indicate that goods have been shipped to the branches.
This is necessary because of the fact that shipments should not be entered in the regular
merchandise accounts of the head office at any other figure than cost. Periodically, from
Expense 10,000.00
Cash 10,000.00
Cash 45,000.00
Customers 45,000.00
Head Office General 66,000.00
Cash 66,000.00
In closing the branch books the inventory is brought into the Purchases from Head Office
account which by its balance shows at billed price the goods disposed of by sale. The latter
figure is taken into the Head Office Merchandise account so that its balance will also be the
amount of goods still on hand as shown by the inventory. Purchases from Head Office and
Head Office Merchandise are memorandum accounts calling attention to the fact that the
merchandise on hand at the branch is not carried at its correct valuation but must be adjusted
before incorporation with the head office accounts. The entries to effect this adjustment on
account of the inventory and to close the branch books are as follows:
Purchases from Head Office (Inventory)$14,000.00
Purchases from Head Office $14,000.00
Head Office Merchandise 63,000.00
Purchases from Head Office 63,000.00
Sales 85,000.00
Head Office General 85,000.00
Head Office General 10,000.00
Expense 10,000.00
These entries close the books of the branch so far as is possible in view of the fact that
accurate results as to profit and loss cannot be shown from the way in which merchandise is
billed to the branch. There is perhaps no objection to using a Profit and Loss account as a
summary account for income and expense items rather than the Head Office General account
as shown here; though a Profit and Loss account is somewhat of a misnomer since profits
and losses cannot be determined. In the problem given all expenses are grouped under one
Expense account. This is done for the sake of brevity, and it is to be understood that as
detailed an expense record will be kept on the books of the branch as may be necessary to
give the information desired.
Head Office Books
Where the head office bills merchandise to the branch at any other figure than cost, the
record of such shipments is best made in much the same way as with consignments.
Memorandum accounts are set up to indicate that goods have been shipped to the branches.
This is necessary because of the fact that shipments should not be entered in the regular
merchandise accounts of the head office at any other figure than cost. Periodically, from
Page 437
memoranda carried in these special accounts, the true values of the merchandise shown as
handled through them must be brought into the regular merchandising accounts. The manner
of making these adjustments is taken up on page 535. Here will be shown all the accounts
affected on the head office books by the current transactions with the branch. The entries
necessary to record the data of the problem are as follows:
Branch A General $ 10,000.00
Cash $10,000.00
Branch A Merchandise 77,000.00
Sales to Branches 77,000.00
Cash 66,000.00
Branch A General 66,000.00
It is to be noted that separate merchandise accounts are opened with each branch by
name but that only one Sales to Branches account need be opened. The Branch Merchandise
account with each branch provides all the necessary data for making the adjustment at the
close of the period, the offsetting memorandum account for all the different Branch
Merchandise accounts being the Sales to Branches account. At the close of the period, upon
report of the total activities for the period at the branch, the following entries are made on the
head office books:
Branch A General $85,000.00
Sales $85,000.00
Expenses 10,000.00
Branch A General 10,000.00
An alternative method of summarizing branch activities is sometimes used, as follows:
Branch A General $85,000.00
Branch A Profit and Loss $85,000.00
Branch A Profit and Loss 10,000.00
Branch A General 10,000.00
Under the first method the effect is to merge the activities of the branch with the similar
activities of the head office. A statistical abstract of the different branches is then depended
upon by the head office management to show the results of the period’s trading at the various
branches. Under the second method the effect is to bring onto the books under the various
branch Profit and Loss accounts the results of the trading in each case. Whichever method
best gives the information desired by the head office will, of course, be adopted.
A brief discussion will now be given of the chief problems met in branch accounting. No
attempt will be made to discuss the problem of branch organization from the standpoint of
system or control. Such a discussion belongs more particularly to the field of auditing than to
that of accounting.
Purchases
handled through them must be brought into the regular merchandising accounts. The manner
of making these adjustments is taken up on page 535. Here will be shown all the accounts
affected on the head office books by the current transactions with the branch. The entries
necessary to record the data of the problem are as follows:
Branch A General $ 10,000.00
Cash $10,000.00
Branch A Merchandise 77,000.00
Sales to Branches 77,000.00
Cash 66,000.00
Branch A General 66,000.00
It is to be noted that separate merchandise accounts are opened with each branch by
name but that only one Sales to Branches account need be opened. The Branch Merchandise
account with each branch provides all the necessary data for making the adjustment at the
close of the period, the offsetting memorandum account for all the different Branch
Merchandise accounts being the Sales to Branches account. At the close of the period, upon
report of the total activities for the period at the branch, the following entries are made on the
head office books:
Branch A General $85,000.00
Sales $85,000.00
Expenses 10,000.00
Branch A General 10,000.00
An alternative method of summarizing branch activities is sometimes used, as follows:
Branch A General $85,000.00
Branch A Profit and Loss $85,000.00
Branch A Profit and Loss 10,000.00
Branch A General 10,000.00
Under the first method the effect is to merge the activities of the branch with the similar
activities of the head office. A statistical abstract of the different branches is then depended
upon by the head office management to show the results of the period’s trading at the various
branches. Under the second method the effect is to bring onto the books under the various
branch Profit and Loss accounts the results of the trading in each case. Whichever method
best gives the information desired by the head office will, of course, be adopted.
A brief discussion will now be given of the chief problems met in branch accounting. No
attempt will be made to discuss the problem of branch organization from the standpoint of
system or control. Such a discussion belongs more particularly to the field of auditing than to
that of accounting.
Purchases
Page 438
From the head office point of view no special problems are met in the matter of
purchasing. From the standpoint of the branch the question of purchases is largely the same
as the question of sales from the head office standpoint, and the problem of sales is chiefly
one of the price at which goods should be billed to the branch. This is treated in the next
section. Attention is called here to the need of a very careful control and checking up on
purchasing activities of the branch where the branch is permitted to buy some portion of its
goods from outside sources. This may become necessary in cases of emergency, or may be a
matter of fixed policy in those cases where commodities are sold at some of the branches
which the head office does not care to furnish or cannot handle with economy. Where the
branch makes purchases both from outside and from the head office, the result may be to
complicate the adjustments necessary at the close of the fiscal period. The underlying
principles on which the accounts and their adjustments rest are, however, the same.
Sales
From the standpoint of the head office, the problem of sales to the branches is, as
mentioned above, largely a problem of policy as to whether goods shall be invoiced at
absolute cost; at cost plus a small percentage for overhead expenses; at sales price, i.e., at the
price at which the branch is expected to sell the commodity; or at some arbitrary figure
which is designed for the purpose of keeping the branch in ignorance of the actual cost of the
goods dealt in and therefore of the profit and loss upon the branch’s activities. If goods are
billed to the branch at sales price and disposed of at the same price, a comparison of the
branch records covering their purchases and their sales should indicate by the difference
between the two the amount of stock on hand at any time; i.e., billing the goods to the branch
at sales price makes the merchandise records of the branch virtually a perpetual inventory of
the goods on hand. This method effects a closer check on losses and waste, for which, of
course, a small allowance must always be made. One of the most serious wastes to be
checked up is occasioned by too liberal weights and measures to customers. On the other
hand, invoicing the goods at sales price gives the branch manager less discretion in adjusting
differences with customers inasmuch as defective goods must usually be returned to the head
office to secure for the branch full credit. Further, billing the goods at sales price with the
purpose of securing accurate control over the branch merchandise necessitates the pursuit of
an inflexible policy of sales at the billed price. Daily or weekly adjustments on account of
fluctuations in the market cannot be made without losing the control over stock which the
policy of billing at sales price secures. In some lines of business this is an insuperable defect.
Where merchandise is invoiced at cost the branch manager has a rather more secure hold
on his customers in that he can give immediate satisfaction by making allowances and
adjustments to settle difficulties as they come up. Particularly where the manager has an
interest in the profits, a much greater incentive is offered him to conduct the affairs of the
branch in an efficient and economical manner. This responsibility and power to make
adjustments may be abused, however, and a greater degree of control can usually be secured
by the head office where merchandise is billed at sales price.
As mentioned above, sometimes goods are billed to the branch at an arbitrary figure.
Inasmuch as the question of control by means of a perpetual inventory does not enter into
this policy, large discretion can be given the branch manager without unsatisfactory results in
purchasing. From the standpoint of the branch the question of purchases is largely the same
as the question of sales from the head office standpoint, and the problem of sales is chiefly
one of the price at which goods should be billed to the branch. This is treated in the next
section. Attention is called here to the need of a very careful control and checking up on
purchasing activities of the branch where the branch is permitted to buy some portion of its
goods from outside sources. This may become necessary in cases of emergency, or may be a
matter of fixed policy in those cases where commodities are sold at some of the branches
which the head office does not care to furnish or cannot handle with economy. Where the
branch makes purchases both from outside and from the head office, the result may be to
complicate the adjustments necessary at the close of the fiscal period. The underlying
principles on which the accounts and their adjustments rest are, however, the same.
Sales
From the standpoint of the head office, the problem of sales to the branches is, as
mentioned above, largely a problem of policy as to whether goods shall be invoiced at
absolute cost; at cost plus a small percentage for overhead expenses; at sales price, i.e., at the
price at which the branch is expected to sell the commodity; or at some arbitrary figure
which is designed for the purpose of keeping the branch in ignorance of the actual cost of the
goods dealt in and therefore of the profit and loss upon the branch’s activities. If goods are
billed to the branch at sales price and disposed of at the same price, a comparison of the
branch records covering their purchases and their sales should indicate by the difference
between the two the amount of stock on hand at any time; i.e., billing the goods to the branch
at sales price makes the merchandise records of the branch virtually a perpetual inventory of
the goods on hand. This method effects a closer check on losses and waste, for which, of
course, a small allowance must always be made. One of the most serious wastes to be
checked up is occasioned by too liberal weights and measures to customers. On the other
hand, invoicing the goods at sales price gives the branch manager less discretion in adjusting
differences with customers inasmuch as defective goods must usually be returned to the head
office to secure for the branch full credit. Further, billing the goods at sales price with the
purpose of securing accurate control over the branch merchandise necessitates the pursuit of
an inflexible policy of sales at the billed price. Daily or weekly adjustments on account of
fluctuations in the market cannot be made without losing the control over stock which the
policy of billing at sales price secures. In some lines of business this is an insuperable defect.
Where merchandise is invoiced at cost the branch manager has a rather more secure hold
on his customers in that he can give immediate satisfaction by making allowances and
adjustments to settle difficulties as they come up. Particularly where the manager has an
interest in the profits, a much greater incentive is offered him to conduct the affairs of the
branch in an efficient and economical manner. This responsibility and power to make
adjustments may be abused, however, and a greater degree of control can usually be secured
by the head office where merchandise is billed at sales price.
As mentioned above, sometimes goods are billed to the branch at an arbitrary figure.
Inasmuch as the question of control by means of a perpetual inventory does not enter into
this policy, large discretion can be given the branch manager without unsatisfactory results in
Page 439
checking up the merchandise. He may be allowed to make whatever adjustments with
customers seem advisable. Changes in selling price can be made as often as conditions
demand, either at the instance of the head office or at the discretion of the manager. A policy
of this sort requires a much more thorough system of report from the branch to the head
office in order to give the head office a means of checking up periodically the activities of
the branch.
It is well to point out that on the books of the head office sales to branches are in no
sense income items and must never be recorded with regular sales to outside parties.
Similarly, sales or transfers among branches are in no sense earnings. It should be noted that,
to keep the head office records correct and up to date, any transfers of goods among branches
should be reported immediately to the head office; better still, the authorization of the head
office, except in cases of emergency, should be given before such transfers can be made.
Adjustments on Branch and Head Office Books
Head Office and Branch accounts are essentially accounts current between the head
office and the various branches. At the close of the fiscal period when the results of the
period’s business are being summarized, the four classes of adjustments which are
sometimes necessary in the case of accounts current may have to be made. The head office
may show a charge to the branch for items which the branch has not yet received at the close
of the fiscal period. Similarly, the branch may have charges and credits to the Head Office
account which the head office records do not show. If this condition exists, the two accounts
must be reconciled in accordance with the method shown in Volume I, page 497. Almost
invariably, unless a system of complete daily reports is in effect between the branch and the
head office, the head office will have to wait for certain reports from the branch at the close
of the fiscal period. The nature of the entries to effect these reports is given in the problem
illustrated on page 532.
The chief adjustment which is needed on the head office books is brought about through
the policy of charging the branch with merchandise at some other figure than cost. Where
this is done, the profit and loss on the branch activities cannot be determined until true costs
are taken into the accounts in place of the fictitious figures used during the current period.
The basis for converting the fictitious figure into a true cost figure is, of course, a secret
known only to the head office. The memorandum accounts covering the merchandising
transactions with the branch furnish the basis for determining the cost of goods sold by the
branch. Thus, if goods are billed at, say, 30% above cost the billed price becomes 130% of
the cost. It is therefore possible to determine the cost of all goods disposed of by the branch
and of those still on hand. If it is desired to merge all the branch activities with the similar
activities of the head office, the only adjustment necessary at the close of the fiscal period is
to convert the sum total of the inventories on hand at the various branches to a cost valuation
basis and include them with the head office inventory. This gives the data needed to
determine the cost of goods sold and gross profit on the combined activities of the various
branches and head office.
It is usually essential that the results of trading at each branch be determined, whether or
not such results be incorporated separately on the head office books. Under the assumption
that they are to be set up on the records of the head office, the billed cost of the goods
customers seem advisable. Changes in selling price can be made as often as conditions
demand, either at the instance of the head office or at the discretion of the manager. A policy
of this sort requires a much more thorough system of report from the branch to the head
office in order to give the head office a means of checking up periodically the activities of
the branch.
It is well to point out that on the books of the head office sales to branches are in no
sense income items and must never be recorded with regular sales to outside parties.
Similarly, sales or transfers among branches are in no sense earnings. It should be noted that,
to keep the head office records correct and up to date, any transfers of goods among branches
should be reported immediately to the head office; better still, the authorization of the head
office, except in cases of emergency, should be given before such transfers can be made.
Adjustments on Branch and Head Office Books
Head Office and Branch accounts are essentially accounts current between the head
office and the various branches. At the close of the fiscal period when the results of the
period’s business are being summarized, the four classes of adjustments which are
sometimes necessary in the case of accounts current may have to be made. The head office
may show a charge to the branch for items which the branch has not yet received at the close
of the fiscal period. Similarly, the branch may have charges and credits to the Head Office
account which the head office records do not show. If this condition exists, the two accounts
must be reconciled in accordance with the method shown in Volume I, page 497. Almost
invariably, unless a system of complete daily reports is in effect between the branch and the
head office, the head office will have to wait for certain reports from the branch at the close
of the fiscal period. The nature of the entries to effect these reports is given in the problem
illustrated on page 532.
The chief adjustment which is needed on the head office books is brought about through
the policy of charging the branch with merchandise at some other figure than cost. Where
this is done, the profit and loss on the branch activities cannot be determined until true costs
are taken into the accounts in place of the fictitious figures used during the current period.
The basis for converting the fictitious figure into a true cost figure is, of course, a secret
known only to the head office. The memorandum accounts covering the merchandising
transactions with the branch furnish the basis for determining the cost of goods sold by the
branch. Thus, if goods are billed at, say, 30% above cost the billed price becomes 130% of
the cost. It is therefore possible to determine the cost of all goods disposed of by the branch
and of those still on hand. If it is desired to merge all the branch activities with the similar
activities of the head office, the only adjustment necessary at the close of the fiscal period is
to convert the sum total of the inventories on hand at the various branches to a cost valuation
basis and include them with the head office inventory. This gives the data needed to
determine the cost of goods sold and gross profit on the combined activities of the various
branches and head office.
It is usually essential that the results of trading at each branch be determined, whether or
not such results be incorporated separately on the head office books. Under the assumption
that they are to be set up on the records of the head office, the billed cost of the goods
Page 440
disposed of at each branch must be converted to a cost basis and shown transferred from the
Head Office Purchases account to the Profit and Loss account with each branch. This
separates the total cost of goods sold as among the various branches and the head office.
When the various branch Profit and Loss accounts are credited with their respective earnings
from sales, the gross profit or loss on the trading activities at the various branches will thus
be shown. Similarly, the regular merchandise accounts in which have been recorded the head
office merchandising activities will show the gross profit on sales made at the head office.
These adjustments are made without interfering in any way with the memorandum accounts
carried on the branch books and on the head office books—accounts which have no place in
the balance sheet of the head office. In their stead will appear the combined inventory of
goods on hand at the branch and the head office converted to a cost basis.
Example of Adjusting Entries
The character of the entry needed to effect these adjustments will now be shown, using
the data of the illustrative problem shown above. Comparison of the report of inventory from
the branch, $14,000, with the record of goods shipped to the branch, $77,000, shows that
goods to the billed value of $63,000 were disposed of at the branch. The records in the head
office show that the goods were billed to the branch at 140% of cost. Converting this figure
of $63,000 on the basis of 140% of cost develops a true cost of goods sold of $45,000. This
is brought onto the head office books by the following entry:
Branch A Profit and Loss $45,000.00
Purchases $45,000.00
Reference to the solution above shows that Branch A Profit and Loss has been charged
with $10,000 expenses and credited with $85,000 earnings from sales. The gross profit,
therefore, on the period’s activities at Branch A is the balance of the Branch A Profit and
Loss account, i.e., $30,000. The only other adjustment necessary is the conversion of the
Branch A inventory of $14,000 to a cost basis. The true cost here is, of course, $10,000 since
the goods were billed at 140% of cost. The $10,000 will be included with the inventory of
goods on hand at the head office before the determination of the head office cost of goods
sold and gross profit can be made.
To secure a better understanding of the interrelations of these various accounts it is
suggested that the student set up all the accounts and follow through them the transactions
given in the illustrative problem above, both on the books of the branch and on the books of
the head office.
A final problem of adjustment as between the head office and branch books concerns the
treatment of fixed assets carried on the books of the branch. It may happen that the branch
makes purchases of various pieces of property which are charged up to fixed asset accounts
on the branch books. To secure uniform treatment, particularly as regards depreciation, it is
customary at the close of the fiscal period to transfer the record of all fixed assets to the head
office books. This is accomplished by entry on the branch books of a charge to Head Office
General account, and credits to the various fixed asset accounts. On the books of the head
office the record will be a charge to the various fixed asset accounts and a credit to the
Head Office Purchases account to the Profit and Loss account with each branch. This
separates the total cost of goods sold as among the various branches and the head office.
When the various branch Profit and Loss accounts are credited with their respective earnings
from sales, the gross profit or loss on the trading activities at the various branches will thus
be shown. Similarly, the regular merchandise accounts in which have been recorded the head
office merchandising activities will show the gross profit on sales made at the head office.
These adjustments are made without interfering in any way with the memorandum accounts
carried on the branch books and on the head office books—accounts which have no place in
the balance sheet of the head office. In their stead will appear the combined inventory of
goods on hand at the branch and the head office converted to a cost basis.
Example of Adjusting Entries
The character of the entry needed to effect these adjustments will now be shown, using
the data of the illustrative problem shown above. Comparison of the report of inventory from
the branch, $14,000, with the record of goods shipped to the branch, $77,000, shows that
goods to the billed value of $63,000 were disposed of at the branch. The records in the head
office show that the goods were billed to the branch at 140% of cost. Converting this figure
of $63,000 on the basis of 140% of cost develops a true cost of goods sold of $45,000. This
is brought onto the head office books by the following entry:
Branch A Profit and Loss $45,000.00
Purchases $45,000.00
Reference to the solution above shows that Branch A Profit and Loss has been charged
with $10,000 expenses and credited with $85,000 earnings from sales. The gross profit,
therefore, on the period’s activities at Branch A is the balance of the Branch A Profit and
Loss account, i.e., $30,000. The only other adjustment necessary is the conversion of the
Branch A inventory of $14,000 to a cost basis. The true cost here is, of course, $10,000 since
the goods were billed at 140% of cost. The $10,000 will be included with the inventory of
goods on hand at the head office before the determination of the head office cost of goods
sold and gross profit can be made.
To secure a better understanding of the interrelations of these various accounts it is
suggested that the student set up all the accounts and follow through them the transactions
given in the illustrative problem above, both on the books of the branch and on the books of
the head office.
A final problem of adjustment as between the head office and branch books concerns the
treatment of fixed assets carried on the books of the branch. It may happen that the branch
makes purchases of various pieces of property which are charged up to fixed asset accounts
on the branch books. To secure uniform treatment, particularly as regards depreciation, it is
customary at the close of the fiscal period to transfer the record of all fixed assets to the head
office books. This is accomplished by entry on the branch books of a charge to Head Office
General account, and credits to the various fixed asset accounts. On the books of the head
office the record will be a charge to the various fixed asset accounts and a credit to the
Page 441
various Branch General accounts. Usually, therefore, on the branch books appear only
current asset items, current liability items, expense and income items.
Reports from the Branch
The reports which the branch makes to the head office depend entirely on the degree of
control to be exercised by the head office over its various branches. Accordingly, no general
methods of universal applicability can be described. A statement of some of the different
kinds of reports and the use made of them will be given. In some cases the branch books are
kept in duplicate, the duplicates of all books of original entry being sent to the head office at
the close of each month or oftener if desired. From these duplicate records the head office
can keep a ledger record with every branch for comparison with the ledgers as kept by the
branches. In other cases the head office requires that the branch send in daily duplicate
copies of all business papers covering the transactions of the branch. Thus sales tickets are
made in manifold, one copy of every sale, whether cash or credit, being sent to the head
office. This furnishes the head office with a control over the selling activities of the branch.
If the branch has charge of its cash a duplicate ticket of all deposits made should be
forwarded to the head office. The canceled checks drawn by the branch must be forwarded
by the banker to the head office. This procedure keeps the head office informed as to the
cash transactions of the branch, giving both a control over the cash and a fairly complete
knowledge of disbursements on account of expenses and of receipts from collections. If,
now, all purchases of stock-in-trade are made from the head office, the latter has a close
control over all the activities of the branch. It may thus keep a duplicate set of records,
although that is scarcely necessary inasmuch as summaries can be made by which to check
up the books of the branch at the close of the fiscal period.
Sometimes, instead of daily reports periodic summaries of the branch activities are made
to the head office and these provide the basis for checking up on the branch at the close of
the fiscal period. Where the head office maintains traveling auditors, such frequent reports
are not necessary.
Examples of Reports
Below are given two examples of different kinds of reports from the branch to the head
office. The first is a periodic summary of cash transactions followed by a statement of
collections from customers. The second form is a type of ledger account carried with each
branch on the books of the head office in accordance with detailed reports made by the
branch or by traveling auditors from the head office. It will be noted that provision is made
in the account by means of special rulings to show the total expenses of each branch, which
total will enter into the trial balance; and also for an analysis of the expenses of each branch
under suitable heads, these latter being treated simply as memoranda. Any credits or
adjustments are entered in red ink, and are to be deducted before showing totals.
Periodic Cash Summary
Receipts Payments
Cash Sales (by days) $...... Wages $......
current asset items, current liability items, expense and income items.
Reports from the Branch
The reports which the branch makes to the head office depend entirely on the degree of
control to be exercised by the head office over its various branches. Accordingly, no general
methods of universal applicability can be described. A statement of some of the different
kinds of reports and the use made of them will be given. In some cases the branch books are
kept in duplicate, the duplicates of all books of original entry being sent to the head office at
the close of each month or oftener if desired. From these duplicate records the head office
can keep a ledger record with every branch for comparison with the ledgers as kept by the
branches. In other cases the head office requires that the branch send in daily duplicate
copies of all business papers covering the transactions of the branch. Thus sales tickets are
made in manifold, one copy of every sale, whether cash or credit, being sent to the head
office. This furnishes the head office with a control over the selling activities of the branch.
If the branch has charge of its cash a duplicate ticket of all deposits made should be
forwarded to the head office. The canceled checks drawn by the branch must be forwarded
by the banker to the head office. This procedure keeps the head office informed as to the
cash transactions of the branch, giving both a control over the cash and a fairly complete
knowledge of disbursements on account of expenses and of receipts from collections. If,
now, all purchases of stock-in-trade are made from the head office, the latter has a close
control over all the activities of the branch. It may thus keep a duplicate set of records,
although that is scarcely necessary inasmuch as summaries can be made by which to check
up the books of the branch at the close of the fiscal period.
Sometimes, instead of daily reports periodic summaries of the branch activities are made
to the head office and these provide the basis for checking up on the branch at the close of
the fiscal period. Where the head office maintains traveling auditors, such frequent reports
are not necessary.
Examples of Reports
Below are given two examples of different kinds of reports from the branch to the head
office. The first is a periodic summary of cash transactions followed by a statement of
collections from customers. The second form is a type of ledger account carried with each
branch on the books of the head office in accordance with detailed reports made by the
branch or by traveling auditors from the head office. It will be noted that provision is made
in the account by means of special rulings to show the total expenses of each branch, which
total will enter into the trial balance; and also for an analysis of the expenses of each branch
under suitable heads, these latter being treated simply as memoranda. Any credits or
adjustments are entered in red ink, and are to be deducted before showing totals.
Periodic Cash Summary
Receipts Payments
Cash Sales (by days) $...... Wages $......
Page 442
Expenses ......
Total for period $...... Sent to Head Office ......
Customers Accts. (as below ...... Payments into Bank
(dates & amts.)
Other Receipts ...... Balance on Hand, carried
to next statement ......
Total $...... $......
Balance, per last statement $......
Customer’s Accounts Collected
Branch Report to Head Office
Branch A Expenses[69]
Head Office Ledger Account—
Summary of Branch Expenses
Total for period $...... Sent to Head Office ......
Customers Accts. (as below ...... Payments into Bank
(dates & amts.)
Other Receipts ...... Balance on Hand, carried
to next statement ......
Total $...... $......
Balance, per last statement $......
Customer’s Accounts Collected
Branch Report to Head Office
Branch A Expenses[69]
Head Office Ledger Account—
Summary of Branch Expenses
Page 443
CHAPTER XXXI
BRANCH HOUSE ACCOUNTING
(Continued)
Foreign Exchange
The foreign trading of American firms has grown of late years to such proportions that a
practical acquaintance with the exchange values of foreign currencies is necessary for the
accountant. The rate of exchange is the equivalent of the currency of one country in that of
another. For instance, the standard value of the British sovereign in the currency of the United
States is $4.8665; that is, the value of the quantity of pure gold in one sovereign in London is
equal to that represented by $4.8665 in New York. Other things being equal, this should always
be the par rate of exchange between the United States and England. The question of the rate of
exchange between countries which have a gold standard is a comparatively simple matter.
Where one of the countries has a silver currency, the variations assume more importance, for
the reason that the intrinsic value of silver converted into gold must be accounted for. Paper
currency, especially in times of war, causes a still greater complication, because in this case it
is uncertain when such paper will be made convertible into gold or silver.
In addition to differences in exchange arising from the conversion of one currency into
another, called the par rate, other things enter into exchange transactions which have a marked
effect upon the actual, or market, rate of exchange. Such conditions as supply and demand for
remittances between countries to satisfy debit balances; the necessary expenses, including cost
of transmission (which can never be more than the actual cost of transporting the specie itself):
interest on the money for the time the draft has to run to maturity or to the time of payment in
the foreign country—these and other factors must be taken into account. The expense of
cabling and the profits of the bankers who transmit the money must be added. Some intangible
factors are the credit condition of the countries and the risks involved in making transfers.
The Accounting Problem of the Foreign Branch
From the viewpoint of accounting, the only problem in connection with foreign branches
which differs from those of domestic branches concerns the conversion of the foreign currency
—in terms of which the records of the foreign branch are kept—into the currency of the head
office. Periodically—usually at the close of the fiscal period—the results as shown by the
branch records must be incorporated with those of the head office. The problem involved is for
the most part due to the fact that, while the activities of the various branches have been
transacted and recorded in terms of one or more currencies, the net results of those activities
are to be taken effect of, usually as a disbursement of dividends, in the terms of the head office
currency. That is, earnings are made and expenses incurred in one currency, and the net result
of the branch’s trading must be disbursed in terms of another currency. The fluctuations in
exchange prevailing throughout the year at the time of the various transactions of the branch
and at the time when the net results of the branch are disbursed as dividends from the head
BRANCH HOUSE ACCOUNTING
(Continued)
Foreign Exchange
The foreign trading of American firms has grown of late years to such proportions that a
practical acquaintance with the exchange values of foreign currencies is necessary for the
accountant. The rate of exchange is the equivalent of the currency of one country in that of
another. For instance, the standard value of the British sovereign in the currency of the United
States is $4.8665; that is, the value of the quantity of pure gold in one sovereign in London is
equal to that represented by $4.8665 in New York. Other things being equal, this should always
be the par rate of exchange between the United States and England. The question of the rate of
exchange between countries which have a gold standard is a comparatively simple matter.
Where one of the countries has a silver currency, the variations assume more importance, for
the reason that the intrinsic value of silver converted into gold must be accounted for. Paper
currency, especially in times of war, causes a still greater complication, because in this case it
is uncertain when such paper will be made convertible into gold or silver.
In addition to differences in exchange arising from the conversion of one currency into
another, called the par rate, other things enter into exchange transactions which have a marked
effect upon the actual, or market, rate of exchange. Such conditions as supply and demand for
remittances between countries to satisfy debit balances; the necessary expenses, including cost
of transmission (which can never be more than the actual cost of transporting the specie itself):
interest on the money for the time the draft has to run to maturity or to the time of payment in
the foreign country—these and other factors must be taken into account. The expense of
cabling and the profits of the bankers who transmit the money must be added. Some intangible
factors are the credit condition of the countries and the risks involved in making transfers.
The Accounting Problem of the Foreign Branch
From the viewpoint of accounting, the only problem in connection with foreign branches
which differs from those of domestic branches concerns the conversion of the foreign currency
—in terms of which the records of the foreign branch are kept—into the currency of the head
office. Periodically—usually at the close of the fiscal period—the results as shown by the
branch records must be incorporated with those of the head office. The problem involved is for
the most part due to the fact that, while the activities of the various branches have been
transacted and recorded in terms of one or more currencies, the net results of those activities
are to be taken effect of, usually as a disbursement of dividends, in the terms of the head office
currency. That is, earnings are made and expenses incurred in one currency, and the net result
of the branch’s trading must be disbursed in terms of another currency. The fluctuations in
exchange prevailing throughout the year at the time of the various transactions of the branch
and at the time when the net results of the branch are disbursed as dividends from the head
Page 444
office, sometimes give rise to a very complicated problem if accurate and satisfactory results
are to be secured.
It is impossible, from the standpoint of practice, to convert every transaction of the branch
into the currency of the head office at the rate prevailing at the time of the transaction; and
furthermore, the funds out of which ultimately some portion of the dividends must be paid are,
at the close of the fiscal period, still held in the possession of the branch and so are not
available except through the process of conversion. Accordingly, the question of the rate of
exchange prevailing at the close of the fiscal period has a very important bearing on the correct
showing of the branch’s activities on the head office books.
It is not purposed here to go into the question of organization, or method of keeping
accounts for the foreign branch. As was stated above in connection with domestic branches,
any system of accounts depends very largely upon the general organization of the head office
and its branches, and this in turn depends on the degree of control and amount of information
desired. The discussion will be limited to the assumption that the branch has an almost
independent organization and is expected to make a full report periodically by means, at least,
of a trial balance of the branch.
Accounts Opened on Books
On the books of the branch a Head Office Control or Adjustment account will be carried
which represents the ownership of the head office in the branch; and on the head office books a
Branch Control or Adjustment account which is the complement of the head office account on
the branch books. Frequently, in addition to these interrelated accounts, a Remittance account
is carried for the purpose of facilitating reference. In this account are entered the remittances
made by the branch to the head office, instead of entering such transactions in the Head Office
Control account. The problem to be discussed here concerns the method of converting the
branch trial balance before incorporating it, and the root of the problem lies in the
determination of the basis for the conversion of the various kinds of items listed therein. Fixed
and current asset and liability items, expense and income items, the Head Office Control and
Remittance accounts—all must be converted. For an accurate and equitable showing of the
branch activities on the head office books under certain conditions, these different classes of
items should not be converted at the same rate. Under other conditions no serious inequity
results from the use of a uniform rate of exchange for the conversion of all items, and in
practice such a rate is handled much more simply than different rates. Of course, the branch
trial balance is in balance previous to conversion but is almost invariably out of balance after
conversion. It becomes necessary, therefore, to take up the difference by means of a debit or
credit to an account called “Exchange” or “Fluctuations in Exchange”—sometimes also called
“Reserve for Fluctuations in Exchange.”
Handling Fluctuations in Foreign Exchange
The proper handling and ultimate disposition of this Exchange or Fluctuations in Exchange
account requires some consideration. If there is a loss in the conversion of the branch trial
balance into the head office currency, that may be treated as a current expense to be charged
ultimately to the current period’s profit and loss. Any profit accruing from the same source may
be similarly handled. Some concerns set aside all profits accruing in this manner into a Reserve
for Fluctuations in Exchange account, against which are charged any losses incurred through
are to be secured.
It is impossible, from the standpoint of practice, to convert every transaction of the branch
into the currency of the head office at the rate prevailing at the time of the transaction; and
furthermore, the funds out of which ultimately some portion of the dividends must be paid are,
at the close of the fiscal period, still held in the possession of the branch and so are not
available except through the process of conversion. Accordingly, the question of the rate of
exchange prevailing at the close of the fiscal period has a very important bearing on the correct
showing of the branch’s activities on the head office books.
It is not purposed here to go into the question of organization, or method of keeping
accounts for the foreign branch. As was stated above in connection with domestic branches,
any system of accounts depends very largely upon the general organization of the head office
and its branches, and this in turn depends on the degree of control and amount of information
desired. The discussion will be limited to the assumption that the branch has an almost
independent organization and is expected to make a full report periodically by means, at least,
of a trial balance of the branch.
Accounts Opened on Books
On the books of the branch a Head Office Control or Adjustment account will be carried
which represents the ownership of the head office in the branch; and on the head office books a
Branch Control or Adjustment account which is the complement of the head office account on
the branch books. Frequently, in addition to these interrelated accounts, a Remittance account
is carried for the purpose of facilitating reference. In this account are entered the remittances
made by the branch to the head office, instead of entering such transactions in the Head Office
Control account. The problem to be discussed here concerns the method of converting the
branch trial balance before incorporating it, and the root of the problem lies in the
determination of the basis for the conversion of the various kinds of items listed therein. Fixed
and current asset and liability items, expense and income items, the Head Office Control and
Remittance accounts—all must be converted. For an accurate and equitable showing of the
branch activities on the head office books under certain conditions, these different classes of
items should not be converted at the same rate. Under other conditions no serious inequity
results from the use of a uniform rate of exchange for the conversion of all items, and in
practice such a rate is handled much more simply than different rates. Of course, the branch
trial balance is in balance previous to conversion but is almost invariably out of balance after
conversion. It becomes necessary, therefore, to take up the difference by means of a debit or
credit to an account called “Exchange” or “Fluctuations in Exchange”—sometimes also called
“Reserve for Fluctuations in Exchange.”
Handling Fluctuations in Foreign Exchange
The proper handling and ultimate disposition of this Exchange or Fluctuations in Exchange
account requires some consideration. If there is a loss in the conversion of the branch trial
balance into the head office currency, that may be treated as a current expense to be charged
ultimately to the current period’s profit and loss. Any profit accruing from the same source may
be similarly handled. Some concerns set aside all profits accruing in this manner into a Reserve
for Fluctuations in Exchange account, against which are charged any losses incurred through
Page 445
conversion. If the first period shows a loss on conversion, it would, of course, be necessary to
reserve out of that period’s profits a sufficient amount to take care of the loss. Usually,
however, the items of profits and losses on conversion of exchange counterbalance each other
fairly well throughout succeeding periods. The item is for the most part comparatively small
and either method of handling it is satisfactory and gives sufficiently correct results under
normal conditions but often too inaccurate under abnormal conditions.
Conversion of Branch Results
The basis on which the closing entries are converted from the foreign to the local currency
is a very important factor. If the ratio between the two countries is more or less stable, an
average rate may be adopted without much variation in the established values. All profits or
losses on exchange resulting from differences between actual rates on current transactions and
this average rate will be entered in the Fluctuations in Exchange account. However, in periods
of rapidly fluctuating rates of exchange, or in transactions with branches where silver currency
or depreciated paper or non-guaranteed currency are in use, the conversion of all items at some
arbitrary or average rate will not give accurate or satisfactory results. In such cases certain
practices have been established as being the most equitable in converting the various accounts
of the branch balance sheet into the local currency for the purpose of amalgamating them into
the home office balance sheet. These practices are summed up as follows:
First convert the foreign currency into dollars at the following rates:
1. Fixed assets at the same rate as before, that is, the rate at the time
of purchase, or average rate for the purchases of a fiscal period.
The reason for this is that fluctuations in the value of fixed
assets, whether expressed in one currency or another, are not
allowed to affect the period’s results.
2. Floating assets and liabilities at the rate current as of the date of
the balance sheet.
3. Revenue items at an average rate for the period.
4. Remittances at the actual rates paid.
5. Control or adjustment account at the same rate as that which had
been established on the head office books at the last period.
To arrive at the average rate in the case of fixed assets it is sufficient to take the rate
prevailing at the end of each month throughout the year and divide the total by twelve. This
becomes necessary where construction or purchases of fixed properties take place throughout
the year. The difference, if the rate is less than par, is credited to the capital expenditure and
debited to Profit and Loss on the head office books. The branch is notified of the adjustment
and makes a similar entry crediting Exchange and debiting the head office with the amount.
Current assets and liabilities are converted at the rates current at the date of the balance
sheet because the balance sheet should represent these values at the exact cost of converting
them into cash at the present moment. If in practice they were actually liquidated, this could
not be realized but in principle it represents the present condition. Revenue items are
convertible at the average rate because they represent items accumulating during the entire
fiscal period; they represent the result of the business activities for the past period, at varying
reserve out of that period’s profits a sufficient amount to take care of the loss. Usually,
however, the items of profits and losses on conversion of exchange counterbalance each other
fairly well throughout succeeding periods. The item is for the most part comparatively small
and either method of handling it is satisfactory and gives sufficiently correct results under
normal conditions but often too inaccurate under abnormal conditions.
Conversion of Branch Results
The basis on which the closing entries are converted from the foreign to the local currency
is a very important factor. If the ratio between the two countries is more or less stable, an
average rate may be adopted without much variation in the established values. All profits or
losses on exchange resulting from differences between actual rates on current transactions and
this average rate will be entered in the Fluctuations in Exchange account. However, in periods
of rapidly fluctuating rates of exchange, or in transactions with branches where silver currency
or depreciated paper or non-guaranteed currency are in use, the conversion of all items at some
arbitrary or average rate will not give accurate or satisfactory results. In such cases certain
practices have been established as being the most equitable in converting the various accounts
of the branch balance sheet into the local currency for the purpose of amalgamating them into
the home office balance sheet. These practices are summed up as follows:
First convert the foreign currency into dollars at the following rates:
1. Fixed assets at the same rate as before, that is, the rate at the time
of purchase, or average rate for the purchases of a fiscal period.
The reason for this is that fluctuations in the value of fixed
assets, whether expressed in one currency or another, are not
allowed to affect the period’s results.
2. Floating assets and liabilities at the rate current as of the date of
the balance sheet.
3. Revenue items at an average rate for the period.
4. Remittances at the actual rates paid.
5. Control or adjustment account at the same rate as that which had
been established on the head office books at the last period.
To arrive at the average rate in the case of fixed assets it is sufficient to take the rate
prevailing at the end of each month throughout the year and divide the total by twelve. This
becomes necessary where construction or purchases of fixed properties take place throughout
the year. The difference, if the rate is less than par, is credited to the capital expenditure and
debited to Profit and Loss on the head office books. The branch is notified of the adjustment
and makes a similar entry crediting Exchange and debiting the head office with the amount.
Current assets and liabilities are converted at the rates current at the date of the balance
sheet because the balance sheet should represent these values at the exact cost of converting
them into cash at the present moment. If in practice they were actually liquidated, this could
not be realized but in principle it represents the present condition. Revenue items are
convertible at the average rate because they represent items accumulating during the entire
fiscal period; they represent the result of the business activities for the past period, at varying
Page 446
rates of exchange. Since the remittance account represents the actual cash paid for cash
transmitted, there is no occasion for changing the rate which has been used at various times
during the period. The Control or Adjustment account likewise was converted at the time the
entries were made to it and represents the exact cost of the various transactions recorded in it.
After all balance sheet items have been converted according to the rates prescribed, it is a
general custom to provide a reserve account to cover any losses on exchange not provided in
the conversion of the accounts. This is done for the purpose of guarding against overstating
values and thus paying dividends out of the capital, since the conversion into head office
currency merely serves as a medium of estimating what the foreign investment really
represents to the stockholders.
An illustrative problem is given below with its solution based on the principles of
conversion just stated. It is to be noted that in practice, within the limitation stated on page 546,
a uniform rate of conversion is generally made use of for all items except remittances, for
which the actual rate is used.
Illustrative Bookkeeping Problem
Problem. At the close of the fiscal period a condensed trial balance
report of the London branch of a New York concern showed as follows:
Trial Balance—London Branch
£ £
N. Y. Control (4.7475) 100,000
Remittance 50,000
Cash 5,000
Customers 75,000
Merchandise Inventory 25,000
Furniture and Fixtures 1,000
Creditors 31,000
Sales 150,000
Purchases 95,000
Expenses 30,000
281,000 281,000
Final Inventory £30,000
The London Control account on the New York books showed a balance of $474,750, and
the Remittance account $237,987.50. Set up, in journal form, the entries necessary to take on
the New York books the results of the period’s activity at London and show the London
Control and London Profit and Loss accounts after adjustment, using the additional data:
1. The Remittance account comprised 5 drafts of £10,000 each, at
4.75, 4.7575, 4.74875, 4.7625, and 4.78 respectively.
transmitted, there is no occasion for changing the rate which has been used at various times
during the period. The Control or Adjustment account likewise was converted at the time the
entries were made to it and represents the exact cost of the various transactions recorded in it.
After all balance sheet items have been converted according to the rates prescribed, it is a
general custom to provide a reserve account to cover any losses on exchange not provided in
the conversion of the accounts. This is done for the purpose of guarding against overstating
values and thus paying dividends out of the capital, since the conversion into head office
currency merely serves as a medium of estimating what the foreign investment really
represents to the stockholders.
An illustrative problem is given below with its solution based on the principles of
conversion just stated. It is to be noted that in practice, within the limitation stated on page 546,
a uniform rate of conversion is generally made use of for all items except remittances, for
which the actual rate is used.
Illustrative Bookkeeping Problem
Problem. At the close of the fiscal period a condensed trial balance
report of the London branch of a New York concern showed as follows:
Trial Balance—London Branch
£ £
N. Y. Control (4.7475) 100,000
Remittance 50,000
Cash 5,000
Customers 75,000
Merchandise Inventory 25,000
Furniture and Fixtures 1,000
Creditors 31,000
Sales 150,000
Purchases 95,000
Expenses 30,000
281,000 281,000
Final Inventory £30,000
The London Control account on the New York books showed a balance of $474,750, and
the Remittance account $237,987.50. Set up, in journal form, the entries necessary to take on
the New York books the results of the period’s activity at London and show the London
Control and London Profit and Loss accounts after adjustment, using the additional data:
1. The Remittance account comprised 5 drafts of £10,000 each, at
4.75, 4.7575, 4.74875, 4.7625, and 4.78 respectively.
Page 447
2. The current rate of exchange is 4.7545.
3. The average rate is 4.7525.
4. The rate at time of purchase of fixed assets was 4.83.
5. No account is to be taken of probable loss from uncollectible
accounts nor of depreciation.
6. Carry the difference in exchange to a reserve.
Solution
Conversion of London Trial Balance
Rate of
£ £
Conversion $ $
New York Control 100,000 4.7475 474,750.00
Remittances[70] 50,000 (See note) 237,987.50
Cash 5,000 4.7545 23,772.50
Customers 75,000 4.7545 356,587.50
Merchandise Inventory 25,000 4.7475 118,687.50
Furniture and Fixtures 1,000 4.83 4,830.00
Creditors. 31,000 4.7545 147,389.50
Sales 150,000 4.7525 712,875.00
Purchases 95,000 4.7525 451,487.50
Expenses 30,000 4.7525 142,575.00
Reserve for Fluctuations
of Exchange 913.00
281,000 281,000 1,335,927.50 1,335,927.50
Final Inventory £30,000 @ 4.7545 = $142,635
Journal Entries to Adjust New York Books
(1) Remittances $237,987.50
London Control $237,987.50
To Credit London with its remittances:
£10,000 @ 4.75 = $47,500.00
10,000 @ 4.7575 = 47,575.00
10,000 @ 4.74875 = 47,487.50
3. The average rate is 4.7525.
4. The rate at time of purchase of fixed assets was 4.83.
5. No account is to be taken of probable loss from uncollectible
accounts nor of depreciation.
6. Carry the difference in exchange to a reserve.
Solution
Conversion of London Trial Balance
Rate of
£ £
Conversion $ $
New York Control 100,000 4.7475 474,750.00
Remittances[70] 50,000 (See note) 237,987.50
Cash 5,000 4.7545 23,772.50
Customers 75,000 4.7545 356,587.50
Merchandise Inventory 25,000 4.7475 118,687.50
Furniture and Fixtures 1,000 4.83 4,830.00
Creditors. 31,000 4.7545 147,389.50
Sales 150,000 4.7525 712,875.00
Purchases 95,000 4.7525 451,487.50
Expenses 30,000 4.7525 142,575.00
Reserve for Fluctuations
of Exchange 913.00
281,000 281,000 1,335,927.50 1,335,927.50
Final Inventory £30,000 @ 4.7545 = $142,635
Journal Entries to Adjust New York Books
(1) Remittances $237,987.50
London Control $237,987.50
To Credit London with its remittances:
£10,000 @ 4.75 = $47,500.00
10,000 @ 4.7575 = 47,575.00
10,000 @ 4.74875 = 47,487.50
Page 448
10,000 @ 4.7625 = 47,625.00
10,000 @ 4.78 = 47,800.00
(2) London Control $712,875.00
London Profit and Loss $712,875.00
To charge London with its sales:
£150,000 @ 4.7525
(3) London Profit and Loss 118,687.50
London Control 118,687.50
To credit London with initial inventory:
£25,000 @ 4.7475
(4) London Profit and Loss 451,487.50
London Control 451,487.50
To credit London with its purchases:
£95,000 @ 4.7525
(5) London Control 142,635.00
London Profit and Loss 142,635.00
To charge London with final inventory:
£30,000 @ 4.7545
(6) London Profit and Loss 142,575.00
London Control 142,575.00
To credit London with its expenses:
£30,000 @ 4.7525
(7) London Control 913.00
Reserve for Exchange Fluctuations 913.00
To charge London with the profit
arising from conversion.
(8) London Profit and Loss 142,760.00
Profit and Loss 142,760.00
To transfer profit at London branch
to general Profit and Loss.
Appended are the London Control account as it would appear after posting the above
entries on the New York books; and the London Profit and Loss account on the New York
books.
London Control
10,000 @ 4.78 = 47,800.00
(2) London Control $712,875.00
London Profit and Loss $712,875.00
To charge London with its sales:
£150,000 @ 4.7525
(3) London Profit and Loss 118,687.50
London Control 118,687.50
To credit London with initial inventory:
£25,000 @ 4.7475
(4) London Profit and Loss 451,487.50
London Control 451,487.50
To credit London with its purchases:
£95,000 @ 4.7525
(5) London Control 142,635.00
London Profit and Loss 142,635.00
To charge London with final inventory:
£30,000 @ 4.7545
(6) London Profit and Loss 142,575.00
London Control 142,575.00
To credit London with its expenses:
£30,000 @ 4.7525
(7) London Control 913.00
Reserve for Exchange Fluctuations 913.00
To charge London with the profit
arising from conversion.
(8) London Profit and Loss 142,760.00
Profit and Loss 142,760.00
To transfer profit at London branch
to general Profit and Loss.
Appended are the London Control account as it would appear after posting the above
entries on the New York books; and the London Profit and Loss account on the New York
books.
London Control
Page 449
Items Rate £ $
Balance one year ago 100,000 474,750.00
London Profit & Loss (Sales) 4.7525 150,000 712,875.00
London Profit & Loss (Final Inventory) 4.7545 30,000 142,635.00
Reserve for Exchange Fluctuations 913.00
280,000 1,331,173.00
Balance 80,000 380,435.50
Items Rate £ $
Remittances J(1) 50,000 237,987.50
See London Profit & Loss 4.7475
(Initial Inventory) 4.7525 25,000 118,687.50
London Profit & Loss (Purchases) 4.7525 95,000 451,487.50
London Profit & Loss (Expenses) 30,000 142,575.00
Balance 80,000 380,435.50
280,000 1,331,173.00
London Profit and Loss [71]
Initial Inventory $118,687.50 Sales $712,875.00
Purchases 451,487.50 Final Inventory 142,635.00
Expenses 142,575.00
Profit & Loss 142,760.00
$855,510.00 $855,510.00
Local Supervision of the Foreign Branch
A question which enters into the accounting with foreign branches arises in connection with
the law of the land in which the branch is opened. “Most foreign countries have some
regulations as to what books must be kept, and the manner of recording the transactions. In
France, for instance, the law requires that a summary of all transactions shall be entered
through the journal, which therefore becomes the posting medium for every transaction. This
book has, in the first instance, to be produced to a public official, who examines it to see that it
is duly paged, none missing, etc., and then stamps it as correct, and anything requiring legal
proceedings in which accounts are concerned must be proved from the journals with the
official visa.”
“Since the work of organizing and installing systems of accounting in branch houses abroad
is of undoubted and growing importance, it is necessary to have not only a practical
acquaintance with the currencies in which the foreign books are kept, and the laws of the land
Balance one year ago 100,000 474,750.00
London Profit & Loss (Sales) 4.7525 150,000 712,875.00
London Profit & Loss (Final Inventory) 4.7545 30,000 142,635.00
Reserve for Exchange Fluctuations 913.00
280,000 1,331,173.00
Balance 80,000 380,435.50
Items Rate £ $
Remittances J(1) 50,000 237,987.50
See London Profit & Loss 4.7475
(Initial Inventory) 4.7525 25,000 118,687.50
London Profit & Loss (Purchases) 4.7525 95,000 451,487.50
London Profit & Loss (Expenses) 30,000 142,575.00
Balance 80,000 380,435.50
280,000 1,331,173.00
London Profit and Loss [71]
Initial Inventory $118,687.50 Sales $712,875.00
Purchases 451,487.50 Final Inventory 142,635.00
Expenses 142,575.00
Profit & Loss 142,760.00
$855,510.00 $855,510.00
Local Supervision of the Foreign Branch
A question which enters into the accounting with foreign branches arises in connection with
the law of the land in which the branch is opened. “Most foreign countries have some
regulations as to what books must be kept, and the manner of recording the transactions. In
France, for instance, the law requires that a summary of all transactions shall be entered
through the journal, which therefore becomes the posting medium for every transaction. This
book has, in the first instance, to be produced to a public official, who examines it to see that it
is duly paged, none missing, etc., and then stamps it as correct, and anything requiring legal
proceedings in which accounts are concerned must be proved from the journals with the
official visa.”
“Since the work of organizing and installing systems of accounting in branch houses abroad
is of undoubted and growing importance, it is necessary to have not only a practical
acquaintance with the currencies in which the foreign books are kept, and the laws of the land
Page 450
in regard to the kind of books which must be kept, but in addition a thorough knowledge of the
manner in which transactions are to be transmitted periodically to the home office, and of their
assimilation with the home accounts and the drafting of the final accounts, balance sheets and
profit and loss statements becomes indispensable.”
The Foreign Sales Agency
Where the foreign branch is merely a selling agency for the home office, and invoices must
be made out at the home office in foreign currency, a convenient way to handle these accounts
is to keep a separate set of records for each foreign currency. A foreign sales journal, customers
ledger, and cash receipts journal, together with foreign notes receivable and sales returns and
allowances journals, where necessary, will comprise all books of original entry needed to
secure sources for postings to the customers’ individual accounts in terms of foreign money. In
this way all charges for goods sent, and credits for returns, allowances, cash and notes received
and discounts allowed, can be kept entirely in foreign currency.
Method of Conversion of Results
Periodically—say, once a month—the total transactions for the month must be converted
into home currency and brought into the general ledger. In normal times a fixed average rate of
exchange based on past experience gives sufficiently accurate results, saves many tedious
calculations and much unnecessary work. At certain times and in certain businesses the
prevailing rate of exchange on the actual day, or the monthly average of daily rates, may need
to be used to secure satisfactory results. With the use of the fixed average rate, as above, the
totals of foreign sales and sales returns journals are converted into home currency and carried
respectively as debits and credits to Accounts Receivable control, and credits and debits to
Sales. The total of the discount column of the cash receipts journal is converted, at the average
rate, and charged to Sales Discount and credited to Accounts Receivable control.
The conversion of the cash received must be handled differently, however. The actual rate
at which the foreign draft or bill received in payment of the customer’s account is converted by
sale to the banker—and so credited to the home office bank account—almost always differs
from the average rate at which the item was charged to the customers’ controlling account.
This, of course, makes no difference with his individual account which is kept in foreign
currency, but does make necessary an adjustment of the general ledger Accounts Receivable
control in order to make it agree with the foreign customers ledger when converted at the
average rate.
Accordingly, in the general cash book two additional columns are provided, viz.: Profit on
Exchange and Loss on Exchange columns, which are used somewhat as is the Sales Discount
column. Every foreign draft or bill when received is entered, in foreign currency, in the foreign
cash book and posted from there to the credit of the customer. When that draft or bill is sold at
the bank (it may be held for some time after receipt for a favorable turn of the money market)
and so converted into home currency, it is entered in the Accounts Receivable column at a
figure representing conversion at the fixed average rate. The difference between this figure and
the actual amount received at the bank is entered in either the Profit on Exchange or Loss on
Exchange column as the case may be, with extension of the actual amount into the bank
column as a charge to the bank account. Thus, the total of the Accounts Receivable column
when posted to the general ledger Accounts Receivable control adjusts that account so that it
manner in which transactions are to be transmitted periodically to the home office, and of their
assimilation with the home accounts and the drafting of the final accounts, balance sheets and
profit and loss statements becomes indispensable.”
The Foreign Sales Agency
Where the foreign branch is merely a selling agency for the home office, and invoices must
be made out at the home office in foreign currency, a convenient way to handle these accounts
is to keep a separate set of records for each foreign currency. A foreign sales journal, customers
ledger, and cash receipts journal, together with foreign notes receivable and sales returns and
allowances journals, where necessary, will comprise all books of original entry needed to
secure sources for postings to the customers’ individual accounts in terms of foreign money. In
this way all charges for goods sent, and credits for returns, allowances, cash and notes received
and discounts allowed, can be kept entirely in foreign currency.
Method of Conversion of Results
Periodically—say, once a month—the total transactions for the month must be converted
into home currency and brought into the general ledger. In normal times a fixed average rate of
exchange based on past experience gives sufficiently accurate results, saves many tedious
calculations and much unnecessary work. At certain times and in certain businesses the
prevailing rate of exchange on the actual day, or the monthly average of daily rates, may need
to be used to secure satisfactory results. With the use of the fixed average rate, as above, the
totals of foreign sales and sales returns journals are converted into home currency and carried
respectively as debits and credits to Accounts Receivable control, and credits and debits to
Sales. The total of the discount column of the cash receipts journal is converted, at the average
rate, and charged to Sales Discount and credited to Accounts Receivable control.
The conversion of the cash received must be handled differently, however. The actual rate
at which the foreign draft or bill received in payment of the customer’s account is converted by
sale to the banker—and so credited to the home office bank account—almost always differs
from the average rate at which the item was charged to the customers’ controlling account.
This, of course, makes no difference with his individual account which is kept in foreign
currency, but does make necessary an adjustment of the general ledger Accounts Receivable
control in order to make it agree with the foreign customers ledger when converted at the
average rate.
Accordingly, in the general cash book two additional columns are provided, viz.: Profit on
Exchange and Loss on Exchange columns, which are used somewhat as is the Sales Discount
column. Every foreign draft or bill when received is entered, in foreign currency, in the foreign
cash book and posted from there to the credit of the customer. When that draft or bill is sold at
the bank (it may be held for some time after receipt for a favorable turn of the money market)
and so converted into home currency, it is entered in the Accounts Receivable column at a
figure representing conversion at the fixed average rate. The difference between this figure and
the actual amount received at the bank is entered in either the Profit on Exchange or Loss on
Exchange column as the case may be, with extension of the actual amount into the bank
column as a charge to the bank account. Thus, the total of the Accounts Receivable column
when posted to the general ledger Accounts Receivable control adjusts that account so that it
Page 451
controls the foreign customers ledger converted at the average rate. The totals of the Profit on
Exchange and Loss on Exchange go as credits and debits respectively to the Profit and Loss on
Exchange account.
The foreign sales agency often collects the accounts and remits total collections
periodically by purchase of one bill or draft on its local bank for the total. There must, of
course, accompany each such remittance a statement of the detailed receipts for proper credit to
individual accounts. The general cash book will show only the total remittance, however.
Regular agency accounts as explained in Chapter XXX will secure the control of the home
office over the agency’s expenditures.
It is usually best to make the foreign customers ledger self-balancing. The Adjustment
account necessary to effect this may, if desired, be kept in both foreign and home currency, thus
showing on its face, by the balance of the home money columns, the agreement of the foreign
ledger with its control account on the general ledger. If, instead of one fixed average rate of
conversion, varying rates are used, the keeping of the Adjustment account in both currencies
becomes imperative.
Where, in the case of foreign sales, the sales invoice and charge to the customer are made
in home currency and payment of that amount in home currency is demanded, the problem of
conversion, as explained above, is not encountered, foreign sales being recorded and handled in
exactly the same way as home sales.
The Foreign Purchasing Agency
If the purchase is made in terms of foreign currency and settlement must be made in that
currency, a procedure and system may be used exactly similar to that just explained for
handling sales.
In both the sales and purchase record books, returns may be entered in the same record by
using red ink, and deducting the red ink totals at the end of each page. This obviates the
necessity of keeping subsidiary adjustment accounts in a separate book, and brings all
information regarding the branch transactions in one compact record.
Exchange and Loss on Exchange go as credits and debits respectively to the Profit and Loss on
Exchange account.
The foreign sales agency often collects the accounts and remits total collections
periodically by purchase of one bill or draft on its local bank for the total. There must, of
course, accompany each such remittance a statement of the detailed receipts for proper credit to
individual accounts. The general cash book will show only the total remittance, however.
Regular agency accounts as explained in Chapter XXX will secure the control of the home
office over the agency’s expenditures.
It is usually best to make the foreign customers ledger self-balancing. The Adjustment
account necessary to effect this may, if desired, be kept in both foreign and home currency, thus
showing on its face, by the balance of the home money columns, the agreement of the foreign
ledger with its control account on the general ledger. If, instead of one fixed average rate of
conversion, varying rates are used, the keeping of the Adjustment account in both currencies
becomes imperative.
Where, in the case of foreign sales, the sales invoice and charge to the customer are made
in home currency and payment of that amount in home currency is demanded, the problem of
conversion, as explained above, is not encountered, foreign sales being recorded and handled in
exactly the same way as home sales.
The Foreign Purchasing Agency
If the purchase is made in terms of foreign currency and settlement must be made in that
currency, a procedure and system may be used exactly similar to that just explained for
handling sales.
In both the sales and purchase record books, returns may be entered in the same record by
using red ink, and deducting the red ink totals at the end of each page. This obviates the
necessity of keeping subsidiary adjustment accounts in a separate book, and brings all
information regarding the branch transactions in one compact record.
Page 452
CHAPTER XXXII
SUSPENSE ACCOUNTS; NUMBERED ACCOUNTS;
ADJUSTMENT OF FIRE LOSSES
Suspense Accounts
Definition of Suspense Accounts—General Purpose
Any account which is used as a place of temporary record for items pending
a determination of their final status or allocation may be called a suspense
account. The definition points out the general purpose for which such accounts
are opened. It frequently becomes necessary to record items on the books as
soon as the transactions giving rise to them have taken place. At the time, the
information needed to determine their final place of record may be lacking.
Stock certificates may find their way into the secretary’s office with the name of
the party to whom transferred omitted; cash may be received through the mails
with the identity of the sender not disclosed; provision must be made for bad
debts before it is known what accounts will prove uncollectible—these and
similar items call for record before their final status is determinable.
When cash is either short or over, the Cash Short and Over account serves
as a temporary adjustment account. Discrepancies between the book record and
the physical inventory of cash due to various causes are temporarily thrown into
this account until further information discloses the cause. When it becomes
evident that such information cannot be secured, any balance is usually treated
as a profit and loss item at the end of the fiscal period. Similarly, discrepancies
between the bank’s cash record and that of the business may be thrown into an
account called “Bank Adjustments” or some other similar title, to show the
nature of the items there recorded. The Petty Cash account, between the periods
of its adjustment by means of a replenishing check, is in the nature of a
suspense account. Only when an analysis of the petty cash expenditures and the
replenishing check are recorded on the books is Petty Cash an asset account.
Failure to locate an error in the trial balance is sometimes recorded on the books
through the medium of a Trial Balance Adjustment account so as not to carry
the difference over into the trial balance of succeeding months. Where such an
account is set up it is a suspense account pending the finding of the error.
SUSPENSE ACCOUNTS; NUMBERED ACCOUNTS;
ADJUSTMENT OF FIRE LOSSES
Suspense Accounts
Definition of Suspense Accounts—General Purpose
Any account which is used as a place of temporary record for items pending
a determination of their final status or allocation may be called a suspense
account. The definition points out the general purpose for which such accounts
are opened. It frequently becomes necessary to record items on the books as
soon as the transactions giving rise to them have taken place. At the time, the
information needed to determine their final place of record may be lacking.
Stock certificates may find their way into the secretary’s office with the name of
the party to whom transferred omitted; cash may be received through the mails
with the identity of the sender not disclosed; provision must be made for bad
debts before it is known what accounts will prove uncollectible—these and
similar items call for record before their final status is determinable.
When cash is either short or over, the Cash Short and Over account serves
as a temporary adjustment account. Discrepancies between the book record and
the physical inventory of cash due to various causes are temporarily thrown into
this account until further information discloses the cause. When it becomes
evident that such information cannot be secured, any balance is usually treated
as a profit and loss item at the end of the fiscal period. Similarly, discrepancies
between the bank’s cash record and that of the business may be thrown into an
account called “Bank Adjustments” or some other similar title, to show the
nature of the items there recorded. The Petty Cash account, between the periods
of its adjustment by means of a replenishing check, is in the nature of a
suspense account. Only when an analysis of the petty cash expenditures and the
replenishing check are recorded on the books is Petty Cash an asset account.
Failure to locate an error in the trial balance is sometimes recorded on the books
through the medium of a Trial Balance Adjustment account so as not to carry
the difference over into the trial balance of succeeding months. Where such an
account is set up it is a suspense account pending the finding of the error.
Page 453
Again, it may sometimes become necessary to adjust arbitrarily a difference
between a controlling account and the total of the ledger which it controls
pending the finding of the discrepancies between the two. Thus, an Accounts
Receivable Control may not accord with the sum total of the customers’
accounts carried in the sales ledger, and it may be deemed advisable to accept
the subsidiary ledger record as correct rather than the figures of the controlling
account. The adjusting item is usually incorporated in the controlling account
but is in the nature of a suspense item pending the allocation of the difference.
As mentioned above, a cash receipt from an unidentified customer must be
recorded in a suitably named suspense account. Similarly, unclaimed wages
which have been charged on the books to the proper ledger account and credited
to cash must be carried until they are called for or until their record may with
reasonable certainty be closed on the books. Unclaimed dividends must also be
held in suspense until such time as a definite settlement of their disposition may
be determined. Advances to subsidiaries when recorded as a charge in open
account against the subsidiary are frequently of the nature of suspense items.
The subsidiary may settle the account by payment of cash, by payment of its
bonds or stock, or the account may not be settled and it then becomes necessary
to write it off as a bad debt.
Similarly, purchase invoices and other like items in dispute may be booked
as suspense items under suitable titles. However, in cases of this kind it is more
usual to hold the invoices until some basis of settlement is reached before
recording them on the books. If the fiscal period closes with these items still
unsettled, it will be necessary to bring them on the books as contingent
liabilities.
The Reserve for Depreciation may be looked upon as a suspense account.
The credit entries therein which serve the several purposes explained elsewhere,
are in the nature of items belonging to asset accounts which are held in suspense
pending the final disposal of all or some part of the asset. This final disposition
may take place either because of sale, loss by fire, or the discard of the asset on
account of complete depreciation. At such a time it becomes necessary to
transfer the portion of the reserve belonging to the asset finally disposed of as a
credit to the asset account in order to clear that account of the asset values
therein shown.
Reserve for Doubtful Accounts as a Suspense Account
In like manner the Reserve for Doubtful Accounts is a suspense account
because at the close of the fiscal period it becomes necessary to make an
between a controlling account and the total of the ledger which it controls
pending the finding of the discrepancies between the two. Thus, an Accounts
Receivable Control may not accord with the sum total of the customers’
accounts carried in the sales ledger, and it may be deemed advisable to accept
the subsidiary ledger record as correct rather than the figures of the controlling
account. The adjusting item is usually incorporated in the controlling account
but is in the nature of a suspense item pending the allocation of the difference.
As mentioned above, a cash receipt from an unidentified customer must be
recorded in a suitably named suspense account. Similarly, unclaimed wages
which have been charged on the books to the proper ledger account and credited
to cash must be carried until they are called for or until their record may with
reasonable certainty be closed on the books. Unclaimed dividends must also be
held in suspense until such time as a definite settlement of their disposition may
be determined. Advances to subsidiaries when recorded as a charge in open
account against the subsidiary are frequently of the nature of suspense items.
The subsidiary may settle the account by payment of cash, by payment of its
bonds or stock, or the account may not be settled and it then becomes necessary
to write it off as a bad debt.
Similarly, purchase invoices and other like items in dispute may be booked
as suspense items under suitable titles. However, in cases of this kind it is more
usual to hold the invoices until some basis of settlement is reached before
recording them on the books. If the fiscal period closes with these items still
unsettled, it will be necessary to bring them on the books as contingent
liabilities.
The Reserve for Depreciation may be looked upon as a suspense account.
The credit entries therein which serve the several purposes explained elsewhere,
are in the nature of items belonging to asset accounts which are held in suspense
pending the final disposal of all or some part of the asset. This final disposition
may take place either because of sale, loss by fire, or the discard of the asset on
account of complete depreciation. At such a time it becomes necessary to
transfer the portion of the reserve belonging to the asset finally disposed of as a
credit to the asset account in order to clear that account of the asset values
therein shown.
Reserve for Doubtful Accounts as a Suspense Account
In like manner the Reserve for Doubtful Accounts is a suspense account
because at the close of the fiscal period it becomes necessary to make an
Page 454
estimate of the probable amount of uncollectible items in order to appraise
correctly the value of outstanding claims against customers. This estimate must
be carried as a credit in the Reserve for Doubtful Accounts because at that time
it is not known definitely to what particular customers’ accounts it applies.
During the following periods, as the information becomes definite as to what
accounts are absolutely uncollectible, the credit held temporarily in the reserve
account is transferred to the particular customer’s account which has proved
uncollectible. Thus, we often speak of charging an uncollectible customer’s
account against the reserve, which is another way of saying that we transfer
from the reserve a portion of the credit held there in suspense, to the customer’s
account after it has been determined to what customer’s account it belongs.
Use of Suspense Ledger
In an effort to keep closer track of doubtful accounts and notes receivable,
such accounts are frequently transferred to what is known as a suspense ledger.
A fundamental misunderstanding seems to exist with regard to the meaning of
such a transfer. A business man often points with pride to the fact that he has
transferred a number of items from his regular customers ledger to a suspense
ledger, implying thereby a policy of conservatism in the value at which he
carries his customers’ accounts on his books. As a matter of fact, the transfer to
the suspense ledger in no sense changes the valuation at which the accounts are
carried on the books. Separation of the doubtful items from those considered
good provides a convenient basis for analysis according to which, at the end of
the fiscal period, it will be possible to make a much more accurate and
intelligent estimate of the probable loss from uncollectible items. Aside from
that and another fact of importance, namely, that by keeping all such accounts in
a suspense ledger it becomes much easier to watch them closely, nothing is to
be gained by the use of a suspense ledger. As to the proper method of handling
this ledger, it is best to carry in conjunction with it a separate control on the
general ledger supplementary to the customers ledger controlling account. This
would be effected at the time of removing an individual account to the suspense
ledger, by transferring the same item from the customers ledger controlling
account to the suspense ledger controlling account.
The form of the suspense ledger is somewhat different from that of the
regular ledger in that provision is made for gathering information as to the
efforts made to collect the items and the result of those efforts. A loose-leaf or
card ledger serves the purpose best. While the form is not standardized, such
information as the report of the mercantile agency at the time of granting the
correctly the value of outstanding claims against customers. This estimate must
be carried as a credit in the Reserve for Doubtful Accounts because at that time
it is not known definitely to what particular customers’ accounts it applies.
During the following periods, as the information becomes definite as to what
accounts are absolutely uncollectible, the credit held temporarily in the reserve
account is transferred to the particular customer’s account which has proved
uncollectible. Thus, we often speak of charging an uncollectible customer’s
account against the reserve, which is another way of saying that we transfer
from the reserve a portion of the credit held there in suspense, to the customer’s
account after it has been determined to what customer’s account it belongs.
Use of Suspense Ledger
In an effort to keep closer track of doubtful accounts and notes receivable,
such accounts are frequently transferred to what is known as a suspense ledger.
A fundamental misunderstanding seems to exist with regard to the meaning of
such a transfer. A business man often points with pride to the fact that he has
transferred a number of items from his regular customers ledger to a suspense
ledger, implying thereby a policy of conservatism in the value at which he
carries his customers’ accounts on his books. As a matter of fact, the transfer to
the suspense ledger in no sense changes the valuation at which the accounts are
carried on the books. Separation of the doubtful items from those considered
good provides a convenient basis for analysis according to which, at the end of
the fiscal period, it will be possible to make a much more accurate and
intelligent estimate of the probable loss from uncollectible items. Aside from
that and another fact of importance, namely, that by keeping all such accounts in
a suspense ledger it becomes much easier to watch them closely, nothing is to
be gained by the use of a suspense ledger. As to the proper method of handling
this ledger, it is best to carry in conjunction with it a separate control on the
general ledger supplementary to the customers ledger controlling account. This
would be effected at the time of removing an individual account to the suspense
ledger, by transferring the same item from the customers ledger controlling
account to the suspense ledger controlling account.
The form of the suspense ledger is somewhat different from that of the
regular ledger in that provision is made for gathering information as to the
efforts made to collect the items and the result of those efforts. A loose-leaf or
card ledger serves the purpose best. While the form is not standardized, such
information as the report of the mercantile agency at the time of granting the
Page 455
original credit; the agent in whose hands the account is placed for collection; the
date of placing the claim in his hands; his report on his efforts to collect the
account; the lawyer to whom the account is given in case suit is brought; the
attorney’s report; the name and address of the trustee or receiver in case the
customer has gone into bankruptcy; the date of filing a claim with the trustee;
the judgment secured; the particulars as to settlement; and provision for
additional remarks—all this information is of value and provision should be
made to record it. It may also be sometimes desirable to make use of a suspense
journal where information in addition to that for which provision has been made
on the ledger account can be collated and kept for reference.
Accounts Receivable Hypothecated
In connection with the handling of accounts receivable it may be well to
draw attention to the growing practice of discounting open accounts receivable
in much the same way in which notes receivable are discounted. In recent years
a group of non-professional bankers have initiated this kind of financing. It may
sometimes happen that a merchant exhausts his credit with his regular banker
and is unable to raise further necessary funds in the usual way. By applying to
the so-called commercial credit companies or these non-professional bankers it
is frequently possible for him to discount his new accounts as he creates them
through current sales to customers and so secure funds for tiding him over a
temporary stringency. The practice, however, is looked upon in business and
regular banking circles as evidence of the financial instability of the merchant
and his probable bankruptcy in the near future. The cost of raising funds in this
way is almost prohibitive excepting in cases of dire need and it is not resorted to
by business houses whose financial condition is sound.
The practice works out somewhat as follows. A merchant desiring to
discount his accounts turns over to the credit company with whom he has made
the arrangement, the invoices of all accounts to be discounted as evidence of the
sales just made to customers. The credit company on the strength of these
invoices advances anywhere from 70% to 80% of their face value, thus
maintaining a margin of safety of from 20% to 30%. The charge made is called
commission rather than interest, and varies from 2% to 5%. To protect the credit
company, frequently such invoices, as they go out to customers, bear a notation
to the effect that payment of the bill is to be made to the credit company and not
to the merchant selling the goods. An obvious and serious objection to this
practice is that it gives the customer information as to the method of financing
to which the seller has been reduced. In view of this objection a few bankers are
date of placing the claim in his hands; his report on his efforts to collect the
account; the lawyer to whom the account is given in case suit is brought; the
attorney’s report; the name and address of the trustee or receiver in case the
customer has gone into bankruptcy; the date of filing a claim with the trustee;
the judgment secured; the particulars as to settlement; and provision for
additional remarks—all this information is of value and provision should be
made to record it. It may also be sometimes desirable to make use of a suspense
journal where information in addition to that for which provision has been made
on the ledger account can be collated and kept for reference.
Accounts Receivable Hypothecated
In connection with the handling of accounts receivable it may be well to
draw attention to the growing practice of discounting open accounts receivable
in much the same way in which notes receivable are discounted. In recent years
a group of non-professional bankers have initiated this kind of financing. It may
sometimes happen that a merchant exhausts his credit with his regular banker
and is unable to raise further necessary funds in the usual way. By applying to
the so-called commercial credit companies or these non-professional bankers it
is frequently possible for him to discount his new accounts as he creates them
through current sales to customers and so secure funds for tiding him over a
temporary stringency. The practice, however, is looked upon in business and
regular banking circles as evidence of the financial instability of the merchant
and his probable bankruptcy in the near future. The cost of raising funds in this
way is almost prohibitive excepting in cases of dire need and it is not resorted to
by business houses whose financial condition is sound.
The practice works out somewhat as follows. A merchant desiring to
discount his accounts turns over to the credit company with whom he has made
the arrangement, the invoices of all accounts to be discounted as evidence of the
sales just made to customers. The credit company on the strength of these
invoices advances anywhere from 70% to 80% of their face value, thus
maintaining a margin of safety of from 20% to 30%. The charge made is called
commission rather than interest, and varies from 2% to 5%. To protect the credit
company, frequently such invoices, as they go out to customers, bear a notation
to the effect that payment of the bill is to be made to the credit company and not
to the merchant selling the goods. An obvious and serious objection to this
practice is that it gives the customer information as to the method of financing
to which the seller has been reduced. In view of this objection a few bankers are
Page 456
willing for payment to be made as usual to the merchant, who must in turn
transfer the identical item or the merchant’s own check for an equivalent
amount to the banker. A periodical settlement with the banker secures from him
a statement and return of the moneys held by way of margin. The accounts as
settled are paid in full to the banker who has previously furnished, say, 70% of
their face value in cash to the merchant. The banker thus holds 30% more
money than he has furnished to the merchant, and as these margins accumulate
it may sometimes happen that the banker is loaning the merchant the latter’s
own money. Consequently, it becomes imperative for the merchant to keep
careful record of all accounts discounted with, and of their payment to, the
banker so that he can protect himself by requiring a settlement as may be shown
necessary.
Accounting for Accounts Receivable Discounted
The accounting procedure in keeping track of these items is very similar to
that for notes receivable discounted. Inasmuch as the practice does not involve
an outright sale of the accounts to the banker, a contingent liability is created in
case the customer does not pay his account, which the merchant will have to
make good to the banker just as in the case of notes receivable unpaid at
maturity. The bookkeeping record of discounted accounts may be considered
under four aspects:
1. At the time of discount.
2. At the time of the banker’s report of customers’
payments.
3. At the time an account is charged back by the banker
because of inability to collect.
4. At the time of final settlement with the bankers.
1. At the time a group of accounts is discounted the charges are to Cash for
the amount of cash received, to Commissions Paid on Discounted Accounts for
the amount of commission, and a charge to the Bankers or to a Bankers’ Margin
account for the margin. The credit offsetting these debits is to an account called
Customers’ Accounts Discounted. No further entry is necessary until the
banker’s report of customers’ payments.
2. At the time an account is reported as paid by the banker, the contingent
liability thereon as carried in the Customers’ Accounts Discounted account has
transfer the identical item or the merchant’s own check for an equivalent
amount to the banker. A periodical settlement with the banker secures from him
a statement and return of the moneys held by way of margin. The accounts as
settled are paid in full to the banker who has previously furnished, say, 70% of
their face value in cash to the merchant. The banker thus holds 30% more
money than he has furnished to the merchant, and as these margins accumulate
it may sometimes happen that the banker is loaning the merchant the latter’s
own money. Consequently, it becomes imperative for the merchant to keep
careful record of all accounts discounted with, and of their payment to, the
banker so that he can protect himself by requiring a settlement as may be shown
necessary.
Accounting for Accounts Receivable Discounted
The accounting procedure in keeping track of these items is very similar to
that for notes receivable discounted. Inasmuch as the practice does not involve
an outright sale of the accounts to the banker, a contingent liability is created in
case the customer does not pay his account, which the merchant will have to
make good to the banker just as in the case of notes receivable unpaid at
maturity. The bookkeeping record of discounted accounts may be considered
under four aspects:
1. At the time of discount.
2. At the time of the banker’s report of customers’
payments.
3. At the time an account is charged back by the banker
because of inability to collect.
4. At the time of final settlement with the bankers.
1. At the time a group of accounts is discounted the charges are to Cash for
the amount of cash received, to Commissions Paid on Discounted Accounts for
the amount of commission, and a charge to the Bankers or to a Bankers’ Margin
account for the margin. The credit offsetting these debits is to an account called
Customers’ Accounts Discounted. No further entry is necessary until the
banker’s report of customers’ payments.
2. At the time an account is reported as paid by the banker, the contingent
liability thereon as carried in the Customers’ Accounts Discounted account has
Page 457
ceased to exist and a reversing entry becomes necessary, Customers’ Accounts
Discounted is charged, and the customer’s account is credited.
3. When an account is not collected and is charged back by the banker, the
contingent liability as carried under Customers’ Accounts Discounted becomes
a real liability which has to be settled by payment to the banker of the amount
of the cash originally advanced by him at the time of discount. At such a time
the entry made will be a debit to Customers’ Accounts Discounted offset by
credits to Cash and to Bankers or Bankers’ Margin account, as the case may be.
4. At the time of final settlement with the bankers, all that remains to be
done is for them to pay over the balance of cash in their hands belonging to the
merchant. This balance of cash is reflected by the amount of margins which
they have demanded at the time of discount. Hence, on the merchant’s books the
transaction will be recorded as a debit to Cash and a credit to Bankers or
Bankers’ Margin account.
In order to keep close track of all accounts under discount it is advisable and
almost necessary to make use of what may be termed a “discounted accounts
register.” Every account, as discounted, should be given a number and entered
in numerical sequence in the register. As an account is paid by the customer and
reported by the banker it should be there shown as paid. The banker at the time
of final settlement must render an accounting for all the accounts not shown as
canceled by the register, either in cash or by a return of the claim against the
customer.
Numbered Accounts
Allotment of Numbers to Accounts
The allotment of a series of numbers to a certain kind of accounts not only
classifies them in an orderly manner by grouping them according to their
resemblances and separating them according to their differences, but the
notation also greatly facilitates locating them and saves much time and effort in
indicating them on vouchers, journal entries, etc. Another advantage is that
posting records may be checked as to their general correctness by an official
who has only a general knowledge of the system. As an illustration, if the asset
accounts have the general classification of 1 and the expense accounts have the
general classification of 9, it needs only a cursory survey of voucher, or ledger
posting data, to see whether an expense item has been charged to a capital
account or vice versa.
Discounted is charged, and the customer’s account is credited.
3. When an account is not collected and is charged back by the banker, the
contingent liability as carried under Customers’ Accounts Discounted becomes
a real liability which has to be settled by payment to the banker of the amount
of the cash originally advanced by him at the time of discount. At such a time
the entry made will be a debit to Customers’ Accounts Discounted offset by
credits to Cash and to Bankers or Bankers’ Margin account, as the case may be.
4. At the time of final settlement with the bankers, all that remains to be
done is for them to pay over the balance of cash in their hands belonging to the
merchant. This balance of cash is reflected by the amount of margins which
they have demanded at the time of discount. Hence, on the merchant’s books the
transaction will be recorded as a debit to Cash and a credit to Bankers or
Bankers’ Margin account.
In order to keep close track of all accounts under discount it is advisable and
almost necessary to make use of what may be termed a “discounted accounts
register.” Every account, as discounted, should be given a number and entered
in numerical sequence in the register. As an account is paid by the customer and
reported by the banker it should be there shown as paid. The banker at the time
of final settlement must render an accounting for all the accounts not shown as
canceled by the register, either in cash or by a return of the claim against the
customer.
Numbered Accounts
Allotment of Numbers to Accounts
The allotment of a series of numbers to a certain kind of accounts not only
classifies them in an orderly manner by grouping them according to their
resemblances and separating them according to their differences, but the
notation also greatly facilitates locating them and saves much time and effort in
indicating them on vouchers, journal entries, etc. Another advantage is that
posting records may be checked as to their general correctness by an official
who has only a general knowledge of the system. As an illustration, if the asset
accounts have the general classification of 1 and the expense accounts have the
general classification of 9, it needs only a cursory survey of voucher, or ledger
posting data, to see whether an expense item has been charged to a capital
account or vice versa.
Page 458
The framework of the classification should be so constructed that any
account, new or old, not already included in the scheme, can be inserted without
disturbing the general order. If this is done, the system can never become
obsolete in the sense of becoming impracticable, because changes can be
inserted in their appropriate place as soon as they occur.
The different schemes or symbols which have been developed from time to
time are the Dewey decimal system with its variations; the mnemonic system;
and a combination of the two. The Dewey decimal system is undoubtedly the
most complete and highly perfected in theory of any, and, as the name indicates,
is a combination of figures and periods giving a symbol of almost unlimited
expansion. The use of figures and symbols offers an infinite number of possible
combinations, but the straight decimal system is in no way practical for general
use, chiefly because a voluminous key is necessary even to interpret the symbol.
The mnemonic system, as its name indicates, was devised for the purpose of
supplying a symbol which would be suggestive and which would indicate the
object that it was intended to identify. The mnemonic symbol consists of a
combination of letters and figures with the occasional use of a period or a dash.
In order to classify completely any object in a large system, according to
general classifications and special subdivisions, it is sometimes necessary to use
five, six, or seven letters to identify one particular piece of machinery. In this
case also, the use of a key becomes a necessity. The mnemonic system pure and
simple is more often used for identifying machinery and tools or other stock,
kept in a factory stock room. It is adapted also to the filing of correspondence.
The two advantages claimed for the mnemonic over the Dewey system are:
1. The letters of the alphabet are used and so give
opportunity for a more rational classification than the
ten possible groups of the decimal system.
2. A system consisting of letters may be made more
easily mnemonic, each letter being, as a rule, the
initial of the term symbolized, and may be recalled to
mind more easily than a number arbitrarily chosen for
that purpose.
The following example shows how easily a machine can be located and
described. If:
M is used for machine
account, new or old, not already included in the scheme, can be inserted without
disturbing the general order. If this is done, the system can never become
obsolete in the sense of becoming impracticable, because changes can be
inserted in their appropriate place as soon as they occur.
The different schemes or symbols which have been developed from time to
time are the Dewey decimal system with its variations; the mnemonic system;
and a combination of the two. The Dewey decimal system is undoubtedly the
most complete and highly perfected in theory of any, and, as the name indicates,
is a combination of figures and periods giving a symbol of almost unlimited
expansion. The use of figures and symbols offers an infinite number of possible
combinations, but the straight decimal system is in no way practical for general
use, chiefly because a voluminous key is necessary even to interpret the symbol.
The mnemonic system, as its name indicates, was devised for the purpose of
supplying a symbol which would be suggestive and which would indicate the
object that it was intended to identify. The mnemonic symbol consists of a
combination of letters and figures with the occasional use of a period or a dash.
In order to classify completely any object in a large system, according to
general classifications and special subdivisions, it is sometimes necessary to use
five, six, or seven letters to identify one particular piece of machinery. In this
case also, the use of a key becomes a necessity. The mnemonic system pure and
simple is more often used for identifying machinery and tools or other stock,
kept in a factory stock room. It is adapted also to the filing of correspondence.
The two advantages claimed for the mnemonic over the Dewey system are:
1. The letters of the alphabet are used and so give
opportunity for a more rational classification than the
ten possible groups of the decimal system.
2. A system consisting of letters may be made more
easily mnemonic, each letter being, as a rule, the
initial of the term symbolized, and may be recalled to
mind more easily than a number arbitrarily chosen for
that purpose.
The following example shows how easily a machine can be located and
described. If:
M is used for machine
Page 459
L for lathes
C for core ramming machines
P for power machines
R for ramming machines
then:
ML would immediately suggest a lathe
MCR a core ramming machine
MPR a power ramming machine
Etc.
Where there are several styles of the same type of machine, numerals may be
added, as MPR₁, MPR₂, etc.
A combination of these two systems which has been applied to large
institutions is characterized by grouping all departments which perform the
same class of service under one letter of the alphabet, and then numbering their
functions. Frederick A. Parkhurst[72] has outlined a very useful system which
may be used in a manufacturing or other plant somewhat as follows. Group A
with subdivisions would include:
1A Accounting Room 1B Sales Department
2A Cost Department 2B Order Department
3A Credit Department 3B Stenographic Department
4A Billing Department
5A Filing Department
Each department of the factory has an arbitrary letter allotted to it and is always
referred to in all records by this letter and number.
The Interstate Commerce Commission uses a numerical system of
numbering accounts by first grouping each class under “general accounts”; then
under each group of general accounts, special accounts called “primary
accounts” are numbered consecutively. These accounts have been analyzed so
minutely that not much leeway is given for inserting new accounts and for this
reason the method is not so elastic as a good classification requires. Thus,
Operating Revenue accounts are classified generally into:
C for core ramming machines
P for power machines
R for ramming machines
then:
ML would immediately suggest a lathe
MCR a core ramming machine
MPR a power ramming machine
Etc.
Where there are several styles of the same type of machine, numerals may be
added, as MPR₁, MPR₂, etc.
A combination of these two systems which has been applied to large
institutions is characterized by grouping all departments which perform the
same class of service under one letter of the alphabet, and then numbering their
functions. Frederick A. Parkhurst[72] has outlined a very useful system which
may be used in a manufacturing or other plant somewhat as follows. Group A
with subdivisions would include:
1A Accounting Room 1B Sales Department
2A Cost Department 2B Order Department
3A Credit Department 3B Stenographic Department
4A Billing Department
5A Filing Department
Each department of the factory has an arbitrary letter allotted to it and is always
referred to in all records by this letter and number.
The Interstate Commerce Commission uses a numerical system of
numbering accounts by first grouping each class under “general accounts”; then
under each group of general accounts, special accounts called “primary
accounts” are numbered consecutively. These accounts have been analyzed so
minutely that not much leeway is given for inserting new accounts and for this
reason the method is not so elastic as a good classification requires. Thus,
Operating Revenue accounts are classified generally into:
Page 460
I Transportation—Rail Line
II Transportation—Water Line
III Incidental
IV Joint Facility
The primary accounts under these general subdivisions are numbered as
follows:
Transportation—Rail Line from #101 to #116
Transportation—Water Line from 121 to 128
Incidental from 131 to 143
Joint Facility from 151 to 152
Operating Expense Accounts are classified under the following general
accounts:
I Maintenance of Way and Structures
II Maintenance of Equipment
III Traffic
IV Transportation—Rail Line
V Transportation—Water Line
VI Miscellaneous Operations
VII General
VIII Transportation for Investment—Cr.
The primary accounts under these are numbered from 201 to 462.
Another numerical method which can be used for general businesses and
which corresponds somewhat to the above is arranged as follows:
100 to 700 Assets and Deferred Charges
800 to 1100 Capital Stock, Liabilities, Reserves, and Surplus
1500 to 2500 Profit and Loss Accounts
The even hundred accounts are the controlling accounts in the general
ledger. The details are carried in subsidiary ledgers and are numbered
consecutively from 101 to 199, etc.
This system also is not so elastic as one constructed on the theory of the
Dewey decimal system, which may be expanded indefinitely without
II Transportation—Water Line
III Incidental
IV Joint Facility
The primary accounts under these general subdivisions are numbered as
follows:
Transportation—Rail Line from #101 to #116
Transportation—Water Line from 121 to 128
Incidental from 131 to 143
Joint Facility from 151 to 152
Operating Expense Accounts are classified under the following general
accounts:
I Maintenance of Way and Structures
II Maintenance of Equipment
III Traffic
IV Transportation—Rail Line
V Transportation—Water Line
VI Miscellaneous Operations
VII General
VIII Transportation for Investment—Cr.
The primary accounts under these are numbered from 201 to 462.
Another numerical method which can be used for general businesses and
which corresponds somewhat to the above is arranged as follows:
100 to 700 Assets and Deferred Charges
800 to 1100 Capital Stock, Liabilities, Reserves, and Surplus
1500 to 2500 Profit and Loss Accounts
The even hundred accounts are the controlling accounts in the general
ledger. The details are carried in subsidiary ledgers and are numbered
consecutively from 101 to 199, etc.
This system also is not so elastic as one constructed on the theory of the
Dewey decimal system, which may be expanded indefinitely without
Page 461
disarranging the system as a whole. First of all the general ledger accounts may
be classified into nine fundamental groups as follows:
1 Asset Accounts
2 Investments and Treasury Securities
3 Prepaid Items
4 Liabilities
5 Accrued Items
6 Valuation Reserves
7 Capital and Surplus
8 Income
9 Expense Accounts
These general groups may be further subdivided indefinitely into groups of
nine, keeping in mind continually that the process of division should be from
general to special and that the progress should be gradual.
1 Asset Accounts
11 Fixed Assets
111 Land
1111 Used and Useful in Operation
11111 Details in Subsidiary Books
1112 Held for Speculative or Investment Purposes
11121 Details in Subsidiary Books
11122
112 Buildings
113 Machinery
114 Tools
115
116
117
118
119
12 Current Assets
be classified into nine fundamental groups as follows:
1 Asset Accounts
2 Investments and Treasury Securities
3 Prepaid Items
4 Liabilities
5 Accrued Items
6 Valuation Reserves
7 Capital and Surplus
8 Income
9 Expense Accounts
These general groups may be further subdivided indefinitely into groups of
nine, keeping in mind continually that the process of division should be from
general to special and that the progress should be gradual.
1 Asset Accounts
11 Fixed Assets
111 Land
1111 Used and Useful in Operation
11111 Details in Subsidiary Books
1112 Held for Speculative or Investment Purposes
11121 Details in Subsidiary Books
11122
112 Buildings
113 Machinery
114 Tools
115
116
117
118
119
12 Current Assets
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121 Cash in Bank
1211 Local Bank
1212 New York Bank
1213 Chicago Bank
122 Petty Cash Fund
123 Notes Receivable
124 Accounts Receivable
125 Merchandise
1251 Inventories
1252 Purchases Raw Material
1253 In Process
1254 Finished Goods
1255
1256
126
127
128
129
8 Income Accounts
81 Sales
811 Merchandise
8112 By Departments, etc.
812 Consignments
8121 Details in Subsidiary Records
9 Expense Accounts
91 Manufacturing
911 Prime
9111 Wages
9112 Freight
912 Manufacturing Expenses
92 Selling Expenses
1211 Local Bank
1212 New York Bank
1213 Chicago Bank
122 Petty Cash Fund
123 Notes Receivable
124 Accounts Receivable
125 Merchandise
1251 Inventories
1252 Purchases Raw Material
1253 In Process
1254 Finished Goods
1255
1256
126
127
128
129
8 Income Accounts
81 Sales
811 Merchandise
8112 By Departments, etc.
812 Consignments
8121 Details in Subsidiary Records
9 Expense Accounts
91 Manufacturing
911 Prime
9111 Wages
9112 Freight
912 Manufacturing Expenses
92 Selling Expenses
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921 Salaries
9211 Details in Subsidiary Records
922 Traveling Expenses
923 Commissions
924 Advertising
925 General Selling
93 Administrative Expenses
94 General Expenses
All accounts under 100 are general ledger accounts, and accounts over 100 are
accounts kept in subsidiary records.
From this outline it is apparent that even though each series is limited to
nine as in the Dewey decimal system, it may be indefinitely expanded to
include a large number of accounts, and will be elastic enough to accommodate
any number of future additions to the system. It also classifies accounts so
definitely that errors in posting are very rare. A skilled bookkeeper would not be
likely to post an income account in any account beginning with 9 for instance.
If this system is used by a large corporation or holding company which
operates branches or factories in different sections of the country, all forming
part of the general system, letters of the alphabet may be allotted to each factory
or branch in addition to the numerical classification. By this means the accounts
of each branch may be kept separate on the books of the head office, but the
corresponding expense accounts will have the same numbers and may be
incorporated in the head office books or balance sheet without any difficulty.
This illustrates the principle of grouping all accounts belonging to the same
classification and separating all accounts which belong to different units of the
same organization.
In establishing a special system of classification for any purpose whatever,
the main points to be kept in mind are that the following requirements shall be
fully met:
1. To enumerate all the kinds of information which may
be classified.
2. To group these items into a limited number of classes.
3. To give each class a definite and unchanging symbol.
9211 Details in Subsidiary Records
922 Traveling Expenses
923 Commissions
924 Advertising
925 General Selling
93 Administrative Expenses
94 General Expenses
All accounts under 100 are general ledger accounts, and accounts over 100 are
accounts kept in subsidiary records.
From this outline it is apparent that even though each series is limited to
nine as in the Dewey decimal system, it may be indefinitely expanded to
include a large number of accounts, and will be elastic enough to accommodate
any number of future additions to the system. It also classifies accounts so
definitely that errors in posting are very rare. A skilled bookkeeper would not be
likely to post an income account in any account beginning with 9 for instance.
If this system is used by a large corporation or holding company which
operates branches or factories in different sections of the country, all forming
part of the general system, letters of the alphabet may be allotted to each factory
or branch in addition to the numerical classification. By this means the accounts
of each branch may be kept separate on the books of the head office, but the
corresponding expense accounts will have the same numbers and may be
incorporated in the head office books or balance sheet without any difficulty.
This illustrates the principle of grouping all accounts belonging to the same
classification and separating all accounts which belong to different units of the
same organization.
In establishing a special system of classification for any purpose whatever,
the main points to be kept in mind are that the following requirements shall be
fully met:
1. To enumerate all the kinds of information which may
be classified.
2. To group these items into a limited number of classes.
3. To give each class a definite and unchanging symbol.
Page 464
4. To provide for expansion of the classification under
each group, and symbolize each subdivision by an
addition to the symbol for the group.
If these general rules are observed, the notation may be numerical or
alphabetical, whichever serves the purposes noted above, and also is most easily
memorized without the use of an elaborate key to interpret the system.
Adjustment of Fire Losses
The Insurance Contract
A fire insurance policy is a contractual engagement, modified by the
conditions stated, to pay or replace, in part or in whole, any loss through fire,
covering the property specified for a definite period. The amount to be paid
cannot exceed the face value of the policy. The main points covered in the
policy are the parties, the property, the risk, the amount, the term, the premium,
and the conditions governing. There are three ways in which the contract may
be terminated, namely: by expiration, cancellation, or forfeiture. Generally the
contract holds good until noon of the day named as the date of expiration.
Therefore, if a fire should break out in the forenoon on that day but the greater
part of the damage were caused after the noon hour, the whole loss would be
covered according to the terms of the policy. The policy can be canceled
immediately by the insured by giving notice to the insurance company. The
latter, however, must give notice and wait five days before the cancellation will
be effective.
In case of cancellation, the premium cost for the expired term is usually
higher proportionately than for the whole term; what is known as the “short
rate” becoming effective. The causes for the forfeiture of the policy are many
and various. Among the reasons are concealment or misrepresentation, or fraud
in connection with taking out the policy or in substantiation of claims for losses
incurred. Some of the parts of the agreement relative to occupancy, vacancy,
change in title, use or allowance of dangerous substances may be the cause.
Then again, neglect of the clauses as to the maintenance of an adequate
sprinkler system, making provisions for watching the building, etc., may lead to
forfeiture.
Requirements in Case of Loss
each group, and symbolize each subdivision by an
addition to the symbol for the group.
If these general rules are observed, the notation may be numerical or
alphabetical, whichever serves the purposes noted above, and also is most easily
memorized without the use of an elaborate key to interpret the system.
Adjustment of Fire Losses
The Insurance Contract
A fire insurance policy is a contractual engagement, modified by the
conditions stated, to pay or replace, in part or in whole, any loss through fire,
covering the property specified for a definite period. The amount to be paid
cannot exceed the face value of the policy. The main points covered in the
policy are the parties, the property, the risk, the amount, the term, the premium,
and the conditions governing. There are three ways in which the contract may
be terminated, namely: by expiration, cancellation, or forfeiture. Generally the
contract holds good until noon of the day named as the date of expiration.
Therefore, if a fire should break out in the forenoon on that day but the greater
part of the damage were caused after the noon hour, the whole loss would be
covered according to the terms of the policy. The policy can be canceled
immediately by the insured by giving notice to the insurance company. The
latter, however, must give notice and wait five days before the cancellation will
be effective.
In case of cancellation, the premium cost for the expired term is usually
higher proportionately than for the whole term; what is known as the “short
rate” becoming effective. The causes for the forfeiture of the policy are many
and various. Among the reasons are concealment or misrepresentation, or fraud
in connection with taking out the policy or in substantiation of claims for losses
incurred. Some of the parts of the agreement relative to occupancy, vacancy,
change in title, use or allowance of dangerous substances may be the cause.
Then again, neglect of the clauses as to the maintenance of an adequate
sprinkler system, making provisions for watching the building, etc., may lead to
forfeiture.
Requirements in Case of Loss
Page 465
When a loss occurs the first thing necessary is to give at once a written
notice to the insurance company and to endeavor to protect the property from
further damage. The next step is to separate the damaged and the undamaged
movable property, and to put these two classes in order so as to facilitate
checking up. Then follows the making out of an inventory giving accurate
details concerning the kind, the amount, the cost, and the damage claimed in
respect to the goods. Upon the arrival of the adjuster of the insurance company,
adjustment may be made immediately, or it may be a protracted affair,
depending on conditions. The insured is required by the terms of the policy to
submit a sworn proof of loss within 60 days. This proof must enumerate the
facts and beliefs of the insured regarding the origin and time of the fire, the
interest the insured has in the property, together with the interest, if any, held by
others, the cash value of each item, the sum total of the loss sustained, the
encumbrances on the property, other insurance, whether valid or not, a copy of
all descriptions and schedules of all the policies, any change in title, use,
occupation, location, possession, or exposure of the property since the issuance
of the policy. It is also required to state by whom and how the insured building
was occupied at the time of the fire. Sometimes the insurance company may
require that this proof be verified by plans or specifications of the building,
machinery, or fixtures that have been destroyed or damaged. At its option, it
may request a certificate from an impartial magistrate or notary public
substantiating the correctness and honesty of the claims presented. It is further
required that the insured keep himself ready to exhibit any remains of the
property in question. He may also be required to submit to an examination
under oath and produce at the option of the insurance company any books of
account, bills and other vouchers, and permit copies or extracts to be made from
them.
Determination of Value of Loss
The insurance policy gives no hard and fast rule regarding the determination
of value. The usual phraseology is: “This Company shall not be liable beyond
the actual cash value of the property at the time any loss or damage occurs and
the loss or damage shall be ascertained or estimated according to such actual
cost value, with the proper deduction for depreciation, however caused, and
shall in no event exceed what it would then cost the insured to repair or replace
the same with material of like kind and quality.”
The insurance company has accordingly the option of using the lower of
two bases of settlement, viz.: (1) actual cash value at the time of the fire; or (2)
notice to the insurance company and to endeavor to protect the property from
further damage. The next step is to separate the damaged and the undamaged
movable property, and to put these two classes in order so as to facilitate
checking up. Then follows the making out of an inventory giving accurate
details concerning the kind, the amount, the cost, and the damage claimed in
respect to the goods. Upon the arrival of the adjuster of the insurance company,
adjustment may be made immediately, or it may be a protracted affair,
depending on conditions. The insured is required by the terms of the policy to
submit a sworn proof of loss within 60 days. This proof must enumerate the
facts and beliefs of the insured regarding the origin and time of the fire, the
interest the insured has in the property, together with the interest, if any, held by
others, the cash value of each item, the sum total of the loss sustained, the
encumbrances on the property, other insurance, whether valid or not, a copy of
all descriptions and schedules of all the policies, any change in title, use,
occupation, location, possession, or exposure of the property since the issuance
of the policy. It is also required to state by whom and how the insured building
was occupied at the time of the fire. Sometimes the insurance company may
require that this proof be verified by plans or specifications of the building,
machinery, or fixtures that have been destroyed or damaged. At its option, it
may request a certificate from an impartial magistrate or notary public
substantiating the correctness and honesty of the claims presented. It is further
required that the insured keep himself ready to exhibit any remains of the
property in question. He may also be required to submit to an examination
under oath and produce at the option of the insurance company any books of
account, bills and other vouchers, and permit copies or extracts to be made from
them.
Determination of Value of Loss
The insurance policy gives no hard and fast rule regarding the determination
of value. The usual phraseology is: “This Company shall not be liable beyond
the actual cash value of the property at the time any loss or damage occurs and
the loss or damage shall be ascertained or estimated according to such actual
cost value, with the proper deduction for depreciation, however caused, and
shall in no event exceed what it would then cost the insured to repair or replace
the same with material of like kind and quality.”
The insurance company has accordingly the option of using the lower of
two bases of settlement, viz.: (1) actual cash value at the time of the fire; or (2)
Page 466
what it would cost the insured party to replace the property lost. The price
which governs, cost or selling, will depend upon the nature of the property. As a
general rule, it is the cost price. For goods which cannot be readily or
advantageously reproduced, like cereals and cotton, the adjustment basis is the
local open market price prevailing immediately before the fire. In adjusting
values, adequate depreciation allowance is made not only for ordinary wear and
tear, but also for losses incidental to changes of fashion, demand, etc.
Adjustment of Differences
Whenever there is a dispute regarding the standards applicable in the
adjustment or a disagreement regarding the method by which the standards are
applied, one or the other of the parties generally invokes the provisions of the
policy for an appraisal. In accordance with the terms of the policy, the insurer
and insured may each appoint an appraiser who in turn selects an umpire. This
official does not act except when called on for a decision if the appraisers
disagree on some point. The appraisers proceed to make a joint appraisement of
the damage caused and the value of the loss. If this appraisal is incorporated in a
written award and signed by the appraisers, it is binding on both parties, and
will be upheld by the courts. This provision is applicable to total and partial
losses, but is limited to questions of value and damage. The appraisers are
generally experts, but may call in any other person to give testimony. They are
not bound by any legal rules of evidence, but may determine their own
procedure.
After the value of the loss has been arrived at, by agreement or appraisal,
the liability as modified by the conditions or limitations comes up for
consideration. There are generally a number of these clauses present in every
policy although they are not always in force. One of these is the pro rata or the
contributing clause. In the standard policy this clause reads as follows: “This
Company shall not be liable under this policy for a greater proportion of any
loss ... than the amount hereby insured shall bear to the whole insurance,
whether valid or not, or by solvent or insolvent insurers covering such
property.” The apportionment of the loss on this basis is often a complicated
affair.
Effect of Coinsurance Clause
Another limitation clause is the “coinsurance,” sometimes called the
“average clause” or “reduced rate” clause. The object of this clause is to make
the relation between value and insurance somewhat more stable and to adjust
which governs, cost or selling, will depend upon the nature of the property. As a
general rule, it is the cost price. For goods which cannot be readily or
advantageously reproduced, like cereals and cotton, the adjustment basis is the
local open market price prevailing immediately before the fire. In adjusting
values, adequate depreciation allowance is made not only for ordinary wear and
tear, but also for losses incidental to changes of fashion, demand, etc.
Adjustment of Differences
Whenever there is a dispute regarding the standards applicable in the
adjustment or a disagreement regarding the method by which the standards are
applied, one or the other of the parties generally invokes the provisions of the
policy for an appraisal. In accordance with the terms of the policy, the insurer
and insured may each appoint an appraiser who in turn selects an umpire. This
official does not act except when called on for a decision if the appraisers
disagree on some point. The appraisers proceed to make a joint appraisement of
the damage caused and the value of the loss. If this appraisal is incorporated in a
written award and signed by the appraisers, it is binding on both parties, and
will be upheld by the courts. This provision is applicable to total and partial
losses, but is limited to questions of value and damage. The appraisers are
generally experts, but may call in any other person to give testimony. They are
not bound by any legal rules of evidence, but may determine their own
procedure.
After the value of the loss has been arrived at, by agreement or appraisal,
the liability as modified by the conditions or limitations comes up for
consideration. There are generally a number of these clauses present in every
policy although they are not always in force. One of these is the pro rata or the
contributing clause. In the standard policy this clause reads as follows: “This
Company shall not be liable under this policy for a greater proportion of any
loss ... than the amount hereby insured shall bear to the whole insurance,
whether valid or not, or by solvent or insolvent insurers covering such
property.” The apportionment of the loss on this basis is often a complicated
affair.
Effect of Coinsurance Clause
Another limitation clause is the “coinsurance,” sometimes called the
“average clause” or “reduced rate” clause. The object of this clause is to make
the relation between value and insurance somewhat more stable and to adjust
Page 467
the rates in accordance with the ascertained probability of big and small losses.
The assumption is that partial losses to the property will also be partial losses to
the insurance company. Rates can be adjusted in the light of the ascertained
probability of the respective occurrence of slight and serious losses, and on the
assumption that partial losses to the property will also be only partial losses to
the insurance company. This clause does not operate to reduce the insured’s
recovery if either the loss or insurance equals or exceeds the named percentage
of value. Where applied, it does so only after any apportionment under the
contribution clause has been determined.
The effect of the coinsurance clause is usually to make the insured a
coinsurer with the company for the difference between an amount limited in the
policy and the face of the policy. The limiting amount is usually 80%, though it
may be any other agreed per cent. The clause in the policy may read somewhat
as follows:
“In consideration of the premium for which this policy is issued, it is
expressly stipulated that in event of loss this company shall be liable for no
greater proportion thereof than the sum hereby insured bears to eighty per cent
of the cash value of the property described herein at the time when such loss
shall happen, nor more than the proportion which this policy bears to the total
insurance.”
Thus, in order to make the insured a coinsurer, in the event of loss the
company’s liability is limited to that proportion which the sum insured bears to
80% of the cash value of the property described in the policy at the time of loss.
Where the loss or the insurance equals or exceeds 80% of the value, the clause
has no effect; when both are less, the insured and the insurer bear the loss in
certain proportions. A few illustrations will show the way in which the liability
of the company is determined. In the case of an 80% coinsurance clause, the
formula by which the liability can be determined is derived as follows:
A = the sum insured, i.e., the face of the policy
B = the amount of the loss
C = the cash value of the property at the time of the loss
L = the liability of the company
Then, in accordance with the provisions of the coinsurance clause,
L= A ×B or AB
The assumption is that partial losses to the property will also be partial losses to
the insurance company. Rates can be adjusted in the light of the ascertained
probability of the respective occurrence of slight and serious losses, and on the
assumption that partial losses to the property will also be only partial losses to
the insurance company. This clause does not operate to reduce the insured’s
recovery if either the loss or insurance equals or exceeds the named percentage
of value. Where applied, it does so only after any apportionment under the
contribution clause has been determined.
The effect of the coinsurance clause is usually to make the insured a
coinsurer with the company for the difference between an amount limited in the
policy and the face of the policy. The limiting amount is usually 80%, though it
may be any other agreed per cent. The clause in the policy may read somewhat
as follows:
“In consideration of the premium for which this policy is issued, it is
expressly stipulated that in event of loss this company shall be liable for no
greater proportion thereof than the sum hereby insured bears to eighty per cent
of the cash value of the property described herein at the time when such loss
shall happen, nor more than the proportion which this policy bears to the total
insurance.”
Thus, in order to make the insured a coinsurer, in the event of loss the
company’s liability is limited to that proportion which the sum insured bears to
80% of the cash value of the property described in the policy at the time of loss.
Where the loss or the insurance equals or exceeds 80% of the value, the clause
has no effect; when both are less, the insured and the insurer bear the loss in
certain proportions. A few illustrations will show the way in which the liability
of the company is determined. In the case of an 80% coinsurance clause, the
formula by which the liability can be determined is derived as follows:
A = the sum insured, i.e., the face of the policy
B = the amount of the loss
C = the cash value of the property at the time of the loss
L = the liability of the company
Then, in accordance with the provisions of the coinsurance clause,
L= A ×B or AB
Page 468
.8C .8C
Three applications of the formula will be illustrated. In the first, both the face of
the policy and the amount of loss are less than 80% of the cash value of the
property. In the second, the policy carries 80% of the value of the property but
the loss is less than 80% of the property value. In the third, while the face of the
policy is less than 80%, the loss is more than 80% of the property value. From
the formula, it is evident that where A is 80% of C, the formula reduces to B;
and where B is 80% of C, it reduces to A. It must be borne in mind, however,
that the insurance company is never liable for more than the amount insured,
i.e., the face of the policy, nor for more than the amount of the loss.
Liability of
Face of Cash Value Amount of Insurance
Policy of Property Loss Company
“A” “C ” “B” “L”
(1) $3,000 $5,000 $2,500 $1,875
(2) 4,000 5,000 2,500 2,500
(3) 3,000 5,000 5,000 3,000
Applying the formula in:
AB 3,000 × 2,500
(1) = = 1,875
.8C .8 of 5,000
AB 4,000 × 2,500
(2) = = 2,500
.8C .8 of 5,000
AB 3,000 × 5,000
(3) = = 3,750
.8C .8 of 5,000
It will be noted in (3) that, inasmuch as the policy is $3,000, only $3,000
can be collected.
When the amount of the liability has been determined, the insurance
company has three options:
Three applications of the formula will be illustrated. In the first, both the face of
the policy and the amount of loss are less than 80% of the cash value of the
property. In the second, the policy carries 80% of the value of the property but
the loss is less than 80% of the property value. In the third, while the face of the
policy is less than 80%, the loss is more than 80% of the property value. From
the formula, it is evident that where A is 80% of C, the formula reduces to B;
and where B is 80% of C, it reduces to A. It must be borne in mind, however,
that the insurance company is never liable for more than the amount insured,
i.e., the face of the policy, nor for more than the amount of the loss.
Liability of
Face of Cash Value Amount of Insurance
Policy of Property Loss Company
“A” “C ” “B” “L”
(1) $3,000 $5,000 $2,500 $1,875
(2) 4,000 5,000 2,500 2,500
(3) 3,000 5,000 5,000 3,000
Applying the formula in:
AB 3,000 × 2,500
(1) = = 1,875
.8C .8 of 5,000
AB 4,000 × 2,500
(2) = = 2,500
.8C .8 of 5,000
AB 3,000 × 5,000
(3) = = 3,750
.8C .8 of 5,000
It will be noted in (3) that, inasmuch as the policy is $3,000, only $3,000
can be collected.
When the amount of the liability has been determined, the insurance
company has three options:
Page 469
1. Payment may be made in cash within 60 days after the
completion of the proof of loss.
2. It may rebuild or replace the property. Notice of such
intention must be given within 30 days from the filing
of proof.
3. It may pay the “sound” value, i.e., the actual cash
value of the property and dispose of what remains of
it for its own account.
In most cases the first method is followed.
Method of Record-Keeping to Facilitate Ready Adjustment
Under the standard contract the insurance company must make adjustment
within 60 days after the report of the loss. Where no differences exist or only
such differences as are capable of easy adjustment between the company and
the insured, payment of the loss is usually made without any delay because of
the advertising value in the community of a quick adjustment of fire losses.
Most of the differences which cause delay in the making of adjustments result
from the inability of the insured to prove satisfactorily the amount of his loss.
Failure to prove loss usually results from a slipshod manner of keeping the
records and a loss of the supporting vouchers. The standard policy provides that
the insurance company may require the production of original bills and
vouchers to establish the cost of the property destroyed. Where these are not
obtainable the process of adjustment may be delayed until data on which to
figure the original cost can be secured which is satisfactory both to the
insurance company and the insured. Accordingly, in order to secure adjustment
of fire losses without delay, the record of all assets should be supported by
original vouchers. Where the asset account is a group account, i.e., one
composed of numerous pieces of property, a subsidiary ledger or register, or
inventory record as it is sometimes called, should be carried, in which appear
the details of the group account. If, then, the assets covered by the group
account are only partially destroyed, it is then possible readily to determine the
cost value of the portion destroyed by comparison with the portion left. In the
case of machinery and tools, furniture and fixtures, delivery equipment, etc., the
use of such a register is particularly advantageous. If the voucher system of
account-keeping is in use, there will be supporting data for all charges to asset
accounts and an examination of these will make it possible to determine the
legitimacy of all such charges.
completion of the proof of loss.
2. It may rebuild or replace the property. Notice of such
intention must be given within 30 days from the filing
of proof.
3. It may pay the “sound” value, i.e., the actual cash
value of the property and dispose of what remains of
it for its own account.
In most cases the first method is followed.
Method of Record-Keeping to Facilitate Ready Adjustment
Under the standard contract the insurance company must make adjustment
within 60 days after the report of the loss. Where no differences exist or only
such differences as are capable of easy adjustment between the company and
the insured, payment of the loss is usually made without any delay because of
the advertising value in the community of a quick adjustment of fire losses.
Most of the differences which cause delay in the making of adjustments result
from the inability of the insured to prove satisfactorily the amount of his loss.
Failure to prove loss usually results from a slipshod manner of keeping the
records and a loss of the supporting vouchers. The standard policy provides that
the insurance company may require the production of original bills and
vouchers to establish the cost of the property destroyed. Where these are not
obtainable the process of adjustment may be delayed until data on which to
figure the original cost can be secured which is satisfactory both to the
insurance company and the insured. Accordingly, in order to secure adjustment
of fire losses without delay, the record of all assets should be supported by
original vouchers. Where the asset account is a group account, i.e., one
composed of numerous pieces of property, a subsidiary ledger or register, or
inventory record as it is sometimes called, should be carried, in which appear
the details of the group account. If, then, the assets covered by the group
account are only partially destroyed, it is then possible readily to determine the
cost value of the portion destroyed by comparison with the portion left. In the
case of machinery and tools, furniture and fixtures, delivery equipment, etc., the
use of such a register is particularly advantageous. If the voucher system of
account-keeping is in use, there will be supporting data for all charges to asset
accounts and an examination of these will make it possible to determine the
legitimacy of all such charges.
Page 470
Another point to be kept in mind if ready adjustment is desired is to make
sure that the policy covering particular property makes a sufficiently definite
statement of the property covered so as to indicate clearly the exact property to
which the policy applies. Oftentimes policies are taken out on buildings with
the description so indefinitely worded that it becomes very difficult, where there
are many buildings, to know just what is covered by any particular policy.
Where policies are taken out covering new equipment as it is purchased, and at
some future time the equipment is moved from building to building, the
problem of allocating the policy with the property covered by it becomes
particularly difficult. To surmount these difficulties it may be wise even to draw
up charts and maps of all buildings and their equipment, indicating on the
insurance policies the particular pieces of property covered by them as shown
on the map. As mentioned above, clear, businesslike records kept by the insured
and properly supported by original data will always make for speedy adjustment
of fire losses.
Adjusting Entries for Fire Losses
To make the books record properly the loss suffered by fire, it is necessary
to set up a special account called “Fire Loss.” To that account will be charged
the full amount of the loss, including any expenses incurred in connection
therewith and also the portion of the unexpired insurance premium which is
canceled by the fire. This account will be credited with the amount of insurance
received or allowed by the insurance company. Stated otherwise, to the account
will be transferred the book value of all property destroyed and all expenses in
connection with the fire. After the account is credited with the amount of
insurance received, the balance shows the net loss suffered by the fire and will
be closed directly into surplus so as not to affect the results of the current
period’s operations. As a rule, at the time of the loss of a fixed asset,
depreciation has accrued from the close of the last fiscal period and this must be
taken into consideration in making the adjustments on the books. The amount of
such accrued depreciation must be charged to the current period’s Depreciation
account because the period must bear its proper proportion of the expense. The
offsetting credit to such charge will be made directly to the asset account rather
than to its Depreciation Reserve account. The depreciation applicable to the
asset destroyed which has accumulated in the past must now be transferred as a
credit to the asset account. After such transfer and entry in the asset account of
the accrued depreciation, the balance of the asset account shows the appraised
value of the asset as at the time of the fire. If this appraised value is accepted as
the true value by the insurance company, no further adjustment is needed and
sure that the policy covering particular property makes a sufficiently definite
statement of the property covered so as to indicate clearly the exact property to
which the policy applies. Oftentimes policies are taken out on buildings with
the description so indefinitely worded that it becomes very difficult, where there
are many buildings, to know just what is covered by any particular policy.
Where policies are taken out covering new equipment as it is purchased, and at
some future time the equipment is moved from building to building, the
problem of allocating the policy with the property covered by it becomes
particularly difficult. To surmount these difficulties it may be wise even to draw
up charts and maps of all buildings and their equipment, indicating on the
insurance policies the particular pieces of property covered by them as shown
on the map. As mentioned above, clear, businesslike records kept by the insured
and properly supported by original data will always make for speedy adjustment
of fire losses.
Adjusting Entries for Fire Losses
To make the books record properly the loss suffered by fire, it is necessary
to set up a special account called “Fire Loss.” To that account will be charged
the full amount of the loss, including any expenses incurred in connection
therewith and also the portion of the unexpired insurance premium which is
canceled by the fire. This account will be credited with the amount of insurance
received or allowed by the insurance company. Stated otherwise, to the account
will be transferred the book value of all property destroyed and all expenses in
connection with the fire. After the account is credited with the amount of
insurance received, the balance shows the net loss suffered by the fire and will
be closed directly into surplus so as not to affect the results of the current
period’s operations. As a rule, at the time of the loss of a fixed asset,
depreciation has accrued from the close of the last fiscal period and this must be
taken into consideration in making the adjustments on the books. The amount of
such accrued depreciation must be charged to the current period’s Depreciation
account because the period must bear its proper proportion of the expense. The
offsetting credit to such charge will be made directly to the asset account rather
than to its Depreciation Reserve account. The depreciation applicable to the
asset destroyed which has accumulated in the past must now be transferred as a
credit to the asset account. After such transfer and entry in the asset account of
the accrued depreciation, the balance of the asset account shows the appraised
value of the asset as at the time of the fire. If this appraised value is accepted as
the true value by the insurance company, no further adjustment is needed and
Page 471
this becomes the figure or amount which is transferred to the Fire Loss account.
If, however, settlement is made on a lesser valuation, in strict theory, the
difference between the book value of the asset and the value accepted as the
basis for settlement should be charged to surplus as an adjustment item
occasioned by insufficient depreciation charges in former periods. Usually,
however, no cognizance is taken of such adjustment and the total book value of
the destroyed asset is charged to Fire Loss account.
If the loss is complete or the insurance company makes a settlement of the
total amount of the policy, the policy is canceled and all unexpired premiums
applicable to it are used up and constitute an additional loss occasioned by fire.
The amount of such unexpired premiums is therefore charged to Fire Loss
account. If settlement is not made for the total amount of the policy, the amount
of the settlement is indorsed on the policy in order to show the amount of
insurance still in force for which the company is liable. The due proportion of
the unexpired premium will be charged off to Fire Loss account. This
proportion will be represented by the ratio of the amount of the settlement to the
face of the policy.
In the case of loss of stock-in-trade by fire it is very necessary to have
available as the basis for determining the value of the merchandise destroyed
the inventory record as at the close of the previous fiscal period. The record of
all purchases, purchase returns, sales, and sales returns from then until the time
of the fire, and the records of previous years, should also be available in order to
determine the average rate of gross profit. If such rate of gross profit is not
available, there must be a rate agreed upon by the insured and the company as
the basis for settlement. The method of determining the value of the goods on
hand at the time of the fire by means of the data just mentioned is explained in
full in Volume I, page 506, under the head of “Book or Estimated Inventories.”
Here also, as in the case of fixed assets, clear, businesslike records lead to a
speedy adjustment of the loss.
If, however, settlement is made on a lesser valuation, in strict theory, the
difference between the book value of the asset and the value accepted as the
basis for settlement should be charged to surplus as an adjustment item
occasioned by insufficient depreciation charges in former periods. Usually,
however, no cognizance is taken of such adjustment and the total book value of
the destroyed asset is charged to Fire Loss account.
If the loss is complete or the insurance company makes a settlement of the
total amount of the policy, the policy is canceled and all unexpired premiums
applicable to it are used up and constitute an additional loss occasioned by fire.
The amount of such unexpired premiums is therefore charged to Fire Loss
account. If settlement is not made for the total amount of the policy, the amount
of the settlement is indorsed on the policy in order to show the amount of
insurance still in force for which the company is liable. The due proportion of
the unexpired premium will be charged off to Fire Loss account. This
proportion will be represented by the ratio of the amount of the settlement to the
face of the policy.
In the case of loss of stock-in-trade by fire it is very necessary to have
available as the basis for determining the value of the merchandise destroyed
the inventory record as at the close of the previous fiscal period. The record of
all purchases, purchase returns, sales, and sales returns from then until the time
of the fire, and the records of previous years, should also be available in order to
determine the average rate of gross profit. If such rate of gross profit is not
available, there must be a rate agreed upon by the insured and the company as
the basis for settlement. The method of determining the value of the goods on
hand at the time of the fire by means of the data just mentioned is explained in
full in Volume I, page 506, under the head of “Book or Estimated Inventories.”
Here also, as in the case of fixed assets, clear, businesslike records lead to a
speedy adjustment of the loss.
Page 472
CHAPTER XXXIII
STATISTICS IN BUSINESS; PRIVATE BOOKS;
JOURNAL VOUCHERS; BUILDING EXPENSES
AND INCOME
Statistics in Business
Value of Business Statistics
Because of the complexity of modern business it is practically
impossible for the management or an executive of a large organization to
rely on personal observations and impressions when formulating plans and
policies. To do so would lead to frequent errors and costly mistakes of
judgment. The human mind cannot adequately grasp the significance of a
multitude of facts in the variety of their occurrence. In consequence many
problems of management are today being solved by the intelligent use of
statistical records or tabulations of past and present operations. By this
means the pertinent facts regarding a business are classified and
summarized, and the analysis of complicated figures and large aggregates is
made possible. The relation of the groups to each other and of each group to
the past, the relation of the unit to the whole, and so on, is best shown by
the tabulation of facts in the form of figures. By reducing the facts to
figures comparisons can easily be made and the proportion of one thing to
another is more accurately presented. By divesting facts from their aspect in
daily life and the caprices of temperament, a truer estimate of tendencies
can be made. Because statistics generally deal with large masses or great
numbers, standards, ratios, and types can easily be established. The
mortality statistics of insurance companies afford a good example of
general averages or ratios that hold true when applied to such an uncertain
proposition as the length of human life. Business statistics, however, cannot
attain this accuracy because facts of a similar kind are not of such frequent
occurrence and consequently the average is not so reliable. But the manager
who is acquainted with the limitations of the statistical method and who
STATISTICS IN BUSINESS; PRIVATE BOOKS;
JOURNAL VOUCHERS; BUILDING EXPENSES
AND INCOME
Statistics in Business
Value of Business Statistics
Because of the complexity of modern business it is practically
impossible for the management or an executive of a large organization to
rely on personal observations and impressions when formulating plans and
policies. To do so would lead to frequent errors and costly mistakes of
judgment. The human mind cannot adequately grasp the significance of a
multitude of facts in the variety of their occurrence. In consequence many
problems of management are today being solved by the intelligent use of
statistical records or tabulations of past and present operations. By this
means the pertinent facts regarding a business are classified and
summarized, and the analysis of complicated figures and large aggregates is
made possible. The relation of the groups to each other and of each group to
the past, the relation of the unit to the whole, and so on, is best shown by
the tabulation of facts in the form of figures. By reducing the facts to
figures comparisons can easily be made and the proportion of one thing to
another is more accurately presented. By divesting facts from their aspect in
daily life and the caprices of temperament, a truer estimate of tendencies
can be made. Because statistics generally deal with large masses or great
numbers, standards, ratios, and types can easily be established. The
mortality statistics of insurance companies afford a good example of
general averages or ratios that hold true when applied to such an uncertain
proposition as the length of human life. Business statistics, however, cannot
attain this accuracy because facts of a similar kind are not of such frequent
occurrence and consequently the average is not so reliable. But the manager
who is acquainted with the limitations of the statistical method and who
Page 473
intelligently understands the business forces with which he is dealing, finds
it sufficiently accurate in the great majority of instances. The frequent and
almost universal use of the sampling method of testing mailing lists, the use
of figures as to the density of population in selling campaigns, and the
increasing use of time studies in factories, show that statistics can be made
to serve as a valuable guide in arriving at important decisions.
Railroad Statistics
Railroad companies have for a long time used statistics to aid them in
interpreting the mass of detail involved in operating over a large area. The
figures are generally grouped into two classes: (1) those showing results of
operations, such as annual reports; and (2) tabulations of operating details.
The latter are devised mainly for the purpose of checking and control.
Another classification, more minute, is the grouping of railroad statistics
according to their nature into:
1. Statistics pertaining to maintenance of roadbed,
track, buildings, signals, etc.
2. Cost of maintaining locomotives, cars, and rolling
stock in general in good condition.
3. Expenses connected with the movement of trains.
4. Expenses in connection with the securing of new
business.
5. Administrative expenses.
By comparing the figures for each group the existing relationship leads to
valuable conclusions.
The compilation of figures showing receipts per passenger, average
journey per passenger, average haul of merchandise, receipts per ton of
freight, relation of cars run to business done, proportion of loaded and
empty car space, cross hauling of empty cars, percentage of empty to
loaded cars, compilations showing cost per passenger mile or ton mile—
these are all valuable and pertinent facts about railroad operation. The most
significant way of stating some facts is by means of figures. This is
especially true of such important and related phases of operation as, for
example, the ratio of the pay-roll to operating revenue, a comparison of the
it sufficiently accurate in the great majority of instances. The frequent and
almost universal use of the sampling method of testing mailing lists, the use
of figures as to the density of population in selling campaigns, and the
increasing use of time studies in factories, show that statistics can be made
to serve as a valuable guide in arriving at important decisions.
Railroad Statistics
Railroad companies have for a long time used statistics to aid them in
interpreting the mass of detail involved in operating over a large area. The
figures are generally grouped into two classes: (1) those showing results of
operations, such as annual reports; and (2) tabulations of operating details.
The latter are devised mainly for the purpose of checking and control.
Another classification, more minute, is the grouping of railroad statistics
according to their nature into:
1. Statistics pertaining to maintenance of roadbed,
track, buildings, signals, etc.
2. Cost of maintaining locomotives, cars, and rolling
stock in general in good condition.
3. Expenses connected with the movement of trains.
4. Expenses in connection with the securing of new
business.
5. Administrative expenses.
By comparing the figures for each group the existing relationship leads to
valuable conclusions.
The compilation of figures showing receipts per passenger, average
journey per passenger, average haul of merchandise, receipts per ton of
freight, relation of cars run to business done, proportion of loaded and
empty car space, cross hauling of empty cars, percentage of empty to
loaded cars, compilations showing cost per passenger mile or ton mile—
these are all valuable and pertinent facts about railroad operation. The most
significant way of stating some facts is by means of figures. This is
especially true of such important and related phases of operation as, for
example, the ratio of the pay-roll to operating revenue, a comparison of the
Page 474
pay-roll of engine men and trainmen with the engine and train mile, or a
comparison of the business done with the pay-roll at each station.
Manufacturing Statistics
Statistics are being increasingly utilized for recording facts in
connection with production, especially in factories where a system of cost-
keeping is in vogue. Various forms and cards are frequently used to collect
the required data which is then grouped or classified in various ways. The
performance of each workman is recorded and the various records are
combined into groups and compared. Statistics as to output, orders on hand
and in process, figures showing idle time, capacity of machines and actual
use, are examples.
Mercantile Statistics
The use of statistics in mercantile establishments is perhaps even more
prevalent than in factories. This is chiefly because factories handle
comparatively few lines, whereas mercantile houses generally carry or deal
in a large number. The figures compiled are generally concerned with one
or more of the following:
1. Sales. The comparison here is by totals, departments,
cash and charge sales, salesmen, territories, lines,
percentages to total, new business, etc.
2. Profits. The same classification is applied as for sales.
Generally discounts and profits are compared.
3. Inventory of stock. Comparison made by cost or
selling price, purchases, quantities sold, used, balance,
percentages of sales, departments, lines, etc.
4. Cost of conducting the business. Comparison made by
classes of expense, departments, percentage of sales, etc.
5. Collection. Comparison made by percentage of sales,
territory, etc.
6. Notes, etc., due. Comparisons made with sales,
territories, lines.
comparison of the business done with the pay-roll at each station.
Manufacturing Statistics
Statistics are being increasingly utilized for recording facts in
connection with production, especially in factories where a system of cost-
keeping is in vogue. Various forms and cards are frequently used to collect
the required data which is then grouped or classified in various ways. The
performance of each workman is recorded and the various records are
combined into groups and compared. Statistics as to output, orders on hand
and in process, figures showing idle time, capacity of machines and actual
use, are examples.
Mercantile Statistics
The use of statistics in mercantile establishments is perhaps even more
prevalent than in factories. This is chiefly because factories handle
comparatively few lines, whereas mercantile houses generally carry or deal
in a large number. The figures compiled are generally concerned with one
or more of the following:
1. Sales. The comparison here is by totals, departments,
cash and charge sales, salesmen, territories, lines,
percentages to total, new business, etc.
2. Profits. The same classification is applied as for sales.
Generally discounts and profits are compared.
3. Inventory of stock. Comparison made by cost or
selling price, purchases, quantities sold, used, balance,
percentages of sales, departments, lines, etc.
4. Cost of conducting the business. Comparison made by
classes of expense, departments, percentage of sales, etc.
5. Collection. Comparison made by percentage of sales,
territory, etc.
6. Notes, etc., due. Comparisons made with sales,
territories, lines.
Page 475
7. Goods returned. Comparisons made with lines,
territories, percentage of sales.
8. Efficiency of employees. Tabulations made showing
profits, percentage on standard of work performed,
comparisons between departments.
9. Advertising. Compilations by departments, mediums,
results, etc.
10. Turnover. Compilations showing total business and
rate of turnover, compared by departments, lines, number of
sales, etc.
11. Cash. Statistics giving receipts and disbursements in
convenient groups.
12. Mark-ups and mark-downs. Statistics by
departments, percentages, etc.
13. Summaries of operation. These are generally
compiled periodically but are carried on continuously as
long as is desirable.
14. Production. Statistics showing amount, completed
work, work in process, orders on hand, time lost, total costs,
unit cost, labor cost, material cost, overhead. All are
classified into groups or further subdivided for comparison.
Each individual manager selects the particular set of facts which he
thinks will best show the trend of the business. The complexity of the
business usually determines the number of reports.
Use of Graphs in the Presentation of Statistics
territories, percentage of sales.
8. Efficiency of employees. Tabulations made showing
profits, percentage on standard of work performed,
comparisons between departments.
9. Advertising. Compilations by departments, mediums,
results, etc.
10. Turnover. Compilations showing total business and
rate of turnover, compared by departments, lines, number of
sales, etc.
11. Cash. Statistics giving receipts and disbursements in
convenient groups.
12. Mark-ups and mark-downs. Statistics by
departments, percentages, etc.
13. Summaries of operation. These are generally
compiled periodically but are carried on continuously as
long as is desirable.
14. Production. Statistics showing amount, completed
work, work in process, orders on hand, time lost, total costs,
unit cost, labor cost, material cost, overhead. All are
classified into groups or further subdivided for comparison.
Each individual manager selects the particular set of facts which he
thinks will best show the trend of the business. The complexity of the
business usually determines the number of reports.
Use of Graphs in the Presentation of Statistics
Page 476
Chart Showing Comparison of Sales
with Cost of Advertising
Long experience or special aptitude may qualify a man to grasp readily
the full significance of statistical compilations in a variety of forms without
the use of charts or graphs. The quicker and surer method, however, in
driving home the essential points of statistics is their graphic presentation.
For the majority of business men the graphic method will accomplish what
statistical tabulation fails to do. While facts are of prime importance, their
method of presentation affects their usefulness and is therefore of greater
importance. The great mass of figures that accountants and efficiency men
only too often present in incomparable form, sometimes far in excess of
requirements, is best classified by means of charts.
Advantages of the Use of Graphs
with Cost of Advertising
Long experience or special aptitude may qualify a man to grasp readily
the full significance of statistical compilations in a variety of forms without
the use of charts or graphs. The quicker and surer method, however, in
driving home the essential points of statistics is their graphic presentation.
For the majority of business men the graphic method will accomplish what
statistical tabulation fails to do. While facts are of prime importance, their
method of presentation affects their usefulness and is therefore of greater
importance. The great mass of figures that accountants and efficiency men
only too often present in incomparable form, sometimes far in excess of
requirements, is best classified by means of charts.
Advantages of the Use of Graphs
Page 477
Chart Showing Comparison of Sales
with Gross Profits
The arguments in favor of the use of charts are that the importance of
written words or figures is apt to be judged from the amount of space used,
or the time spent in writing or compiling them; whereas the graphic method
shows the vital facts in a way which compels attention. The statistics are
easily compared and when figures are visualized in graphic form relations
are seen at once. One week is readily compared with another, one year with
the previous year, one man’s performance with another’s, and so on.
Graphic methods are not only in many cases better but also cheaper.
This is especially true if a number of copies have to be made. It requires
with Gross Profits
The arguments in favor of the use of charts are that the importance of
written words or figures is apt to be judged from the amount of space used,
or the time spent in writing or compiling them; whereas the graphic method
shows the vital facts in a way which compels attention. The statistics are
easily compared and when figures are visualized in graphic form relations
are seen at once. One week is readily compared with another, one year with
the previous year, one man’s performance with another’s, and so on.
Graphic methods are not only in many cases better but also cheaper.
This is especially true if a number of copies have to be made. It requires
Page 478
more work to copy a mass of figures than to draw a few lines or figures by
means of blue-print tracings. If many copies are needed, the photographic
method of reproduction may be used. Then again, in statistical tabulations it
is necessary to rearrange the figures in various orders so as to make
different tabulations comparable.
means of blue-print tracings. If many copies are needed, the photographic
method of reproduction may be used. Then again, in statistical tabulations it
is necessary to rearrange the figures in various orders so as to make
different tabulations comparable.
Page 479
Chart Showing Comparison of Sales, Purchases,
and Sales Salaries
and Sales Salaries
Page 480
Chart Showing Comparison of Sales
with Cost of Sales
Principles of Graph Construction
The following principles should be observed in making graphs:
1. Graphs should be simple so that the full significance is readily seen.
If a chart requires a great deal of study its very purpose is defeated. As a
general rule, only two lines should be used. This is especially true if the
lines are apt to intersect one or more times. If there are a number of
interrelated figures to be presented, it is better to make separate charts on
one sheet or to place them together in some other way.
2. Most statistics can be presented by one or more curves where the
quantity is expressed by the distance of the curve from the base line, and the
time is represented by the horizontal movement of the curve.
with Cost of Sales
Principles of Graph Construction
The following principles should be observed in making graphs:
1. Graphs should be simple so that the full significance is readily seen.
If a chart requires a great deal of study its very purpose is defeated. As a
general rule, only two lines should be used. This is especially true if the
lines are apt to intersect one or more times. If there are a number of
interrelated figures to be presented, it is better to make separate charts on
one sheet or to place them together in some other way.
2. Most statistics can be presented by one or more curves where the
quantity is expressed by the distance of the curve from the base line, and the
time is represented by the horizontal movement of the curve.
Page 481
3. For a curve the vertical scale should be so selected that the zero line
will appear on the diagram. This may require a break in the graph, as shown
on page 585.
4. When the scale represents percentages the 100% line should be
emphasized in some distinctive way.
5. The curves should be sharply distinguished from the ruling of the
paper.
6. The lettering and the figures should be so placed as to be read as
easily from the base as the bottom, or from the right-hand edge of the
diagram as the bottom.
7. The titles should be clear and complete and, if necessary, subtitles
and descriptions should be used.
The illustrations on pages 585-588 show how data lend themselves to
graphic presentation.
Private Books
Purpose and Content
Private books are sometimes kept when it is not desirable for employees
to know certain important data relative to the business. Secrecy then is the
main purpose in their use in a great many businesses. The general
knowledge of certain facts about the business or certain processes or
methods of procedure which belong peculiarly to the business might be
harmful. Where competition is particularly keen between two or more
concerns, instances have been known of the employees of one concern
being the paid agents of the other, thus securing information essential to
underbidding on contracts. It is desirable at times to keep the employees of
a partnership or a corporation in ignorance of the earning capacity of the
business or of any secret contracts covering price agreements that may be in
effect according to which larger rebates are to be allowed one concern than
another. Other items about which it may be necessary to maintain secrecy
are: the valuations at which patents, franchises, and other intangible assets
are carried; partner’s capitals, drawings, and salaries; manufacturing costs;
the method and rate at which the overhead expense is apportioned over the
will appear on the diagram. This may require a break in the graph, as shown
on page 585.
4. When the scale represents percentages the 100% line should be
emphasized in some distinctive way.
5. The curves should be sharply distinguished from the ruling of the
paper.
6. The lettering and the figures should be so placed as to be read as
easily from the base as the bottom, or from the right-hand edge of the
diagram as the bottom.
7. The titles should be clear and complete and, if necessary, subtitles
and descriptions should be used.
The illustrations on pages 585-588 show how data lend themselves to
graphic presentation.
Private Books
Purpose and Content
Private books are sometimes kept when it is not desirable for employees
to know certain important data relative to the business. Secrecy then is the
main purpose in their use in a great many businesses. The general
knowledge of certain facts about the business or certain processes or
methods of procedure which belong peculiarly to the business might be
harmful. Where competition is particularly keen between two or more
concerns, instances have been known of the employees of one concern
being the paid agents of the other, thus securing information essential to
underbidding on contracts. It is desirable at times to keep the employees of
a partnership or a corporation in ignorance of the earning capacity of the
business or of any secret contracts covering price agreements that may be in
effect according to which larger rebates are to be allowed one concern than
another. Other items about which it may be necessary to maintain secrecy
are: the valuations at which patents, franchises, and other intangible assets
are carried; partner’s capitals, drawings, and salaries; manufacturing costs;
the method and rate at which the overhead expense is apportioned over the
Page 482
product; the policy as to the creation of reserves of various sorts; the profit
and loss account; the methods of financing as indicated by notes payable;
and so on.
Operation of Private Books
No particular difficulty is experienced in the keeping of private books.
A full set of records composed of journal, cash book, and ledger, may be
maintained, though there is often no need for a cash book. These records,
while containing essential information about the business, are usually
spoken of as being subsidiary to the general books in the sense that the
general books are operated by an employee who maintains a controlling
account for the private books. In order to gather the material for the
controlling account the books of original entry of the general records must
be provided with additional columns for the private ledger. Any item about
which it is desirable to keep employees in ignorance is simply charged or
credited to private ledger with no explanation on the general books as to its
ultimate disposition. The same item as taken into the private books is, by
means of a journal entry, given its proper disposition, with the offset as a
charge or credit, as the case may be, to a general ledger controlling account
which is carried on the private ledger. These two controlling accounts—the
one on the general ledger with the private ledger, and the one on the private
ledger with the general ledger—are complementary to each other, thus
making both ledgers self-balancing. A consolidation of the two trial
balances, the one from the general ledger and the other from the private
ledger, with both controlling accounts eliminated or treated as canceled
items, is necessary in order to present the full statement of the business.
To illustrate the way in which secrecy covering certain types of
transactions may be maintained, it may be well to trace a few transactions
through the books. Suppose it is desired to make a cash rebate to a favored
customer. The check is drawn payable to private ledger account and run
through the cash book as a charge in the private ledger column, to be posted
ultimately to the private ledger controlling account on the general ledger.
The check is entered as a cash receipt on the private cash book with the
credit to general ledger. A check is then drawn on the private ledger cash
payable to the favored customer, with the proper charge to Sales Rebates
and Allowances or other similarly named account, and posted to that
and loss account; the methods of financing as indicated by notes payable;
and so on.
Operation of Private Books
No particular difficulty is experienced in the keeping of private books.
A full set of records composed of journal, cash book, and ledger, may be
maintained, though there is often no need for a cash book. These records,
while containing essential information about the business, are usually
spoken of as being subsidiary to the general books in the sense that the
general books are operated by an employee who maintains a controlling
account for the private books. In order to gather the material for the
controlling account the books of original entry of the general records must
be provided with additional columns for the private ledger. Any item about
which it is desirable to keep employees in ignorance is simply charged or
credited to private ledger with no explanation on the general books as to its
ultimate disposition. The same item as taken into the private books is, by
means of a journal entry, given its proper disposition, with the offset as a
charge or credit, as the case may be, to a general ledger controlling account
which is carried on the private ledger. These two controlling accounts—the
one on the general ledger with the private ledger, and the one on the private
ledger with the general ledger—are complementary to each other, thus
making both ledgers self-balancing. A consolidation of the two trial
balances, the one from the general ledger and the other from the private
ledger, with both controlling accounts eliminated or treated as canceled
items, is necessary in order to present the full statement of the business.
To illustrate the way in which secrecy covering certain types of
transactions may be maintained, it may be well to trace a few transactions
through the books. Suppose it is desired to make a cash rebate to a favored
customer. The check is drawn payable to private ledger account and run
through the cash book as a charge in the private ledger column, to be posted
ultimately to the private ledger controlling account on the general ledger.
The check is entered as a cash receipt on the private cash book with the
credit to general ledger. A check is then drawn on the private ledger cash
payable to the favored customer, with the proper charge to Sales Rebates
and Allowances or other similarly named account, and posted to that
Page 483
account on the private ledger. In a similar way checks for dividends,
salaries, etc., can be drawn to the order of private ledger and their proper
distribution be shown only on the private books.
At the time of closing the books, if some temporary proprietorship
accounts are carried on the general ledger and some on the private ledger,
those carried on the general ledger are closed off by transfer to the Private
Ledger Controlling account instead of, as usually, to the summary Profit
and Loss account. The adjustment of the books is usually made both on the
general ledger and on the private ledger. If certain fixed assets subject to
depreciation are carried on the general ledger, the adjustment of their values
will have to be made by debit as usual to Depreciation account, with a
credit to the suitable Depreciation Reserve account. This Depreciation
account, of course, is in closing charged to Private Ledger instead of to
Profit and Loss. If the Merchandise Inventory account and the Sales and
Purchases accounts are carried on the general ledger, the cost of goods sold
will be developed as usual on the general ledger and then transferred to the
Private Ledger account. More often, however, most of these adjustments on
account of depreciation reserves and reserve for doubtful accounts and the
merchandise inventories are handled only on the private ledger. The Profit
and Loss account as carried on the private ledger shows the net profit and
usually all appropriations of that profit. The result is that the dividend
accounts, the various reservations of profits, and Surplus account are
handled only on the private books.
The private books are usually kept by the general auditor, the secretary,
or general manager of a corporation, and by one of the partners or a trusted
employee in the case of a partnership.
Journal Vouchers
Need for the Journal Voucher
Since the introduction of special journals to take care of cash, sales, and
purchases, the present-day journal is used principally as a record for
adjusting entries between accounts, the opening and closing entries of the
ledger, and any other unusual transactions for which no other specialized
form of book has been provided. For this reason it is very important that all
salaries, etc., can be drawn to the order of private ledger and their proper
distribution be shown only on the private books.
At the time of closing the books, if some temporary proprietorship
accounts are carried on the general ledger and some on the private ledger,
those carried on the general ledger are closed off by transfer to the Private
Ledger Controlling account instead of, as usually, to the summary Profit
and Loss account. The adjustment of the books is usually made both on the
general ledger and on the private ledger. If certain fixed assets subject to
depreciation are carried on the general ledger, the adjustment of their values
will have to be made by debit as usual to Depreciation account, with a
credit to the suitable Depreciation Reserve account. This Depreciation
account, of course, is in closing charged to Private Ledger instead of to
Profit and Loss. If the Merchandise Inventory account and the Sales and
Purchases accounts are carried on the general ledger, the cost of goods sold
will be developed as usual on the general ledger and then transferred to the
Private Ledger account. More often, however, most of these adjustments on
account of depreciation reserves and reserve for doubtful accounts and the
merchandise inventories are handled only on the private ledger. The Profit
and Loss account as carried on the private ledger shows the net profit and
usually all appropriations of that profit. The result is that the dividend
accounts, the various reservations of profits, and Surplus account are
handled only on the private books.
The private books are usually kept by the general auditor, the secretary,
or general manager of a corporation, and by one of the partners or a trusted
employee in the case of a partnership.
Journal Vouchers
Need for the Journal Voucher
Since the introduction of special journals to take care of cash, sales, and
purchases, the present-day journal is used principally as a record for
adjusting entries between accounts, the opening and closing entries of the
ledger, and any other unusual transactions for which no other specialized
form of book has been provided. For this reason it is very important that all
Page 484
the evidence which may be necessary to explain or to prove the correctness
of an entry, together with the authority for making it, shall be instantly
available in some convenient form. This not only saves much time and
irritation in hunting up scattered data to explain an unusual entry, but it
relieves the bookkeeper of any personal responsibility which might attach
to him for making entries not strictly in accordance with correct accounting
principles. It has been seen in an earlier chapter that the authorization of
cash disbursements by means of the formal voucher gives a valuable control
over cash and the bookkeeping record of it. In like manner, for entries
appearing in the journal, the use of the journal voucher accomplishes these
purposes.
The forms in which journal vouchers are made out vary with the
requirements of each business, but in general they are very simple and
follow the same general principles. Two features are essential: (1) the
voucher must show clearly the purpose for which it is drawn; and (2) it
should provide proper authority, with full explanation of the reasons for
making the entry. The usual form is illustrated below:
of an entry, together with the authority for making it, shall be instantly
available in some convenient form. This not only saves much time and
irritation in hunting up scattered data to explain an unusual entry, but it
relieves the bookkeeper of any personal responsibility which might attach
to him for making entries not strictly in accordance with correct accounting
principles. It has been seen in an earlier chapter that the authorization of
cash disbursements by means of the formal voucher gives a valuable control
over cash and the bookkeeping record of it. In like manner, for entries
appearing in the journal, the use of the journal voucher accomplishes these
purposes.
The forms in which journal vouchers are made out vary with the
requirements of each business, but in general they are very simple and
follow the same general principles. Two features are essential: (1) the
voucher must show clearly the purpose for which it is drawn; and (2) it
should provide proper authority, with full explanation of the reasons for
making the entry. The usual form is illustrated below:
Page 485
Journal Voucher (face)
Journal Voucher (reverse)
The entries at the top of the back of the voucher give information for
filing purposes only. Where the original vouchers are kept in a loose-leaf
Journal Voucher (reverse)
The entries at the top of the back of the voucher give information for
filing purposes only. Where the original vouchers are kept in a loose-leaf
Page 486
binder (thus constituting the journal), only the duplicates, folded lengthwise
and filed in an upright binder, need have the notations made on the back.
Method of Use
The same form of voucher may be used in two ways. A regular journal
may serve as the posting medium to the various ledger accounts affected. In
this case each entry is given a number which corresponds with the number
on the voucher. All the original data and the explanations which are
necessary to authorize the entry are attached to the vouchers which are filed
away by months in numerical order.
The second method is to make out vouchers in duplicate. The original,
with the approval of the proper officials and a brief explanation, is filed in a
loose-leaf binder which constitutes the journal. The duplicate, numbered
like the original, has attached to it all bulky papers, correspondence or other
evidence, and is filed away by months in numerical or alphabetical order,
whichever best serves the purpose of the accountant. This method saves the
time of recopying the debits and credits in a bound book, and also makes it
possible to separate journal entries for use in different posting departments.
There is still some objection to loose-leaf general journals, however,
though it is gradually disappearing with the use of proper safeguards.
Index to Journal Vouchers
If vouchers are filed numerically and it is found advisable to keep an
alphabetical list for the purpose of bringing together all journal vouchers on
one subject or from one firm, a supplementary card index giving year,
month, and voucher number, may be kept which will serve for several years
—as shown below:
and filed in an upright binder, need have the notations made on the back.
Method of Use
The same form of voucher may be used in two ways. A regular journal
may serve as the posting medium to the various ledger accounts affected. In
this case each entry is given a number which corresponds with the number
on the voucher. All the original data and the explanations which are
necessary to authorize the entry are attached to the vouchers which are filed
away by months in numerical order.
The second method is to make out vouchers in duplicate. The original,
with the approval of the proper officials and a brief explanation, is filed in a
loose-leaf binder which constitutes the journal. The duplicate, numbered
like the original, has attached to it all bulky papers, correspondence or other
evidence, and is filed away by months in numerical or alphabetical order,
whichever best serves the purpose of the accountant. This method saves the
time of recopying the debits and credits in a bound book, and also makes it
possible to separate journal entries for use in different posting departments.
There is still some objection to loose-leaf general journals, however,
though it is gradually disappearing with the use of proper safeguards.
Index to Journal Vouchers
If vouchers are filed numerically and it is found advisable to keep an
alphabetical list for the purpose of bringing together all journal vouchers on
one subject or from one firm, a supplementary card index giving year,
month, and voucher number, may be kept which will serve for several years
—as shown below:
Page 487
Card Index for Journal Vouchers
If it is desirable to keep a record of the amounts also, this simple form
may be extended to include voucher numbers and amounts as follows:
Card Index for Journal Vouchers
Content of Voucher
Vouchers for the different journal entries should comprise the following
information: in general, correspondence or memoranda approved by proper
If it is desirable to keep a record of the amounts also, this simple form
may be extended to include voucher numbers and amounts as follows:
Card Index for Journal Vouchers
Content of Voucher
Vouchers for the different journal entries should comprise the following
information: in general, correspondence or memoranda approved by proper
Page 488
authority, which should explain the reason for the entry and refer to the
original charge or item against which the entry applies. Vouchers for
returned purchases should have the following information attached: the
shipment record, the stock record, the credit memorandum from the vendor,
and correspondence or signed memoranda explaining why requirements
were not up to standard.
Monthly depreciation charges should have attached a list of the capital
accounts, the percentage of depreciation charged to each, and the one-
twelfth which applies to the present month.
Adjustments for allowances on contracts should have the reference or
copy of the contract agreement, all correspondence which finally disposes
of the settlement, and references to any other legal or official authority
which was instrumental in effecting the present settlement.
In making unusual deductions or reserves at the time the books are
closed, all the data bearing on the subject should be gathered, or, if this is
not possible, very clear references should be made to the places where such
material may be found. This is important, because investigations may be
made at any time either to readjust or to confirm the entries, or to locate the
responsibility for making them.
Little time is needed to gather all the facts bearing on a transaction at
the time it is entered on the books, but if the present officials are promoted
or leave, it may at a later date take days or weeks to collect the information
necessary to explain the reason for the entries made.
Other Methods of Authorizing Entries
A method sometimes used of authorizing journal entries requires the use
of a loose-leaf journal for its easy operation. Every entry made by the
bookkeeper is sent for approval to the auditor, manager, or other responsible
person. Approval is evidenced by signature or initialing. Where the use of
the formal journal voucher is found to be cumbersome, this method gives
satisfactory results.
Similar to the journal voucher as authority for entry is the debit and
credit slip used for authorizing inter-ledger postings. In a large
establishment where the sales ledger, for instance, is divided alphabetically
among a number of ledger clerks, adjustments as between the different
original charge or item against which the entry applies. Vouchers for
returned purchases should have the following information attached: the
shipment record, the stock record, the credit memorandum from the vendor,
and correspondence or signed memoranda explaining why requirements
were not up to standard.
Monthly depreciation charges should have attached a list of the capital
accounts, the percentage of depreciation charged to each, and the one-
twelfth which applies to the present month.
Adjustments for allowances on contracts should have the reference or
copy of the contract agreement, all correspondence which finally disposes
of the settlement, and references to any other legal or official authority
which was instrumental in effecting the present settlement.
In making unusual deductions or reserves at the time the books are
closed, all the data bearing on the subject should be gathered, or, if this is
not possible, very clear references should be made to the places where such
material may be found. This is important, because investigations may be
made at any time either to readjust or to confirm the entries, or to locate the
responsibility for making them.
Little time is needed to gather all the facts bearing on a transaction at
the time it is entered on the books, but if the present officials are promoted
or leave, it may at a later date take days or weeks to collect the information
necessary to explain the reason for the entries made.
Other Methods of Authorizing Entries
A method sometimes used of authorizing journal entries requires the use
of a loose-leaf journal for its easy operation. Every entry made by the
bookkeeper is sent for approval to the auditor, manager, or other responsible
person. Approval is evidenced by signature or initialing. Where the use of
the formal journal voucher is found to be cumbersome, this method gives
satisfactory results.
Similar to the journal voucher as authority for entry is the debit and
credit slip used for authorizing inter-ledger postings. In a large
establishment where the sales ledger, for instance, is divided alphabetically
among a number of ledger clerks, adjustments as between the different
Page 489
ledgers are usually made by means of these debit and credit slips, which
when properly signed by the head bookkeeper give the authority for making
the necessary ledger entry.
Building Expenses and Income
Allocation of Building Expense
It is purposed here to draw attention to two problems in connection with
the bookkeeping records of buildings owned by the business. The one
problem has to do with the proper allocation of the various building
expenses as between the different departments of a business such as
manufacturing, selling, general administration, etc., and even the
subdepartments within these general classifications. It frequently happens
that the same building is used partially for manufacturing and partially as a
warehouse and sales room, while it may also contain the administrative
offices. Within each of these groups there may be various subdepartments.
A large store may be departmentalized and it may be desirable to show the
results of operation by departments. If cost accounting by departments is
determined upon, it becomes necessary to carry the departmental analysis
beyond the gross profit stage, in which case building expense must be taken
account of and spread equitably over the various departments. Likewise,
within the factory it may be desirable to allocate the item of building
expense over the various departments of storeskeeping, costing, and
production proper, and even a further analysis may be necessary depending
somewhat on the detailed information desired. Where building expense has
to be spread over these various departments and subdepartments, an
equitable basis of distribution must be found. A common basis is the
amount of floor space used by the various departments. This method is not
always fair inasmuch as some portions of the building are subject to heavier
wear and tear, and therefore to heavier maintenance and depreciation
charges, than other portions. Consideration must be taken of all the physical
factors involved in order to secure an equitable distribution of the expense.
Ownership versus Renting
The second problem has to do with the gathering of information as to
the relative advantages of owning or renting a building. The chief elements
when properly signed by the head bookkeeper give the authority for making
the necessary ledger entry.
Building Expenses and Income
Allocation of Building Expense
It is purposed here to draw attention to two problems in connection with
the bookkeeping records of buildings owned by the business. The one
problem has to do with the proper allocation of the various building
expenses as between the different departments of a business such as
manufacturing, selling, general administration, etc., and even the
subdepartments within these general classifications. It frequently happens
that the same building is used partially for manufacturing and partially as a
warehouse and sales room, while it may also contain the administrative
offices. Within each of these groups there may be various subdepartments.
A large store may be departmentalized and it may be desirable to show the
results of operation by departments. If cost accounting by departments is
determined upon, it becomes necessary to carry the departmental analysis
beyond the gross profit stage, in which case building expense must be taken
account of and spread equitably over the various departments. Likewise,
within the factory it may be desirable to allocate the item of building
expense over the various departments of storeskeeping, costing, and
production proper, and even a further analysis may be necessary depending
somewhat on the detailed information desired. Where building expense has
to be spread over these various departments and subdepartments, an
equitable basis of distribution must be found. A common basis is the
amount of floor space used by the various departments. This method is not
always fair inasmuch as some portions of the building are subject to heavier
wear and tear, and therefore to heavier maintenance and depreciation
charges, than other portions. Consideration must be taken of all the physical
factors involved in order to secure an equitable distribution of the expense.
Ownership versus Renting
The second problem has to do with the gathering of information as to
the relative advantages of owning or renting a building. The chief elements
Page 490
of expense which must be met in connection with the ownership of
buildings are maintenance, depreciation, taxes, and insurance. In
determining the relative advantages of ownership or leasing, the item of
interest on investment in buildings must also be taken into consideration. It
is doubtful, however, whether this last item should be brought onto the
books as a cost of ownership. As in the case of a manufactured product, the
item of interest is best handled by means of a statistical record rather than
as an entry upon the financial records of the business.
Methods of Bookkeeping
Two methods of presenting the information on the books are met with.
In the one case, an account is kept with Building Expense and Income to
which are charged all expenses in connection with the building and to
which are credited any items of income, as from subleasing, etc. Instead of
having the one account, separate accounts may be kept and cleared at the
end of the fiscal period through Building Expense and Income account
before transfer to Profit and Loss. The difference between the net cost of
building ownership, as indicated by Building Expense and Income account,
and the market rental value of similar space and accommodations elsewhere
will represent the net advantage or disadvantage of ownership as compared
with leasing. At this point, before making the comparison, it will be
necessary to take into consideration the item of interest on the money
invested.
The second method is simply a variation of the first so far as securing
the information desired is concerned. Under it the Building Maintenance
account is charged with all expenses as above and credited with a fair rental
value as determined by market conditions for similar space elsewhere. The
difference between the charges and credits to the Building Maintenance
account will be an indication of the profit or loss on the policy of the
ownership. A theoretical objection to this last method is that the crediting of
a fair rental to the account makes necessary a charge to a rent account,
which will have to be shown as a charge to some department or phase of
business activity, such as the factory, sales department, etc. As in the case of
interest, the best authority inclines towards treating rent as an item of
financial management rather than as a burden to the other departments of
the business. Practically, however, where the expense of rent is actually
buildings are maintenance, depreciation, taxes, and insurance. In
determining the relative advantages of ownership or leasing, the item of
interest on investment in buildings must also be taken into consideration. It
is doubtful, however, whether this last item should be brought onto the
books as a cost of ownership. As in the case of a manufactured product, the
item of interest is best handled by means of a statistical record rather than
as an entry upon the financial records of the business.
Methods of Bookkeeping
Two methods of presenting the information on the books are met with.
In the one case, an account is kept with Building Expense and Income to
which are charged all expenses in connection with the building and to
which are credited any items of income, as from subleasing, etc. Instead of
having the one account, separate accounts may be kept and cleared at the
end of the fiscal period through Building Expense and Income account
before transfer to Profit and Loss. The difference between the net cost of
building ownership, as indicated by Building Expense and Income account,
and the market rental value of similar space and accommodations elsewhere
will represent the net advantage or disadvantage of ownership as compared
with leasing. At this point, before making the comparison, it will be
necessary to take into consideration the item of interest on the money
invested.
The second method is simply a variation of the first so far as securing
the information desired is concerned. Under it the Building Maintenance
account is charged with all expenses as above and credited with a fair rental
value as determined by market conditions for similar space elsewhere. The
difference between the charges and credits to the Building Maintenance
account will be an indication of the profit or loss on the policy of the
ownership. A theoretical objection to this last method is that the crediting of
a fair rental to the account makes necessary a charge to a rent account,
which will have to be shown as a charge to some department or phase of
business activity, such as the factory, sales department, etc. As in the case of
interest, the best authority inclines towards treating rent as an item of
financial management rather than as a burden to the other departments of
the business. Practically, however, where the expense of rent is actually
Page 491
incurred through the use of a building belonging to outside parties, the
prevailing practice at the present time is to charge rent expense to the
departments using the accommodations. Consistency seems to demand that
both interest and rent be treated in the same way, and handled as financial
management items.
Workmen’s Dwellings and Social Betterment Work
To maintain a fairly constant supply of labor, a corporation frequently
finds it necessary to provide housing accommodations for its employees.
This may be because the concern is located far from a settled community
and outside capital cannot be induced to provide the needed
accommodations. Accordingly, corporations oftentimes spend large sums in
so-called social betterment work, and it is customary for the corporation to
charge a fair rental on workmen’s dwellings. The expense in connection
with such work is to be treated rather as an item of extraordinary expense
just as the income from the corporation’s investment in workmen’s
dwellings must be treated as income outside the regular operations of the
business. The problem here is simply the determination of the proper place
to show the items of expense and income in the profit and loss summary for
the period.
prevailing practice at the present time is to charge rent expense to the
departments using the accommodations. Consistency seems to demand that
both interest and rent be treated in the same way, and handled as financial
management items.
Workmen’s Dwellings and Social Betterment Work
To maintain a fairly constant supply of labor, a corporation frequently
finds it necessary to provide housing accommodations for its employees.
This may be because the concern is located far from a settled community
and outside capital cannot be induced to provide the needed
accommodations. Accordingly, corporations oftentimes spend large sums in
so-called social betterment work, and it is customary for the corporation to
charge a fair rental on workmen’s dwellings. The expense in connection
with such work is to be treated rather as an item of extraordinary expense
just as the income from the corporation’s investment in workmen’s
dwellings must be treated as income outside the regular operations of the
business. The problem here is simply the determination of the proper place
to show the items of expense and income in the profit and loss summary for
the period.
Page 492
CHAPTER XXXIV
THE CONSOLIDATED BALANCE SHEET
AND PROFIT AND LOSS SUMMARY
Purpose and Function
The consolidated balance sheet is a form of statement distinctively American. As indicated in
previous chapters, its use has arisen as a result of the corporation laws of some of the states
which allow the formation of the holding company. This, if strictly a financing company, has a
very simple operating organization. Its chief assets are usually the securities, capital stock and
bonds, of the subsidiary companies which it owns in part or in full. Accordingly, its balance
sheet is comparatively simple; in fact this very simplicity results in giving little information as to
its real financial condition or that of the subsidiaries which it owns. If, however, the holding
company is at the same time both an operating and a financing corporation, all the complexities
encountered in the balance sheet of a manufacturing company will be found on that of the
holding company. However, the financial statement of an operating holding company is not any
more intelligible because of its complexity than that of a purely financing corporation.
The items on the balance sheet of either type of corporation which are evidence of the
activities peculiar to a holding company are, as stated above, the securities of the subsidiary
concerns held by the holding company and whatever advances have been made on open account
to the various subsidiaries in order to provide funds for making extensions or for recouping
losses incurred by the subsidiaries. The principles governing the valuation of the securities of the
holding company have already been stated and explained in Chapter XV. In that chapter were
stated the different applications of the principles of valuation to the three conditions met;
namely, (1) the condition in which the holding company owns the entire capital stock of the
subsidiary; (2) the condition in which a controlling but partial interest only is held; and (3) the
condition in which the holding company is a minority stockholder of the subsidiary. In making
up the balance sheet of the holding company the application of these principles to the valuation
of the holdings of the corporation must be carefully handled. Aside from this problem of
valuation, the balance sheet of the holding company presents no new problems. Such a balance
sheet, however, gives very little information as to the actual financial condition of the
corporation because its finances are tied up so completely with the financial condition of the
various subsidiaries. In order, therefore, to present a statement which will intelligently show the
real condition of the holding company, it becomes necessary to combine or consolidate the
statements of financial condition of all its subsidiaries.
Problem of Partial Ownership
Where the ownership of the subsidiaries is complete, the consolidated balance sheet in which
are brought together all the various assets and liabilities of the subsidiaries, presents a true, full,
and intelligent statement of the financial condition of the holding company. Where, however,
ownership is not complete, in which case there may be majority or minority holdings, the
problem of drawing up a statement which will present the actual condition of the holding
company is more difficult and much more complex. Manifestly, a consolidated balance sheet
THE CONSOLIDATED BALANCE SHEET
AND PROFIT AND LOSS SUMMARY
Purpose and Function
The consolidated balance sheet is a form of statement distinctively American. As indicated in
previous chapters, its use has arisen as a result of the corporation laws of some of the states
which allow the formation of the holding company. This, if strictly a financing company, has a
very simple operating organization. Its chief assets are usually the securities, capital stock and
bonds, of the subsidiary companies which it owns in part or in full. Accordingly, its balance
sheet is comparatively simple; in fact this very simplicity results in giving little information as to
its real financial condition or that of the subsidiaries which it owns. If, however, the holding
company is at the same time both an operating and a financing corporation, all the complexities
encountered in the balance sheet of a manufacturing company will be found on that of the
holding company. However, the financial statement of an operating holding company is not any
more intelligible because of its complexity than that of a purely financing corporation.
The items on the balance sheet of either type of corporation which are evidence of the
activities peculiar to a holding company are, as stated above, the securities of the subsidiary
concerns held by the holding company and whatever advances have been made on open account
to the various subsidiaries in order to provide funds for making extensions or for recouping
losses incurred by the subsidiaries. The principles governing the valuation of the securities of the
holding company have already been stated and explained in Chapter XV. In that chapter were
stated the different applications of the principles of valuation to the three conditions met;
namely, (1) the condition in which the holding company owns the entire capital stock of the
subsidiary; (2) the condition in which a controlling but partial interest only is held; and (3) the
condition in which the holding company is a minority stockholder of the subsidiary. In making
up the balance sheet of the holding company the application of these principles to the valuation
of the holdings of the corporation must be carefully handled. Aside from this problem of
valuation, the balance sheet of the holding company presents no new problems. Such a balance
sheet, however, gives very little information as to the actual financial condition of the
corporation because its finances are tied up so completely with the financial condition of the
various subsidiaries. In order, therefore, to present a statement which will intelligently show the
real condition of the holding company, it becomes necessary to combine or consolidate the
statements of financial condition of all its subsidiaries.
Problem of Partial Ownership
Where the ownership of the subsidiaries is complete, the consolidated balance sheet in which
are brought together all the various assets and liabilities of the subsidiaries, presents a true, full,
and intelligent statement of the financial condition of the holding company. Where, however,
ownership is not complete, in which case there may be majority or minority holdings, the
problem of drawing up a statement which will present the actual condition of the holding
company is more difficult and much more complex. Manifestly, a consolidated balance sheet
Page 493
under either of these latter conditions as to partial ownership cannot be applicable alone to the
holding company, inasmuch as in such a statement there must be included interests over which
the holding company has no direct control or authority.
Because of this difficulty, three different ways of attempting to show the holding company’s
condition are met with. One method makes no attempt to overcome the difficulty but limits itself
to showing simply the balance sheet of the holding company as explained in the early part of this
chapter. A second method consists in showing the balance sheet of the holding company
supported by the separate balance sheets of all of the subsidiary companies. The third method is
the method of the consolidated balance sheet which has just been briefly explained. This last is,
perhaps, the most satisfactory method of the three. The insufficiency of the first method and the
objection to it have been referred to already. The second method gives all essential information
but presents it in such form that it is practically impossible for anyone but a trained student of
finance and accounting to correlate the various parts and arrive at an intelligent understanding of
actual conditions. The stockholder or the outsider is usually completely at a loss to know the
meaning of all the figures and statements presented. Under the third method the data as to the
condition of the various companies are brought together and presented in logical form on the
consolidated balance sheet so that the combined statement shows as clearly as is possible the
condition of the holding company.
Conditions under which Used
It should be clearly understood that the consolidated balance sheet is not a balance sheet of
the holding company except and only when the holding company owns the entire capital stock
of all the subsidiaries. A consolidated balance sheet, therefore, is a statement which presents the
condition of all of the subsidiary companies. If it reflects the condition of the holding company
better than the latter’s balance sheet, then, and then only, should a consolidated balance sheet be
used. A fine distinction must sometimes be drawn to determine when it is more desirable, in the
interests of an accurate showing of condition, to present a consolidated balance sheet rather than
the balance sheet of the holding company, and a delicate appreciation is needed of the various
financial problems involved. When the holding company is not the complete owner but
nevertheless has a controlling interest in all the subsidiaries, the method of the consolidated
balance sheet is usually the better way of showing its financial condition. Where the holding
company, however, holds only minority interests, it is oftentimes open to question as to whether
the consolidated balance sheet gives a true presentation of the facts of financial condition,
especially in view of the fact that the holding company cannot always control the policies of its
subsidiaries.
The Setting Up of the Consolidated Balance Sheet
With this explanation of purpose and function of the consolidated balance sheet, it is
purposed now to draw attention to some of the problems met in drawing up such a statement.
The first essential condition to facilitate the consolidation of the balance sheets of the various
subsidiaries with that of the holding company is that standardized methods of accounting
resulting in a similar classification of accounts and presentation of results be used by all the
subsidiaries. The consolidated statement is then merely a combination of the values of similar
items in all the balance sheets to determine the valuation at which the consolidated items shall
appear.
holding company, inasmuch as in such a statement there must be included interests over which
the holding company has no direct control or authority.
Because of this difficulty, three different ways of attempting to show the holding company’s
condition are met with. One method makes no attempt to overcome the difficulty but limits itself
to showing simply the balance sheet of the holding company as explained in the early part of this
chapter. A second method consists in showing the balance sheet of the holding company
supported by the separate balance sheets of all of the subsidiary companies. The third method is
the method of the consolidated balance sheet which has just been briefly explained. This last is,
perhaps, the most satisfactory method of the three. The insufficiency of the first method and the
objection to it have been referred to already. The second method gives all essential information
but presents it in such form that it is practically impossible for anyone but a trained student of
finance and accounting to correlate the various parts and arrive at an intelligent understanding of
actual conditions. The stockholder or the outsider is usually completely at a loss to know the
meaning of all the figures and statements presented. Under the third method the data as to the
condition of the various companies are brought together and presented in logical form on the
consolidated balance sheet so that the combined statement shows as clearly as is possible the
condition of the holding company.
Conditions under which Used
It should be clearly understood that the consolidated balance sheet is not a balance sheet of
the holding company except and only when the holding company owns the entire capital stock
of all the subsidiaries. A consolidated balance sheet, therefore, is a statement which presents the
condition of all of the subsidiary companies. If it reflects the condition of the holding company
better than the latter’s balance sheet, then, and then only, should a consolidated balance sheet be
used. A fine distinction must sometimes be drawn to determine when it is more desirable, in the
interests of an accurate showing of condition, to present a consolidated balance sheet rather than
the balance sheet of the holding company, and a delicate appreciation is needed of the various
financial problems involved. When the holding company is not the complete owner but
nevertheless has a controlling interest in all the subsidiaries, the method of the consolidated
balance sheet is usually the better way of showing its financial condition. Where the holding
company, however, holds only minority interests, it is oftentimes open to question as to whether
the consolidated balance sheet gives a true presentation of the facts of financial condition,
especially in view of the fact that the holding company cannot always control the policies of its
subsidiaries.
The Setting Up of the Consolidated Balance Sheet
With this explanation of purpose and function of the consolidated balance sheet, it is
purposed now to draw attention to some of the problems met in drawing up such a statement.
The first essential condition to facilitate the consolidation of the balance sheets of the various
subsidiaries with that of the holding company is that standardized methods of accounting
resulting in a similar classification of accounts and presentation of results be used by all the
subsidiaries. The consolidated statement is then merely a combination of the values of similar
items in all the balance sheets to determine the valuation at which the consolidated items shall
appear.
Page 494
On the balance sheets of the various companies certain accounts will appear which represent
intercompany relationships. Thus, on that of the holding company appear the securities which
are represented on the statements of the subsidiaries by their net assets. In other words, the
securities of the holding company are assets represented by the proprietorship items of the
various subsidiaries. Sometimes on the consolidated balance sheet both items are shown. This
results, of course, in an almost exact duplication of items inasmuch as the holding company’s
securities are a statement of the net asset values of the subsidiaries. The better method of
presentation, however, seems to be the elimination of the securities of the holding company
against the proprietorship items of the subsidiaries. It may frequently happen that the values of
these two items to be eliminated are not the same. This will always be the case if the holding
company values its securities either above or below the par of the capital stocks of the
subsidiaries, plus any surplus belonging to the subsidiary at date of purchase by the holding
company.
It is to be presumed that the values at which the securities are held on the books of the
holding company represent the latter’s estimate of the value of its interests in the various
subsidiaries. If this value is more than the net worth of the subsidiary as shown by its capital
stock outstanding and surplus at the time of purchase by the holding company, the difference
between the value at which the securities are carried by the holding company and the net worth
of the subsidiary must represent the value placed by the holding company on the good-will of
the subsidiary. This good-will does not appear, of course, on the books of the subsidiary. Hence,
in consolidating the balance sheet of the subsidiary with that of the holding company, it is
necessary to set up the asset good-will and thus increase the net worth of the subsidiary to the
point where it can be exactly canceled against the value of the securities on the balance sheet of
the holding company. If, however, the value of the securities on the holding company’s books is
less than the net worth of the subsidiary, that condition indicates that in the opinion of the
holding company the assets of the subsidiary as carried on the subsidiary’s books are
overvalued. In this case it becomes necessary, upon consolidation, to set up a depreciation
reserve under suitable title.
The effect of this, so far as the eliminations on the consolidated balance sheet are concerned,
is merely to set up under the title Depreciation Reserve the portion of the subsidiary’s capital
stock—or capital stock and surplus—not canceled by the amount at which the holding company
carries on its books the value of its interest in the subsidiary. Instead of carrying this difference
in values under the title Depreciation Reserve, it is sometimes shown as Capital Surplus. This is
merely another way of saying that the portion of the subsidiary’s capital stock not canceled by
the holding company’s investment in the subsidiary is simply carried on the consolidated
balance sheet under another name. Another method of handling this uncanceled amount is to
carry it into the consolidated balance sheet as a credit to Good-Will account, and so secure a
reduction in the value at which this intangible asset is shown in the balance sheet of the allied
companies. This may sometimes result in reducing the value of good-will to a negligible figure,
or in writing it off the books entirely, or even in showing it with a credit balance. There is little
to choose between the methods; the author prefers the use of the depreciation reserve. The
balance sheets of all of the subsidiaries are in this way consolidated with the balance sheet of the
holding company.
On the consolidated balance sheet as at the date of the purchase of the various subsidiaries,
there will not therefore be shown any item of surplus, inasmuch as the items of surplus on the
balance sheets of the various subsidiaries have been eliminated together with their capital stock
intercompany relationships. Thus, on that of the holding company appear the securities which
are represented on the statements of the subsidiaries by their net assets. In other words, the
securities of the holding company are assets represented by the proprietorship items of the
various subsidiaries. Sometimes on the consolidated balance sheet both items are shown. This
results, of course, in an almost exact duplication of items inasmuch as the holding company’s
securities are a statement of the net asset values of the subsidiaries. The better method of
presentation, however, seems to be the elimination of the securities of the holding company
against the proprietorship items of the subsidiaries. It may frequently happen that the values of
these two items to be eliminated are not the same. This will always be the case if the holding
company values its securities either above or below the par of the capital stocks of the
subsidiaries, plus any surplus belonging to the subsidiary at date of purchase by the holding
company.
It is to be presumed that the values at which the securities are held on the books of the
holding company represent the latter’s estimate of the value of its interests in the various
subsidiaries. If this value is more than the net worth of the subsidiary as shown by its capital
stock outstanding and surplus at the time of purchase by the holding company, the difference
between the value at which the securities are carried by the holding company and the net worth
of the subsidiary must represent the value placed by the holding company on the good-will of
the subsidiary. This good-will does not appear, of course, on the books of the subsidiary. Hence,
in consolidating the balance sheet of the subsidiary with that of the holding company, it is
necessary to set up the asset good-will and thus increase the net worth of the subsidiary to the
point where it can be exactly canceled against the value of the securities on the balance sheet of
the holding company. If, however, the value of the securities on the holding company’s books is
less than the net worth of the subsidiary, that condition indicates that in the opinion of the
holding company the assets of the subsidiary as carried on the subsidiary’s books are
overvalued. In this case it becomes necessary, upon consolidation, to set up a depreciation
reserve under suitable title.
The effect of this, so far as the eliminations on the consolidated balance sheet are concerned,
is merely to set up under the title Depreciation Reserve the portion of the subsidiary’s capital
stock—or capital stock and surplus—not canceled by the amount at which the holding company
carries on its books the value of its interest in the subsidiary. Instead of carrying this difference
in values under the title Depreciation Reserve, it is sometimes shown as Capital Surplus. This is
merely another way of saying that the portion of the subsidiary’s capital stock not canceled by
the holding company’s investment in the subsidiary is simply carried on the consolidated
balance sheet under another name. Another method of handling this uncanceled amount is to
carry it into the consolidated balance sheet as a credit to Good-Will account, and so secure a
reduction in the value at which this intangible asset is shown in the balance sheet of the allied
companies. This may sometimes result in reducing the value of good-will to a negligible figure,
or in writing it off the books entirely, or even in showing it with a credit balance. There is little
to choose between the methods; the author prefers the use of the depreciation reserve. The
balance sheets of all of the subsidiaries are in this way consolidated with the balance sheet of the
holding company.
On the consolidated balance sheet as at the date of the purchase of the various subsidiaries,
there will not therefore be shown any item of surplus, inasmuch as the items of surplus on the
balance sheets of the various subsidiaries have been eliminated together with their capital stock
Page 495
items against the securities on the balance sheet of the holding company. This is as it should be.
Surplus account properly used should represent only profits reserved from operation. The
holding company cannot, therefore, previous to its operation, show any item of surplus even
though the subsidiary companies have accumulated profits which they, of course, are entirely
right in showing under the title Surplus.
A distinction must be made here between what is termed “contributed” surplus and
“operating” surplus. Any corporation, the holding company included, may at the time of its
organization have some portion of its capital represented by contributed or capital surplus. It has
been pointed out that this may arise either through subscription to its stock at a premium, or by a
later donation of stock by its stockholders which, when sold, may be recorded as working capital
surplus or contributed surplus. It is not possible, however, for any corporation, previous to its
operation, to show as a balance sheet item an operating surplus from which it might be possible
to declare dividends.
Showing of Intercompany Accounts
At the time of consolidation, intercompany accounts of various sorts will also appear. The
holding company may have made advances of cash to some of the subsidiaries. These will be
shown on the books of the holding company as open account claims against the subsidiaries,
while on the books of the subsidiaries they appear as increases among the assets—usually cash
or other current items—offset by open liability claims in favor of the holding company. The
account receivable on the holding company’s books should be eliminated against the account
payable on the books of the subsidiary. Similarly, there may be numerous inter-subsidiary
accounts which may be eliminated, the ones against the others. The need for a very careful
classification of accounts receivable in order to separate the claims against trade debtors from
those against allied companies should be emphasized when it is desirable to consolidate balance
sheets on which these various classes of accounts receivable appear.
Showing of Notes Discounted
One kind of intercompany item needs further consideration. A corporation may, as the holder
of the notes of an allied company, have had those notes discounted. On the maker’s books the
notes appear as a liability. On the holder’s books, after discount, the notes will be shown as a
contingent asset offset by a contingent liability of equal amount. Upon consolidation of all the
balance sheets, neither the contingent asset nor liability will appear, being canceled against each
other, but the full liability as maker of the notes must be shown; for now that the notes have
passed into possession of an outsider, the bank, the liability is no longer an intercompany
liability but one for which the consolidated interests are fully liable.
Reconcilement of Current Accounts
Previous to the consolidation of the balance sheets, it is possible that some of the
intercompany accounts may need reconciliation just as any other current accounts. For instance,
Company A may have shipped goods to Company B and have charged B’s account, but A’s
account on B’s records may not yet have been credited because the goods have not yet been
received. All items in transit will require reconciliation. These are all intercompany transactions
which will be eliminated upon consolidation; but to make exact cancellation possible, the
intercompany current accounts on the books of the various companies must be reconciled.
Surplus account properly used should represent only profits reserved from operation. The
holding company cannot, therefore, previous to its operation, show any item of surplus even
though the subsidiary companies have accumulated profits which they, of course, are entirely
right in showing under the title Surplus.
A distinction must be made here between what is termed “contributed” surplus and
“operating” surplus. Any corporation, the holding company included, may at the time of its
organization have some portion of its capital represented by contributed or capital surplus. It has
been pointed out that this may arise either through subscription to its stock at a premium, or by a
later donation of stock by its stockholders which, when sold, may be recorded as working capital
surplus or contributed surplus. It is not possible, however, for any corporation, previous to its
operation, to show as a balance sheet item an operating surplus from which it might be possible
to declare dividends.
Showing of Intercompany Accounts
At the time of consolidation, intercompany accounts of various sorts will also appear. The
holding company may have made advances of cash to some of the subsidiaries. These will be
shown on the books of the holding company as open account claims against the subsidiaries,
while on the books of the subsidiaries they appear as increases among the assets—usually cash
or other current items—offset by open liability claims in favor of the holding company. The
account receivable on the holding company’s books should be eliminated against the account
payable on the books of the subsidiary. Similarly, there may be numerous inter-subsidiary
accounts which may be eliminated, the ones against the others. The need for a very careful
classification of accounts receivable in order to separate the claims against trade debtors from
those against allied companies should be emphasized when it is desirable to consolidate balance
sheets on which these various classes of accounts receivable appear.
Showing of Notes Discounted
One kind of intercompany item needs further consideration. A corporation may, as the holder
of the notes of an allied company, have had those notes discounted. On the maker’s books the
notes appear as a liability. On the holder’s books, after discount, the notes will be shown as a
contingent asset offset by a contingent liability of equal amount. Upon consolidation of all the
balance sheets, neither the contingent asset nor liability will appear, being canceled against each
other, but the full liability as maker of the notes must be shown; for now that the notes have
passed into possession of an outsider, the bank, the liability is no longer an intercompany
liability but one for which the consolidated interests are fully liable.
Reconcilement of Current Accounts
Previous to the consolidation of the balance sheets, it is possible that some of the
intercompany accounts may need reconciliation just as any other current accounts. For instance,
Company A may have shipped goods to Company B and have charged B’s account, but A’s
account on B’s records may not yet have been credited because the goods have not yet been
received. All items in transit will require reconciliation. These are all intercompany transactions
which will be eliminated upon consolidation; but to make exact cancellation possible, the
intercompany current accounts on the books of the various companies must be reconciled.
Page 496
Valuation of Inventory
The problem of the valuation of the stock-in-trade inventory on the consolidated balance
sheet is perhaps the most troublesome. The situation with regard to inventories of stock-in-trade
is often complicated by the fact that the same raw material or partly finished material may pass
through the hands of several companies each doing certain processes upon it. The process of
manufacture may not be completed until the goods are turned over ultimately to the holding
company for sale and final distribution to the consumer. This—or other possible variations of the
procedure—is usually the situation so far as stock-in-trade is concerned. Inasmuch as the various
subsidiaries are independent corporate organizations, the price at which they transfer their
product to the allied subsidiaries is not cost price but a sale price determined, perhaps not by
market conditions, but rather by some fixed policy set by the holding company; although it
frequently happens that market price is the price at which the partially completed product is
turned over to allied subsidiaries. However determined, the price includes an element of profit
which from the standpoint of the holding company is not a realized profit until the goods are
finally disposed of to the outside consumer. Were the manufacture carried out by a single
corporate organization, the product, as it passed through its various stages of manufacture,
would be charged into each succeeding stage at the costs accumulated during preceding stages,
and the element of profit would not need to be considered until the product was ultimately sold
by the holding company.
Thus, the valuation at which the inventory of stock-in-trade is carried on the books of the
various subsidiaries is often inflated by the profit in each case, so that by the time the product
reaches the holding company it may carry a very large element of unrealized profit. While from
the standpoint of each subsidiary company the act of transfer has been legally a sale and
therefore the seller is entitled to a profit on the sale, without which there would be no element of
profit appearing in the operations of each subsidiary company at any time, from the standpoint
of the holding company such transactions are in no sense sales, but are simple transfers from one
process or stage of manufacture to another.
In order to show the true condition as to the value of the inventory of stock-in-trade on the
consolidated balance sheet, it becomes necessary to eliminate these intercompany items of profit
loaded onto the goods at the time of transfer between companies. The figure at which the value
of the consolidated inventories will appear in the consolidated balance sheet should represent the
actual cost figure, as if the entire process of manufacture were carried on under one corporate
organization. The corresponding offset to this reduction in value of the consolidated inventories
will appear as a reduction in the surplus as shown on the consolidated balance sheet.
This principle of inventory valuation should always be applied to the full in the case where
the holding company is the complete owner of all its subsidiaries. It cannot, however, be too
rigorously lived up to under conditions where the holding company may not have absolute
control over the policies of the subsidiary companies. It may sometimes even be modified by the
fact that the product as turned over by one company to another is in such stage of completion
that there is a ready market for it outside that of the allied subsidiaries. The accountant is,
however, treading on somewhat uncertain ground when he attempts to incorporate any element
of profit in the consolidated inventory. Conservative management as adopted by some of our
largest corporations eliminates all elements of profit, and that should be the standard practice.
Only under unusual circumstances and after a very careful consideration of all the conditions
The problem of the valuation of the stock-in-trade inventory on the consolidated balance
sheet is perhaps the most troublesome. The situation with regard to inventories of stock-in-trade
is often complicated by the fact that the same raw material or partly finished material may pass
through the hands of several companies each doing certain processes upon it. The process of
manufacture may not be completed until the goods are turned over ultimately to the holding
company for sale and final distribution to the consumer. This—or other possible variations of the
procedure—is usually the situation so far as stock-in-trade is concerned. Inasmuch as the various
subsidiaries are independent corporate organizations, the price at which they transfer their
product to the allied subsidiaries is not cost price but a sale price determined, perhaps not by
market conditions, but rather by some fixed policy set by the holding company; although it
frequently happens that market price is the price at which the partially completed product is
turned over to allied subsidiaries. However determined, the price includes an element of profit
which from the standpoint of the holding company is not a realized profit until the goods are
finally disposed of to the outside consumer. Were the manufacture carried out by a single
corporate organization, the product, as it passed through its various stages of manufacture,
would be charged into each succeeding stage at the costs accumulated during preceding stages,
and the element of profit would not need to be considered until the product was ultimately sold
by the holding company.
Thus, the valuation at which the inventory of stock-in-trade is carried on the books of the
various subsidiaries is often inflated by the profit in each case, so that by the time the product
reaches the holding company it may carry a very large element of unrealized profit. While from
the standpoint of each subsidiary company the act of transfer has been legally a sale and
therefore the seller is entitled to a profit on the sale, without which there would be no element of
profit appearing in the operations of each subsidiary company at any time, from the standpoint
of the holding company such transactions are in no sense sales, but are simple transfers from one
process or stage of manufacture to another.
In order to show the true condition as to the value of the inventory of stock-in-trade on the
consolidated balance sheet, it becomes necessary to eliminate these intercompany items of profit
loaded onto the goods at the time of transfer between companies. The figure at which the value
of the consolidated inventories will appear in the consolidated balance sheet should represent the
actual cost figure, as if the entire process of manufacture were carried on under one corporate
organization. The corresponding offset to this reduction in value of the consolidated inventories
will appear as a reduction in the surplus as shown on the consolidated balance sheet.
This principle of inventory valuation should always be applied to the full in the case where
the holding company is the complete owner of all its subsidiaries. It cannot, however, be too
rigorously lived up to under conditions where the holding company may not have absolute
control over the policies of the subsidiary companies. It may sometimes even be modified by the
fact that the product as turned over by one company to another is in such stage of completion
that there is a ready market for it outside that of the allied subsidiaries. The accountant is,
however, treading on somewhat uncertain ground when he attempts to incorporate any element
of profit in the consolidated inventory. Conservative management as adopted by some of our
largest corporations eliminates all elements of profit, and that should be the standard practice.
Only under unusual circumstances and after a very careful consideration of all the conditions
Page 497
should the consolidated inventory be carried at any other valuation than that of full
manufacturing cost.
Reserve for Intercompany Profits
In eliminating intercompany profits from the valuation of the inventory, use is sometimes
made of a Reserve for Intercompany Profits account. The reserve is created by a charge against
Surplus. The inflated valuation of the inventory is allowed to stand but it is offset by this reserve
in sufficient amount to reduce its value to a cost basis.
Valuation of Inventory—Minority Interests
An interesting problem arises in handling the consolidated inventories and other similar
items when there are minority interests to be taken into account. To write down the inventory to
a cost basis for the consolidated companies involves a valuation below cost for the subsidiary
companies which purchased the commodities from their allied companies. This is hardly
equitable to the minority interests in those companies, for they are concerned not with what is
the proper basis for valuation on the consolidated balance sheet but rather on their own balance
sheet. Their company as a distinct legal organization has the right to show all the profits arising
out of a valuation of its inventory on its own purchase-cost basis. Recognizing this right, some
accountants advocate carrying the portion of the inventory represented by the ratio of the
minority interests to the whole interests, at the cost price to the subsidiary and writing down the
rest of it to a true cost basis for the consolidated companies. The effect of this is to leave
undisturbed the portion of the subsidiary’s surplus belonging to, or, more strictly, representing
the minority interests. Such a method results in the valuation of the inventory on two different
bases for the consolidated balance sheet—a practice which is objectionable. The more
conservative policy is to write down the whole inventory to a consolidated cost basis, charging
the amount written off against the consolidated company’s surplus. This will leave the minority
interest surplus unaffected by the changed basis of valuation—a desirable thing from the
standpoint of equity to the minority.
Valuation of Liabilities
So far as the liabilities of the corporation are concerned, the values at which these will be
carried on the consolidated balance sheet will be the combined values of all the liabilities of the
subsidiaries, aside from the intercompany accounts payable and other similar items which have
been canceled against the accounts receivable of the subsidiaries and holding company.
Showing of Capital Stock
The showing of the capital stock item on the consolidated balance sheet will depend
somewhat on the degree of ownership of the holding company. If the ownership is partial, in
addition to the capital stock of the holding company a statement must appear of the consolidated
minority interests of the various subsidiaries. This should, of course, be shown separately from
the capital stock of the holding company. This becomes necessary because of the fact that items
which do not belong in full to the holding company have been incorporated with the assets on
the consolidated balance sheet. It is seldom if ever feasible to attempt a separation of the various
asset items on the basis of the degree of ownership of the holding company; hence, the only
offset to the inclusion of asset values not belonging to the holding company is by showing the
outside interest in those assets by means of the minority holdings of capital stock.
manufacturing cost.
Reserve for Intercompany Profits
In eliminating intercompany profits from the valuation of the inventory, use is sometimes
made of a Reserve for Intercompany Profits account. The reserve is created by a charge against
Surplus. The inflated valuation of the inventory is allowed to stand but it is offset by this reserve
in sufficient amount to reduce its value to a cost basis.
Valuation of Inventory—Minority Interests
An interesting problem arises in handling the consolidated inventories and other similar
items when there are minority interests to be taken into account. To write down the inventory to
a cost basis for the consolidated companies involves a valuation below cost for the subsidiary
companies which purchased the commodities from their allied companies. This is hardly
equitable to the minority interests in those companies, for they are concerned not with what is
the proper basis for valuation on the consolidated balance sheet but rather on their own balance
sheet. Their company as a distinct legal organization has the right to show all the profits arising
out of a valuation of its inventory on its own purchase-cost basis. Recognizing this right, some
accountants advocate carrying the portion of the inventory represented by the ratio of the
minority interests to the whole interests, at the cost price to the subsidiary and writing down the
rest of it to a true cost basis for the consolidated companies. The effect of this is to leave
undisturbed the portion of the subsidiary’s surplus belonging to, or, more strictly, representing
the minority interests. Such a method results in the valuation of the inventory on two different
bases for the consolidated balance sheet—a practice which is objectionable. The more
conservative policy is to write down the whole inventory to a consolidated cost basis, charging
the amount written off against the consolidated company’s surplus. This will leave the minority
interest surplus unaffected by the changed basis of valuation—a desirable thing from the
standpoint of equity to the minority.
Valuation of Liabilities
So far as the liabilities of the corporation are concerned, the values at which these will be
carried on the consolidated balance sheet will be the combined values of all the liabilities of the
subsidiaries, aside from the intercompany accounts payable and other similar items which have
been canceled against the accounts receivable of the subsidiaries and holding company.
Showing of Capital Stock
The showing of the capital stock item on the consolidated balance sheet will depend
somewhat on the degree of ownership of the holding company. If the ownership is partial, in
addition to the capital stock of the holding company a statement must appear of the consolidated
minority interests of the various subsidiaries. This should, of course, be shown separately from
the capital stock of the holding company. This becomes necessary because of the fact that items
which do not belong in full to the holding company have been incorporated with the assets on
the consolidated balance sheet. It is seldom if ever feasible to attempt a separation of the various
asset items on the basis of the degree of ownership of the holding company; hence, the only
offset to the inclusion of asset values not belonging to the holding company is by showing the
outside interest in those assets by means of the minority holdings of capital stock.
Page 498
Showing of Surplus
The other element of net worth, i.e., the surplus, will also have to be adjusted in order to give
the best showing of the interest of the various parties therein. This is, of course, the operating
surplus referred to above. The portion of the surplus belonging to the holding company as
indicated by its proportion of ownership in the allied companies will be shown separately from
the portion of surplus belonging to the minority interests. Sometimes when this is relatively
insignificant it is shown as a liability rather than as an item of net worth, on the ground that the
minority has a claim on that surplus and will very probably, in the near future, receive it by way
of dividends. It would seem to be, however, a truer index of the exact status of affairs at the time
of the consolidation, to show the item separately as a portion of surplus in the net worth section
of the balance sheet.
Showing of Deficit
When it becomes necessary to incorporate a deficit rather than a surplus, conservative
practice usually demands that the entire deficit be shown as belonging to the holding company
rather than merely its proportionate share as indicated by its share of ownership in the
subsidiary. This is advisable because an initial deficit is often an indication of the inability of the
company to be operated profitably, in which case the holding company may have to stand
practically the entire deficit.
Showing of Profit and Loss Summary
The consolidated balance sheet should be supported by a consolidated profit and loss
summary. Just as with the balance sheet, a distinction is made between the profit and loss
statement of the holding company and the consolidated profit and loss statement in which are
brought together the summaries of all of the allied companies. If the holding company is
primarily a financing company, its chief source of earnings will be from dividends on the stocks
of the subsidiary companies held by it. The profit and loss summary of the holding company
may be a true reflection of its earning condition for the current year if proper provision has been
made for the losses of the subsidiary companies which have been operated unprofitably. The
information which the holding company’s profit and loss summary gives, however, is not
adequate or sufficient on which to base an intelligent judgment as to whether it is a correct
statement of current operations. Much the same difficulties are met in connection with it as in
connection with the balance sheet of the holding company referred to above. For instance, if,
during a given period, some of the subsidiary companies were operated at a loss or on a narrow
margin of profit but dividends were declared out of surplus earnings accumulated from other
periods, there would be no indication on the profit and loss summary of the holding company as
to the actual conditions under which the earnings of the holding company had been secured. In
other words, there would appear on the profit and loss summary of the holding company as
earnings for the current period items representing accumulated earnings from previous periods.
Thus, the profit and loss summary of the holding company would not give a true reflection
of the earnings for the current period, and furthermore would give no information whereby it
would be possible for an interested party to form any judgment as to the current operations of
the holding company and its subsidiaries. Inasmuch as the holding company usually owns a
majority interest in all the subsidiaries and therefore can dictate their policies, the management
of the holding company is always in possession of the true status of affairs, but the stockholder
or other interested party can form no judgment whatever as to the actual condition. On the profit
The other element of net worth, i.e., the surplus, will also have to be adjusted in order to give
the best showing of the interest of the various parties therein. This is, of course, the operating
surplus referred to above. The portion of the surplus belonging to the holding company as
indicated by its proportion of ownership in the allied companies will be shown separately from
the portion of surplus belonging to the minority interests. Sometimes when this is relatively
insignificant it is shown as a liability rather than as an item of net worth, on the ground that the
minority has a claim on that surplus and will very probably, in the near future, receive it by way
of dividends. It would seem to be, however, a truer index of the exact status of affairs at the time
of the consolidation, to show the item separately as a portion of surplus in the net worth section
of the balance sheet.
Showing of Deficit
When it becomes necessary to incorporate a deficit rather than a surplus, conservative
practice usually demands that the entire deficit be shown as belonging to the holding company
rather than merely its proportionate share as indicated by its share of ownership in the
subsidiary. This is advisable because an initial deficit is often an indication of the inability of the
company to be operated profitably, in which case the holding company may have to stand
practically the entire deficit.
Showing of Profit and Loss Summary
The consolidated balance sheet should be supported by a consolidated profit and loss
summary. Just as with the balance sheet, a distinction is made between the profit and loss
statement of the holding company and the consolidated profit and loss statement in which are
brought together the summaries of all of the allied companies. If the holding company is
primarily a financing company, its chief source of earnings will be from dividends on the stocks
of the subsidiary companies held by it. The profit and loss summary of the holding company
may be a true reflection of its earning condition for the current year if proper provision has been
made for the losses of the subsidiary companies which have been operated unprofitably. The
information which the holding company’s profit and loss summary gives, however, is not
adequate or sufficient on which to base an intelligent judgment as to whether it is a correct
statement of current operations. Much the same difficulties are met in connection with it as in
connection with the balance sheet of the holding company referred to above. For instance, if,
during a given period, some of the subsidiary companies were operated at a loss or on a narrow
margin of profit but dividends were declared out of surplus earnings accumulated from other
periods, there would be no indication on the profit and loss summary of the holding company as
to the actual conditions under which the earnings of the holding company had been secured. In
other words, there would appear on the profit and loss summary of the holding company as
earnings for the current period items representing accumulated earnings from previous periods.
Thus, the profit and loss summary of the holding company would not give a true reflection
of the earnings for the current period, and furthermore would give no information whereby it
would be possible for an interested party to form any judgment as to the current operations of
the holding company and its subsidiaries. Inasmuch as the holding company usually owns a
majority interest in all the subsidiaries and therefore can dictate their policies, the management
of the holding company is always in possession of the true status of affairs, but the stockholder
or other interested party can form no judgment whatever as to the actual condition. On the profit
Page 499
and loss statement of the holding company there will be no data as to gross earnings, operating
expenses, fixed charges, or miscellaneous income and expense items reflecting the operating
conditions of the various subsidiaries. Furthermore, if a subsidiary company has been operating
at a loss and has declared no dividend, the absence of that item of earnings from the profit and
loss summary of the holding company would not be necessarily a proper reflection of the
condition of the subsidiary on the holding company’s summary. It might be necessary, in order
properly to show the true condition of affairs, to make provision by way of a reserve for the loss
of the subsidiary.
Again, it becomes very easy, if control of the holding company is in the hands of an
unscrupulous clique, to understate the profits of the holding company by refusal to declare such
a dividend on the part of each subsidiary as will reflect the true earnings of the subsidiary for the
current period. Such a policy may be used for the purpose of manipulating the stocks of the
various companies.
The Consolidated Profit and Loss Summary
For these reasons and others of the same kind as those mentioned in connection with the
balance sheet of the holding company, it is best, in order to give an intelligent showing of
condition, to set up a consolidated profit and loss account. The comment made on the
consolidated balance sheet is here pertinent also. It is not a profit and loss account of the holding
company for it includes also items representing other interests. In some respects it is an
unwieldy instrument, but it seems to be the best way in which to show the actual condition of the
holding company’s operations. On the consolidated profit and loss summary the earnings from
dividends which appear as the chief source of the holding company’s earnings on its profit and
loss summary will be eliminated and in their stead will appear the combined earnings of the
allied companies. This might seem to be an inflation of earnings inasmuch as the goods which
were sold by one company and are recorded by it as earnings will be resold by another company
on whose books they will appear also as earnings. The sale of the same goods may thus appear
as earnings in many of the subsidiaries. However, such a showing of combined results does
provide a true basis on which to judge earnings in comparison with the values invested by the
various companies from the use of which values the earnings have been derived. Similarly, on
the consolidated profit and loss statement will appear all the operating expenses and other items
belonging to the individual profit and loss summaries of the subsidiaries. As it is necessary on
the consolidated balance sheet to make some adjustments in the surplus on account of the
unrealized elements of profits in the values at which the combined inventories were taken over,
so this same adjustment will perhaps be best handled as an appropriation of profits in the last
section of the consolidated profit and loss summary.
If the holding company owns all of the stock of the subsidiaries, a true profit and loss
summary with no inflated values should be drawn up. In this there will appear only the sales to
outside consumers; no intercompany sales should be shown. The cost of goods sold will be
determined on the same basis, viz., the basis of cost from the standpoint of the consolidated
companies as a unit organization, all intercompany profits being eliminated. All the expenses of
the subsidiaries are loaded onto, and therefore absorbed in, the cost of the goods sold by the
holding company. Usually only the holding company’s expenses—selling, general
administrative, etc.—will appear as such on the consolidated profit and loss summary. Where,
however, there are minority interests to be taken into account, the method of combining all the
elements is doubtless the most satisfactory.
expenses, fixed charges, or miscellaneous income and expense items reflecting the operating
conditions of the various subsidiaries. Furthermore, if a subsidiary company has been operating
at a loss and has declared no dividend, the absence of that item of earnings from the profit and
loss summary of the holding company would not be necessarily a proper reflection of the
condition of the subsidiary on the holding company’s summary. It might be necessary, in order
properly to show the true condition of affairs, to make provision by way of a reserve for the loss
of the subsidiary.
Again, it becomes very easy, if control of the holding company is in the hands of an
unscrupulous clique, to understate the profits of the holding company by refusal to declare such
a dividend on the part of each subsidiary as will reflect the true earnings of the subsidiary for the
current period. Such a policy may be used for the purpose of manipulating the stocks of the
various companies.
The Consolidated Profit and Loss Summary
For these reasons and others of the same kind as those mentioned in connection with the
balance sheet of the holding company, it is best, in order to give an intelligent showing of
condition, to set up a consolidated profit and loss account. The comment made on the
consolidated balance sheet is here pertinent also. It is not a profit and loss account of the holding
company for it includes also items representing other interests. In some respects it is an
unwieldy instrument, but it seems to be the best way in which to show the actual condition of the
holding company’s operations. On the consolidated profit and loss summary the earnings from
dividends which appear as the chief source of the holding company’s earnings on its profit and
loss summary will be eliminated and in their stead will appear the combined earnings of the
allied companies. This might seem to be an inflation of earnings inasmuch as the goods which
were sold by one company and are recorded by it as earnings will be resold by another company
on whose books they will appear also as earnings. The sale of the same goods may thus appear
as earnings in many of the subsidiaries. However, such a showing of combined results does
provide a true basis on which to judge earnings in comparison with the values invested by the
various companies from the use of which values the earnings have been derived. Similarly, on
the consolidated profit and loss statement will appear all the operating expenses and other items
belonging to the individual profit and loss summaries of the subsidiaries. As it is necessary on
the consolidated balance sheet to make some adjustments in the surplus on account of the
unrealized elements of profits in the values at which the combined inventories were taken over,
so this same adjustment will perhaps be best handled as an appropriation of profits in the last
section of the consolidated profit and loss summary.
If the holding company owns all of the stock of the subsidiaries, a true profit and loss
summary with no inflated values should be drawn up. In this there will appear only the sales to
outside consumers; no intercompany sales should be shown. The cost of goods sold will be
determined on the same basis, viz., the basis of cost from the standpoint of the consolidated
companies as a unit organization, all intercompany profits being eliminated. All the expenses of
the subsidiaries are loaded onto, and therefore absorbed in, the cost of the goods sold by the
holding company. Usually only the holding company’s expenses—selling, general
administrative, etc.—will appear as such on the consolidated profit and loss summary. Where,
however, there are minority interests to be taken into account, the method of combining all the
elements is doubtless the most satisfactory.
Page 500
Illustration of Consolidated Balance Sheet
Problem. Company X, the holding company, owns all of the capital stock of Company Z and
60% of the stock of Company Y. Company X is chiefly the financing company, Company Y is
the selling company, while Company Z manufactures the commodities and turns them over to
Company Y at a price slightly under the market. The following balance sheets of the several
companies show their condition at the close of the fiscal period. Company Z records show that
the cost of the merchandise carried on the balance sheet of Company Y at $75,000 is $60,000. It
is required to draw up a consolidated balance sheet of the affiliated companies.
Company X—Balance Sheet
Cash $ 50,000.00 Notes Payable $ 100,000.00
Notes Receivable Y 100,000.00 Bonds 500,000.00
Advances to Z 250,000.00 Capital Stock 1,000,000.00
Stock Y 300,000.00 Surplus 250,000.00
Stock Z 550,000.00
Patents 500,000.00
Other Property 100,000.00
$1,850,000.00 $1,850,000.00
Company Y—Balance Sheet
Cash $ 25,000.00 Notes Payable X $100,000.00
Accounts Receivable 125,000.00 Accounts Payable 25,000.00
Notes Receivable 100,000.00 Bonds 75,000.00
Notes Receivable Z 50,000.00 Capital Stock 500,000.00
Z (open account) 50,000.00 Surplus 25,000.00
Merchandise 75,000.00
Plant 300,000.00
$725,000.00 $725,000.00
Company Z—Balance Sheet
Cash $ 40,000.00 Company X
Accounts Receivable 180,000.00 (open account) $250,000.00
Notes Receivable 230,000.00 Notes Payable Y 50,000.00
Merchandise 150,000.00 Company Y
Plant 350,000.00 (open account) 50,000.00
Capital Stock 450,000.00
Problem. Company X, the holding company, owns all of the capital stock of Company Z and
60% of the stock of Company Y. Company X is chiefly the financing company, Company Y is
the selling company, while Company Z manufactures the commodities and turns them over to
Company Y at a price slightly under the market. The following balance sheets of the several
companies show their condition at the close of the fiscal period. Company Z records show that
the cost of the merchandise carried on the balance sheet of Company Y at $75,000 is $60,000. It
is required to draw up a consolidated balance sheet of the affiliated companies.
Company X—Balance Sheet
Cash $ 50,000.00 Notes Payable $ 100,000.00
Notes Receivable Y 100,000.00 Bonds 500,000.00
Advances to Z 250,000.00 Capital Stock 1,000,000.00
Stock Y 300,000.00 Surplus 250,000.00
Stock Z 550,000.00
Patents 500,000.00
Other Property 100,000.00
$1,850,000.00 $1,850,000.00
Company Y—Balance Sheet
Cash $ 25,000.00 Notes Payable X $100,000.00
Accounts Receivable 125,000.00 Accounts Payable 25,000.00
Notes Receivable 100,000.00 Bonds 75,000.00
Notes Receivable Z 50,000.00 Capital Stock 500,000.00
Z (open account) 50,000.00 Surplus 25,000.00
Merchandise 75,000.00
Plant 300,000.00
$725,000.00 $725,000.00
Company Z—Balance Sheet
Cash $ 40,000.00 Company X
Accounts Receivable 180,000.00 (open account) $250,000.00
Notes Receivable 230,000.00 Notes Payable Y 50,000.00
Merchandise 150,000.00 Company Y
Plant 350,000.00 (open account) 50,000.00
Capital Stock 450,000.00
Page 501
Surplus 150,000.00
$950,000.00 $950,000.00
Solution
Working Sheet
Assets Co. X Co. Y Co. Z
Cash $ 50,000.00 $ 25,000.00 $ 40,000.00
Notes Receivable 100,000.00 230,000.00
Notes Receivable Y 100,000.00
Notes Receivable Z 50,000.00
Accounts Receivable 125,000.00 180,000.00
Advances to Z 250,000.00
Co. Z (open account) 50,000.00
Stock Y 300,000.00
Stock Z 550,000.00 550,000.00
Merchandise 75,000.00 150,000.00
Patents 500,000.00
Other Property 100,000.00
Plant 300,000.00 350,000.00
Good-Will
$1,850,000.00 $725,000.00 $950,000.00
Liabilities and Capital
Notes Payable $ 100,000.00 $......... $.........
Notes Payable X 100,000.00
Notes Payable Y 50,000.00
Accounts Payable 25,000.00
Co. X (open account) 250,000.00
Co. Y (open account) 50,000.00
Bonds 500,000.00 75,000.00
Capital Stock 1,000,000.00 500,000.00 450,000.00
Surplus 250,000.00 25,000.00 150,000.00
$1,850,000.00 $725,000.00 $950,000.00
$950,000.00 $950,000.00
Solution
Working Sheet
Assets Co. X Co. Y Co. Z
Cash $ 50,000.00 $ 25,000.00 $ 40,000.00
Notes Receivable 100,000.00 230,000.00
Notes Receivable Y 100,000.00
Notes Receivable Z 50,000.00
Accounts Receivable 125,000.00 180,000.00
Advances to Z 250,000.00
Co. Z (open account) 50,000.00
Stock Y 300,000.00
Stock Z 550,000.00 550,000.00
Merchandise 75,000.00 150,000.00
Patents 500,000.00
Other Property 100,000.00
Plant 300,000.00 350,000.00
Good-Will
$1,850,000.00 $725,000.00 $950,000.00
Liabilities and Capital
Notes Payable $ 100,000.00 $......... $.........
Notes Payable X 100,000.00
Notes Payable Y 50,000.00
Accounts Payable 25,000.00
Co. X (open account) 250,000.00
Co. Y (open account) 50,000.00
Bonds 500,000.00 75,000.00
Capital Stock 1,000,000.00 500,000.00 450,000.00
Surplus 250,000.00 25,000.00 150,000.00
$1,850,000.00 $725,000.00 $950,000.00
Page 502
Assets Combined Elimination Consolidated
Cash $ 115,000.00 $ 115,000.00
Notes Receivable 330,000.00 330,000.00
Notes Receivable Y 100,000.00 (a) 100,000.00
Notes Receivable Z 50,000.00 (b) 50,000.00
Accounts Receivable 305,000.00 305,000.00
Advances to Z 250,000.00 (c) 250,000.00
Co. Z (open account) 50,000.00 (d) 50,000.00
Stock Y 300,000.00 (e) 300,000.00
Stock Z (f) 550,000.00
Merchandise 225,000.00 (g)[73] 15,000.00 210,000.00
Patents 500,000.00 500,000.00
Other Property 100,000.00 100,000.00
Plant 650,000.00 650,000.00
Good-Will (f)[74] 100,000.00 100,000.00
$3,525,000.00 $1,215,000.00 $2,310,000.00
Liabilities and Capital
Notes Payable $ 100,000.00 $......... $ 100,000.00
Notes Payable X 100,000.00 (a) 100,000.00
Notes Payable Y 50,000.00 (b) 50,000.00
Accounts Payable 25,000.00 25,000.00
Co. X (open account) 250,000.00 (c) 250,000.00
Co. Y (open account) 50,000.00 (d) 50,000.00
Bonds 575,000.00 575,000.00
Capital Stock 1,950,000.00 (e) 300,000.00 1,000,000.00
(f) 450,000.00 200,000.00
Surplus 425,000.00 (g) 15,000.00 410,000.00
$3,525,000.00 $1,215,000.00 $2,310,000.00
Company X and its Subsidiaries
Consolidated Balance Sheet
Assets Liabilities and Capital
Cash $ 115,000.00 Notes Payable $ 100,000.00
Notes Receivable 330,000.00 Accounts Payable 25,000.00
Cash $ 115,000.00 $ 115,000.00
Notes Receivable 330,000.00 330,000.00
Notes Receivable Y 100,000.00 (a) 100,000.00
Notes Receivable Z 50,000.00 (b) 50,000.00
Accounts Receivable 305,000.00 305,000.00
Advances to Z 250,000.00 (c) 250,000.00
Co. Z (open account) 50,000.00 (d) 50,000.00
Stock Y 300,000.00 (e) 300,000.00
Stock Z (f) 550,000.00
Merchandise 225,000.00 (g)[73] 15,000.00 210,000.00
Patents 500,000.00 500,000.00
Other Property 100,000.00 100,000.00
Plant 650,000.00 650,000.00
Good-Will (f)[74] 100,000.00 100,000.00
$3,525,000.00 $1,215,000.00 $2,310,000.00
Liabilities and Capital
Notes Payable $ 100,000.00 $......... $ 100,000.00
Notes Payable X 100,000.00 (a) 100,000.00
Notes Payable Y 50,000.00 (b) 50,000.00
Accounts Payable 25,000.00 25,000.00
Co. X (open account) 250,000.00 (c) 250,000.00
Co. Y (open account) 50,000.00 (d) 50,000.00
Bonds 575,000.00 575,000.00
Capital Stock 1,950,000.00 (e) 300,000.00 1,000,000.00
(f) 450,000.00 200,000.00
Surplus 425,000.00 (g) 15,000.00 410,000.00
$3,525,000.00 $1,215,000.00 $2,310,000.00
Company X and its Subsidiaries
Consolidated Balance Sheet
Assets Liabilities and Capital
Cash $ 115,000.00 Notes Payable $ 100,000.00
Notes Receivable 330,000.00 Accounts Payable 25,000.00
Page 503
Accounts Receivable 305,000.00 Bonds 575,000.00
Merchandise 210,000.00 Total Liabilities. $700,000.00
Other Property 100,000.00
Plant 650,000.00 Capital Stock of Co. X 1,000,000.00
Patents 500,000.00 Capital Stock of Subsidiaries
Good-Will 100,000.00 not owned by Co. X 200,000.00
Surplus of Affiliated Companies. 400,000.00
Surplus of Minority Interests. 10,000.00
$2,310,000.00 $2,310,000.00
Comments on Problem. There is little in the solution to which attention need be directed. In
the handling of the capital stock items, it will be noted that only $300,000 of Company Y’s stock
is eliminated, the remainder of $200,000 being shown on the consolidated balance sheet as a
minority interest. In eliminating Company Z’s capital stock, it becomes necessary to bring a
good-will item of $100,000 onto the consolidated balance sheet. This is shown on the working
sheet by means of the three “f” items in the “Elimination” column. On the consolidated balance
sheet it will be noted that the minority interest in Surplus (40% of $25,000, Y’s surplus) is not
shown affected by the reduction of Y’s inventory to a cost basis. The solution assumes that all
the surplus items on the balance sheets of the various companies represent operating surplus
accumulated since the purchase of the subsidiaries by the holding company.
This problem calls attention to some of the questions encountered in handling the
consolidated balance sheet, although in practice much more complicated situations arise. All that
can be hoped for here is to impress upon the student some fundamental principles to be observed
and to point out some of the methods used in order best to express the relations of the various
interests in the business. The idea of the consolidated balance sheet is simple in concept but
usually difficult of full realization.
Merchandise 210,000.00 Total Liabilities. $700,000.00
Other Property 100,000.00
Plant 650,000.00 Capital Stock of Co. X 1,000,000.00
Patents 500,000.00 Capital Stock of Subsidiaries
Good-Will 100,000.00 not owned by Co. X 200,000.00
Surplus of Affiliated Companies. 400,000.00
Surplus of Minority Interests. 10,000.00
$2,310,000.00 $2,310,000.00
Comments on Problem. There is little in the solution to which attention need be directed. In
the handling of the capital stock items, it will be noted that only $300,000 of Company Y’s stock
is eliminated, the remainder of $200,000 being shown on the consolidated balance sheet as a
minority interest. In eliminating Company Z’s capital stock, it becomes necessary to bring a
good-will item of $100,000 onto the consolidated balance sheet. This is shown on the working
sheet by means of the three “f” items in the “Elimination” column. On the consolidated balance
sheet it will be noted that the minority interest in Surplus (40% of $25,000, Y’s surplus) is not
shown affected by the reduction of Y’s inventory to a cost basis. The solution assumes that all
the surplus items on the balance sheets of the various companies represent operating surplus
accumulated since the purchase of the subsidiaries by the holding company.
This problem calls attention to some of the questions encountered in handling the
consolidated balance sheet, although in practice much more complicated situations arise. All that
can be hoped for here is to impress upon the student some fundamental principles to be observed
and to point out some of the methods used in order best to express the relations of the various
interests in the business. The idea of the consolidated balance sheet is simple in concept but
usually difficult of full realization.
Page 504
CHAPTER XXXV
ACCOUNTS AND REPORTS OF
RECEIVERS AND TRUSTEES
Appointment of Assignee or Receiver
A condition of bankruptcy does not necessarily exist in order to secure the appointment of an officer of the
court or a representative of a business for the purpose of taking possession and disposing of the property and
applying the proceeds to the liquidation of some or all of the debts. The titles given to the various capacities of the
representative of the business or the court are assignee, receiver, and trustee. An assignee is a party to whom the
owner of a business makes a general assignment of his business, usually for the benefit of his creditors. The owner
is usually bankrupt or verging on bankruptcy at such a time. The assignee becomes a representative of the owner,
appointed by him, and to that extent the owner is able to regulate the distribution of his estate. As a usual thing the
creditors must consent to the appointment of the assignee if the estate is to be liquidated and distributed under his
control. If such consent is not given or if the appointment of the assignee and his conduct of the liquidation prove
unsatisfactory, it is possible for certain creditors to bring bankruptcy proceedings against the owner and secure the
settlement of the estate under bankruptcy procedure. It is usually held, however, that no creditor who has given
active approval of the liquidation under assignment can become a party to an application in bankruptcy. The
procedure of the assignee in winding up the affairs of the owner does not differ in any essential respect, so far as
the accounting is concerned, from that of the receiver or trustee. The accounting features, therefore, will be treated
under the later heads of “Receiver” and “Trustee.”
If everything is satisfactory to both parties, a complete settlement of the estate will be effected by the assignee
and the affairs of the owner will thus be wound up. In case of dissatisfaction, or in the absence of a general
assignment in favor of creditors, proceedings in bankruptcy may be brought against the owner. As was pointed out
in Chapter XXVIII, a receiver as an agent of the court may act in two capacities, he may be either a receiver in
bankruptcy or a receiver in equity.
The receiver in bankruptcy takes possession of all the property of the bankrupt with the expectation of its
ultimate disposal and the application of the amounts realized therefrom to the liquidation of the debts of the
bankrupt. The receiver in equity, however, usually comes into possession of only a part of the property, which he is
to use in whatever way seems best for the liquidation of the more pressing current claims of creditors. In this latter
case a condition of insolvency cannot be said to exist because usually the assets exceed the liabilities. Simply
because the management has allowed the current assets to become tied up in a more or less unrealizable form
which is inapplicable to payment of liabilities, the business finds itself in difficulty. It becomes necessary
temporarily to turn the property over to a representative of the owner and his creditors in order to satisfy their
claims and at the same time to preserve the property from needless dissipation until such time as a satisfactory
settlement with creditors can be made and the business placed on a sound footing once again. In case, however, a
condition of insolvency exists, i.e., a condition in which the liabilities exceed the assets, a receiver in bankruptcy
may be appointed by the court upon application of the creditors or at the request of the owner.
Appointment of Trustee
If the owner makes a voluntary application for settlement in bankruptcy there is usually no need to appoint a
receiver. The creditors may come together almost immediately and elect a trustee who takes charge of the property
and applies it to settlement with the creditors. If the bankruptcy is involuntary, it is frequently necessary for the
court to appoint a receiver to whom the property of the proposed bankrupt is turned over for safe-keeping until the
exact status of the owner can be determined and a trustee appointed. The primary duty of the receiver and the
purpose of his appointment is to prevent the dissipation of the owner’s property and to maintain its integrity, thus
insuring its full application to the claims of creditors. Hence, whether the procedure is one in voluntary or in
involuntary bankruptcy, the receiver may be appointed if the court deems that the conditions so warrant. A receiver
will almost always be appointed in case any of the properties of the proposed bankrupt are of a perishable nature
and must be disposed of immediately to secure any return from them. In the absence of a receiver, sometimes the
marshal in bankruptcy is called upon to take possession of the property and preserve it.
ACCOUNTS AND REPORTS OF
RECEIVERS AND TRUSTEES
Appointment of Assignee or Receiver
A condition of bankruptcy does not necessarily exist in order to secure the appointment of an officer of the
court or a representative of a business for the purpose of taking possession and disposing of the property and
applying the proceeds to the liquidation of some or all of the debts. The titles given to the various capacities of the
representative of the business or the court are assignee, receiver, and trustee. An assignee is a party to whom the
owner of a business makes a general assignment of his business, usually for the benefit of his creditors. The owner
is usually bankrupt or verging on bankruptcy at such a time. The assignee becomes a representative of the owner,
appointed by him, and to that extent the owner is able to regulate the distribution of his estate. As a usual thing the
creditors must consent to the appointment of the assignee if the estate is to be liquidated and distributed under his
control. If such consent is not given or if the appointment of the assignee and his conduct of the liquidation prove
unsatisfactory, it is possible for certain creditors to bring bankruptcy proceedings against the owner and secure the
settlement of the estate under bankruptcy procedure. It is usually held, however, that no creditor who has given
active approval of the liquidation under assignment can become a party to an application in bankruptcy. The
procedure of the assignee in winding up the affairs of the owner does not differ in any essential respect, so far as
the accounting is concerned, from that of the receiver or trustee. The accounting features, therefore, will be treated
under the later heads of “Receiver” and “Trustee.”
If everything is satisfactory to both parties, a complete settlement of the estate will be effected by the assignee
and the affairs of the owner will thus be wound up. In case of dissatisfaction, or in the absence of a general
assignment in favor of creditors, proceedings in bankruptcy may be brought against the owner. As was pointed out
in Chapter XXVIII, a receiver as an agent of the court may act in two capacities, he may be either a receiver in
bankruptcy or a receiver in equity.
The receiver in bankruptcy takes possession of all the property of the bankrupt with the expectation of its
ultimate disposal and the application of the amounts realized therefrom to the liquidation of the debts of the
bankrupt. The receiver in equity, however, usually comes into possession of only a part of the property, which he is
to use in whatever way seems best for the liquidation of the more pressing current claims of creditors. In this latter
case a condition of insolvency cannot be said to exist because usually the assets exceed the liabilities. Simply
because the management has allowed the current assets to become tied up in a more or less unrealizable form
which is inapplicable to payment of liabilities, the business finds itself in difficulty. It becomes necessary
temporarily to turn the property over to a representative of the owner and his creditors in order to satisfy their
claims and at the same time to preserve the property from needless dissipation until such time as a satisfactory
settlement with creditors can be made and the business placed on a sound footing once again. In case, however, a
condition of insolvency exists, i.e., a condition in which the liabilities exceed the assets, a receiver in bankruptcy
may be appointed by the court upon application of the creditors or at the request of the owner.
Appointment of Trustee
If the owner makes a voluntary application for settlement in bankruptcy there is usually no need to appoint a
receiver. The creditors may come together almost immediately and elect a trustee who takes charge of the property
and applies it to settlement with the creditors. If the bankruptcy is involuntary, it is frequently necessary for the
court to appoint a receiver to whom the property of the proposed bankrupt is turned over for safe-keeping until the
exact status of the owner can be determined and a trustee appointed. The primary duty of the receiver and the
purpose of his appointment is to prevent the dissipation of the owner’s property and to maintain its integrity, thus
insuring its full application to the claims of creditors. Hence, whether the procedure is one in voluntary or in
involuntary bankruptcy, the receiver may be appointed if the court deems that the conditions so warrant. A receiver
will almost always be appointed in case any of the properties of the proposed bankrupt are of a perishable nature
and must be disposed of immediately to secure any return from them. In the absence of a receiver, sometimes the
marshal in bankruptcy is called upon to take possession of the property and preserve it.
Page 505
The receiver holds the property until the first meeting of the creditors which must be called by the court within
30 days after the owner has been adjudged a bankrupt by the court. Creditors are entitled to 10 days’ notice of the
meeting in order to make their plans to attend. The chief business of this first meeting of creditors is the
appointment of a trustee who takes over the property from the receiver in case one has been appointed, or from the
bankrupt in the absence of the intermediary receiver. It is the duty of the trustee to take charge of the entire
property, to turn it into cash as quickly and advantageously as possible, and to apply the proceeds to the liquidation
of all claims against it.
It is purposed now to discuss some of the accounting phases of the receiver’s and trustee’s activities and to
present also some more or less academic theories with regard to such accounting.
Accounts and Reports of a Receiver in Equity
When a receiver in equity is appointed by the court, he is entrusted with property for a specific purpose and
must render a full accounting of his stewardship. It becomes necessary, therefore, for him to keep full record of all
his activities. In simple situations where his activities are not complex, the keeping of a record of cash receipts and
disbursements is sometimes deemed all that is required. Usually, however, it is much better for the receiver to keep
a complete set of books showing the detail of his operation of the business, thus enabling him to furnish any
desired information. The receiver generally acts under the somewhat specific orders of the court and must be
careful to follow out those instructions in all matters. The opening up of the accounts of the receiver will depend
somewhat on the court’s order specifying the property to be taken over.
It frequently happens that only a portion of the property passes into the possession and control of the receiver.
As a usual thing he does not take onto his records the liabilities of the corporation incurred prior to his
appointment, although he may be ordered by the court to pay those liabilities or some portion of them. His books
will show, however, the liabilities incurred by him in his conduct of the business. Sometimes this requires a nice
distinction and care must be exercised in making it—as in the case of goods ordered prior to the appointment of
the receiver but not received until after his appointment. At the time the receiver takes over the properties, an
account is opened with him on the books of the corporation, in which he is charged with all properties turned over
to him and credited with all valuation reserves applicable to those properties. But, as stated above, no credit for
liabilities is entered. The offsetting entries to the receiver’s account are credits and debits respectively to the
accounts of the assets taken over and the valuation reserve accounts. On the books of the receiver these entries are
reversed, i.e., the various asset accounts will be charged and their valuation reserves credited and a credit will be
made to the corporation in receivership for the net values taken over. In case he is required by the order of the
court to pay any of the prior liabilities of the corporation, the entry for such becomes a debit to an account called
Debts Paid for the Corporation, or other similar title, and a credit to his cash.
In keeping account of the regular operations of the receiver, nothing new in principle is met. The receiver must
at all times be careful to keep distinct all payments on his own account from those for the corporation. Similarly,
he must keep separate the expenses which are incurred by him and those which belong to the corporation but
which he pays. It is held, for instance, that the interest charges on the corporation’s obligations are not an operating
expense of the receiver although he may be ordered by the court to pay them. Some of his duties will more than
likely be to realize partly or fully on some of the assets turned over to him, in addition to the regular trading assets
with which he conducts most of the business. These are accounted for on his books just as they would be on the
books of the corporation. In a similar way any liabilities liquidated, record of which appears on his books, will be
shown canceled in the usual way. As mentioned above, care must be exercised to keep his liabilities separate from
those of the corporation. In the payment of liabilities the question of priority often arises. He must be careful in
passing on their priority and he may have to secure the instructions of the court before settling the matter. This will
be true particularly with regard to receiver’s certificates, the court usually determining at the time of their issue
their relative priority as compared with the other liabilities. On the books of the receiver certain expenses will
appear which are peculiar to the receivership. These include such items as lawyers’ and accountants’ fees, bonding
company costs, etc., and are, of course, to be treated as his expenses. He should close his books periodically, and
so far as possible the period of closing should correspond with the regular fiscal period of the corporation for the
sake of preserving the continuity of the records for purposes of comparison.
Reports to the Court
The receiver must make periodic reports to the court—the first report to be made shortly after the assumption
of his duties. In it he presents schedules or inventories of the properties taken over. If some of these are mortgaged
30 days after the owner has been adjudged a bankrupt by the court. Creditors are entitled to 10 days’ notice of the
meeting in order to make their plans to attend. The chief business of this first meeting of creditors is the
appointment of a trustee who takes over the property from the receiver in case one has been appointed, or from the
bankrupt in the absence of the intermediary receiver. It is the duty of the trustee to take charge of the entire
property, to turn it into cash as quickly and advantageously as possible, and to apply the proceeds to the liquidation
of all claims against it.
It is purposed now to discuss some of the accounting phases of the receiver’s and trustee’s activities and to
present also some more or less academic theories with regard to such accounting.
Accounts and Reports of a Receiver in Equity
When a receiver in equity is appointed by the court, he is entrusted with property for a specific purpose and
must render a full accounting of his stewardship. It becomes necessary, therefore, for him to keep full record of all
his activities. In simple situations where his activities are not complex, the keeping of a record of cash receipts and
disbursements is sometimes deemed all that is required. Usually, however, it is much better for the receiver to keep
a complete set of books showing the detail of his operation of the business, thus enabling him to furnish any
desired information. The receiver generally acts under the somewhat specific orders of the court and must be
careful to follow out those instructions in all matters. The opening up of the accounts of the receiver will depend
somewhat on the court’s order specifying the property to be taken over.
It frequently happens that only a portion of the property passes into the possession and control of the receiver.
As a usual thing he does not take onto his records the liabilities of the corporation incurred prior to his
appointment, although he may be ordered by the court to pay those liabilities or some portion of them. His books
will show, however, the liabilities incurred by him in his conduct of the business. Sometimes this requires a nice
distinction and care must be exercised in making it—as in the case of goods ordered prior to the appointment of
the receiver but not received until after his appointment. At the time the receiver takes over the properties, an
account is opened with him on the books of the corporation, in which he is charged with all properties turned over
to him and credited with all valuation reserves applicable to those properties. But, as stated above, no credit for
liabilities is entered. The offsetting entries to the receiver’s account are credits and debits respectively to the
accounts of the assets taken over and the valuation reserve accounts. On the books of the receiver these entries are
reversed, i.e., the various asset accounts will be charged and their valuation reserves credited and a credit will be
made to the corporation in receivership for the net values taken over. In case he is required by the order of the
court to pay any of the prior liabilities of the corporation, the entry for such becomes a debit to an account called
Debts Paid for the Corporation, or other similar title, and a credit to his cash.
In keeping account of the regular operations of the receiver, nothing new in principle is met. The receiver must
at all times be careful to keep distinct all payments on his own account from those for the corporation. Similarly,
he must keep separate the expenses which are incurred by him and those which belong to the corporation but
which he pays. It is held, for instance, that the interest charges on the corporation’s obligations are not an operating
expense of the receiver although he may be ordered by the court to pay them. Some of his duties will more than
likely be to realize partly or fully on some of the assets turned over to him, in addition to the regular trading assets
with which he conducts most of the business. These are accounted for on his books just as they would be on the
books of the corporation. In a similar way any liabilities liquidated, record of which appears on his books, will be
shown canceled in the usual way. As mentioned above, care must be exercised to keep his liabilities separate from
those of the corporation. In the payment of liabilities the question of priority often arises. He must be careful in
passing on their priority and he may have to secure the instructions of the court before settling the matter. This will
be true particularly with regard to receiver’s certificates, the court usually determining at the time of their issue
their relative priority as compared with the other liabilities. On the books of the receiver certain expenses will
appear which are peculiar to the receivership. These include such items as lawyers’ and accountants’ fees, bonding
company costs, etc., and are, of course, to be treated as his expenses. He should close his books periodically, and
so far as possible the period of closing should correspond with the regular fiscal period of the corporation for the
sake of preserving the continuity of the records for purposes of comparison.
Reports to the Court
The receiver must make periodic reports to the court—the first report to be made shortly after the assumption
of his duties. In it he presents schedules or inventories of the properties taken over. If some of these are mortgaged
Page 506
or have other liens on them, the facts should be indicated. At the same time schedules of the corporation’s creditors
should be drawn up, grouped under the heads of preferential, secured, unsecured, and contingent. In the
preferential group appear those claims against the corporation which are given preference by law, such as taxes
due the state, wages due workmen, mechanics’ liens, etc. In the secured group appear the claims of creditors who
hold property as partial or full security for their claims. In the unsecured group appear all claims not secured; while
in the contingent group appear the usual items of contingent liability such as were discussed in Chapter XIX.
Subsequent reports will be made to the court at its will or at least once yearly. No standardized form is
followed in the submission of these reports, the attorney’s wishes usually governing. The report is designed for the
purpose of apprising the court of the progress of the receiver’s administration and should cover such items as the
assets realized during the period since the last report, the liabilities liquidated, and the results of the operation of
the properties held by the receiver. A convenient form for the showing of this report is that known as the “charge
and discharge” form. Under it the receiver is shown charged with certain items of property and income received,
and discharged with liabilities paid and other similar items. Whatever variations from this form are needed to meet
particular conditions, these should be incorporated. The report may follow somewhat the order of the items shown
below.
“The receiver charges himself with:
1. The assets at the date of the receivership (or at the date of the last report),
exclusive of permanent or fixed assets.
2. Additions to such assets since discovered.
3. Increments upon realization of such assets.
4. Amounts realized from the sale of permanent or fixed assets.
5. Amounts realized from the sale of receiver’s certificates.
6. Increases in the amount of receiver’s liabilities.
7. Gross income from the operation of the property.
“The receiver credits himself with:
1. Preferred or other liabilities of the company paid.
2. Decreases in the assets stated as taken over at the date of the receivership.
3. Losses on realization of such assets.
4. Expenditures on permanent or fixed assets.
5. Receiver’s certificates repaid.
6. Decreases in the amount of receiver’s liabilities.
7. Interest charges paid.
8. Expenses of operation of the property.
9. Receivership expenses.
10. The assets at the close of the period covered by the report, exclusive of
permanent or fixed assets.”[75]
This report may well be supported by a comparative balance sheet showing the condition at the time of the
previous report and now. A profit and loss account to show the operations of the receiver is also helpful. A
summary of all cash transactions may be included.
In a final report to the court a summary should be presented of all the operations since the beginning of the
receiver’s control. This will, of course, show whatever property is turned back to the corporation. Upon the close
of the receivership the receiver’s books may be closed up by crediting the accounts of the various assets which are
turned back to the corporation, charging the corporation’s account which was originally set up at the time the
property was taken over by the receiver and through which adjustments of the values of the assets have been made
at the time of sale or otherwise. An important thing to keep in mind in connection with all accounts and reports of
should be drawn up, grouped under the heads of preferential, secured, unsecured, and contingent. In the
preferential group appear those claims against the corporation which are given preference by law, such as taxes
due the state, wages due workmen, mechanics’ liens, etc. In the secured group appear the claims of creditors who
hold property as partial or full security for their claims. In the unsecured group appear all claims not secured; while
in the contingent group appear the usual items of contingent liability such as were discussed in Chapter XIX.
Subsequent reports will be made to the court at its will or at least once yearly. No standardized form is
followed in the submission of these reports, the attorney’s wishes usually governing. The report is designed for the
purpose of apprising the court of the progress of the receiver’s administration and should cover such items as the
assets realized during the period since the last report, the liabilities liquidated, and the results of the operation of
the properties held by the receiver. A convenient form for the showing of this report is that known as the “charge
and discharge” form. Under it the receiver is shown charged with certain items of property and income received,
and discharged with liabilities paid and other similar items. Whatever variations from this form are needed to meet
particular conditions, these should be incorporated. The report may follow somewhat the order of the items shown
below.
“The receiver charges himself with:
1. The assets at the date of the receivership (or at the date of the last report),
exclusive of permanent or fixed assets.
2. Additions to such assets since discovered.
3. Increments upon realization of such assets.
4. Amounts realized from the sale of permanent or fixed assets.
5. Amounts realized from the sale of receiver’s certificates.
6. Increases in the amount of receiver’s liabilities.
7. Gross income from the operation of the property.
“The receiver credits himself with:
1. Preferred or other liabilities of the company paid.
2. Decreases in the assets stated as taken over at the date of the receivership.
3. Losses on realization of such assets.
4. Expenditures on permanent or fixed assets.
5. Receiver’s certificates repaid.
6. Decreases in the amount of receiver’s liabilities.
7. Interest charges paid.
8. Expenses of operation of the property.
9. Receivership expenses.
10. The assets at the close of the period covered by the report, exclusive of
permanent or fixed assets.”[75]
This report may well be supported by a comparative balance sheet showing the condition at the time of the
previous report and now. A profit and loss account to show the operations of the receiver is also helpful. A
summary of all cash transactions may be included.
In a final report to the court a summary should be presented of all the operations since the beginning of the
receiver’s control. This will, of course, show whatever property is turned back to the corporation. Upon the close
of the receivership the receiver’s books may be closed up by crediting the accounts of the various assets which are
turned back to the corporation, charging the corporation’s account which was originally set up at the time the
property was taken over by the receiver and through which adjustments of the values of the assets have been made
at the time of sale or otherwise. An important thing to keep in mind in connection with all accounts and reports of
Page 507
the receiver is the necessity for making full and adequate explanations of all entries, giving the authority for them
and their source.
Accounts and Reports in
Bankruptcy Proceedings
Initial Statements Presented to the Court
In the case of a voluntary bankrupt, as was stated in Chapter XXVIII, at the time of the petition to the court a
schedule must be presented of all the property owned by the bankrupt and a list of his creditors giving the address,
if known, the amount of the claim, the consideration, and the security held, if any. If the bankrupt makes any claim
for exemption of any properties, that claim should be presented at this time. These schedules must follow the
forms prescribed by the court. In the case of an involuntary bankrupt, these various schedules will, of course, not
be available at the time the petition is made, inasmuch as the condition of the proposed bankrupt is undetermined;
the amounts of his assets and of his liabilities are unknown. It becomes necessary, therefore, to examine him in the
presence of the court for the purpose of securing a statement of all property owned and of all claims against it. This
information, as elicited by court examination, becomes the basis for the receiver’s and trustee’s records. If a
receiver is appointed by the court and remains in possession of the property for any length of time, it will be
necessary for him to present periodic reports to show the condition of the property at various times and a statement
of his operations. The reports which he will make will be similar to those which a trustee would make had he been
appointed immediately; therefore, the matter of reports and accounts for both the receiver and the trustee can be
treated together.
Reports and Accounts of Receiver or Trustee
The law provides that the trustee must keep regular accounts showing all amounts received and the sources
from which received, and all amounts expended and on what account such expenditures were made. This would
seem to imply merely the keeping of a record of the cash received and expended. The trustee, however, is looked
upon both as the representative of the bankrupt, as custodian of his property, and as the representative of the
creditors for the purpose of liquidating their claims. Immediately upon assuming office he must make, or cause to
be made, a complete inventory of all property coming into his possession. In valuing this inventory all real and
personal property belonging to the bankrupt’s estate must be appraised by three disinterested appraisers appointed
by the court. The trustee must make a written report to the court of the condition of the estate, as to the amount of
money on hand and any other details demanded by the court, within the first month after his appointment, and
bimonthly thereafter unless otherwise ordered by the court. His final report must be made 15 days before the final
meeting of the creditors is called by the court.
In disposing of the property of the bankrupt, provision is made that without court order the trustee cannot sell
any of the property for less than 75% of the value at which it was appraised by the court’s appraisers. The right of
set-off is allowed, i.e., if the bankrupt has a claim against any of his creditors, the amount of the claim is canceled
dollar for dollar against the creditor’s claim and only the balance of the claim is to be prorated on the same basis as
the other creditors.
The trustee must keep a careful record of all properties disposed of by him and of all liabilities liquidated.
What constitutes a careful record will depend largely on the circumstances in each case. Sometimes merely a
record of cash received and disbursed will fulfill all requirements. In other cases it may be necessary to keep a full
set of books in order properly to secure the information needed in the accounting to the court and the creditors. All
reports made should be narrative in form rather than consisting only of formal schedules and accounts. A
straightforward statement of all the activities of the trustee, supported by schedules in order to show summarized
results, is the desideratum.
Liquidating Dividends
Whenever the cash in the hands of the trustee is sufficient to pay the claims of preference creditors and a 5%
dividend to the unsecured creditors, a dividend must be declared. The declaration of the dividend is placed in the
hands of the referee in bankruptcy who is a direct representative of the court in most bankruptcy matters. The
trustee must pay the dividend within 10 days after its declaration by the referee who prepares and delivers to the
trustee dividend sheets showing the dividend declared and the parties to whom payable. All dividend checks drawn
by the trustee must be countersigned by the referee.
and their source.
Accounts and Reports in
Bankruptcy Proceedings
Initial Statements Presented to the Court
In the case of a voluntary bankrupt, as was stated in Chapter XXVIII, at the time of the petition to the court a
schedule must be presented of all the property owned by the bankrupt and a list of his creditors giving the address,
if known, the amount of the claim, the consideration, and the security held, if any. If the bankrupt makes any claim
for exemption of any properties, that claim should be presented at this time. These schedules must follow the
forms prescribed by the court. In the case of an involuntary bankrupt, these various schedules will, of course, not
be available at the time the petition is made, inasmuch as the condition of the proposed bankrupt is undetermined;
the amounts of his assets and of his liabilities are unknown. It becomes necessary, therefore, to examine him in the
presence of the court for the purpose of securing a statement of all property owned and of all claims against it. This
information, as elicited by court examination, becomes the basis for the receiver’s and trustee’s records. If a
receiver is appointed by the court and remains in possession of the property for any length of time, it will be
necessary for him to present periodic reports to show the condition of the property at various times and a statement
of his operations. The reports which he will make will be similar to those which a trustee would make had he been
appointed immediately; therefore, the matter of reports and accounts for both the receiver and the trustee can be
treated together.
Reports and Accounts of Receiver or Trustee
The law provides that the trustee must keep regular accounts showing all amounts received and the sources
from which received, and all amounts expended and on what account such expenditures were made. This would
seem to imply merely the keeping of a record of the cash received and expended. The trustee, however, is looked
upon both as the representative of the bankrupt, as custodian of his property, and as the representative of the
creditors for the purpose of liquidating their claims. Immediately upon assuming office he must make, or cause to
be made, a complete inventory of all property coming into his possession. In valuing this inventory all real and
personal property belonging to the bankrupt’s estate must be appraised by three disinterested appraisers appointed
by the court. The trustee must make a written report to the court of the condition of the estate, as to the amount of
money on hand and any other details demanded by the court, within the first month after his appointment, and
bimonthly thereafter unless otherwise ordered by the court. His final report must be made 15 days before the final
meeting of the creditors is called by the court.
In disposing of the property of the bankrupt, provision is made that without court order the trustee cannot sell
any of the property for less than 75% of the value at which it was appraised by the court’s appraisers. The right of
set-off is allowed, i.e., if the bankrupt has a claim against any of his creditors, the amount of the claim is canceled
dollar for dollar against the creditor’s claim and only the balance of the claim is to be prorated on the same basis as
the other creditors.
The trustee must keep a careful record of all properties disposed of by him and of all liabilities liquidated.
What constitutes a careful record will depend largely on the circumstances in each case. Sometimes merely a
record of cash received and disbursed will fulfill all requirements. In other cases it may be necessary to keep a full
set of books in order properly to secure the information needed in the accounting to the court and the creditors. All
reports made should be narrative in form rather than consisting only of formal schedules and accounts. A
straightforward statement of all the activities of the trustee, supported by schedules in order to show summarized
results, is the desideratum.
Liquidating Dividends
Whenever the cash in the hands of the trustee is sufficient to pay the claims of preference creditors and a 5%
dividend to the unsecured creditors, a dividend must be declared. The declaration of the dividend is placed in the
hands of the referee in bankruptcy who is a direct representative of the court in most bankruptcy matters. The
trustee must pay the dividend within 10 days after its declaration by the referee who prepares and delivers to the
trustee dividend sheets showing the dividend declared and the parties to whom payable. All dividend checks drawn
by the trustee must be countersigned by the referee.
Page 508
Relative Standing of the Creditors
In connection with the creditors of a receiver in equity a statement was made above of the various classes of
creditors whose claims are to be satisfied. These consist of preference creditors, secured creditors, and unsecured
creditors. The trustee in making his liquidating dividends will pay first those creditors who are given preference by
law. Within the preference class the order of priority of claims is as follows:
1. Taxes due the government, the state, or the municipality.
2. The actual costs incurred by the trustee or receiver in the preservation of the
estate subsequent to time of filing the petition in bankruptcy.
3. The filing fees paid by creditors in the case of a petition in involuntary
bankruptcy.
4. The costs of administration by the trustee.
5. The wages due workmen, clerks, servants, etc., earned within three months prior
to the date of commencement of proceedings—not exceeding $300 to each
claimant.
6. Debts owing to any person who, by federal or state law, is entitled to priority. In
the State of Pennsylvania claims on account of rent are frequently entitled to
this kind of priority.
Creditors who are fully secured rest their claims against the security held by them and not against the trustee.
Any surplus realized on the property held must be turned over to the trustee for the benefit of unsecured creditors.
The general rule in the case of a lien is that the remedy against the property must be exhausted first before any
creditor may share with the unsecured creditors. When all the property has been realized upon and all the cash
which has come into the hands of the trustee has been disbursed in satisfaction of the claims of the various
creditors, the trustee’s duties are at an end and his records may be closed up.
Statement of Affairs
While having no legal status in this country, the statement of affairs, as it is called, is used to serve certain
purposes in connection with matters in insolvency proceedings. Under the English bankruptcy laws such a
statement is required of every insolvent debtor. Its complementary schedule, known as the deficiency account, is
also required. In this country the chief significance of these two forms of statement is found in the examinations
set by the various state boards of certified public accountants. They may, however, serve some additional purposes,
chief of which are the following:
1. To show whether a receiver in equity should be appointed to manage the affairs
of the business.
2. To show whether the creditors should advance funds in order to allow the
business to continue, and perhaps in this way be able to meet its debts in full.
3. To show whether bankruptcy should be forced.
4. It may prove a valuable method of showing the exact condition of affairs to an
incoming partner or investor.
The statement of affairs presents lists of all assets at their book values and also at the values which they might
fairly be expected to realize upon a forced sale. Against this showing of the assets, an analysis is set up of all the
claims against the business by its outside creditors on the basis of the various classes of creditors referred to above,
namely, preference creditors, fully secured creditors, partially secured creditors, and unsecured creditors. Such a
statement gives information in such form that it can be used for the purposes enumerated above. There are two
forms of presenting this information. In the one the liabilities are shown on the left-hand side and the assets on the
right-hand side, as is the case with the English form of balance sheet. The reason sometimes given for this is either
that it is analogous to the English form of balance sheet or that in such a case the liabilities may be expected to
exceed the assets and are therefore of prime importance. In the other form the assets are shown on the left and the
liabilities on the right, as in the usual form of balance sheet. This latter form is the one shown here. The statement
of affairs thus ties together the values shown on the balance sheet as taken from the books, with a fair estimate of
In connection with the creditors of a receiver in equity a statement was made above of the various classes of
creditors whose claims are to be satisfied. These consist of preference creditors, secured creditors, and unsecured
creditors. The trustee in making his liquidating dividends will pay first those creditors who are given preference by
law. Within the preference class the order of priority of claims is as follows:
1. Taxes due the government, the state, or the municipality.
2. The actual costs incurred by the trustee or receiver in the preservation of the
estate subsequent to time of filing the petition in bankruptcy.
3. The filing fees paid by creditors in the case of a petition in involuntary
bankruptcy.
4. The costs of administration by the trustee.
5. The wages due workmen, clerks, servants, etc., earned within three months prior
to the date of commencement of proceedings—not exceeding $300 to each
claimant.
6. Debts owing to any person who, by federal or state law, is entitled to priority. In
the State of Pennsylvania claims on account of rent are frequently entitled to
this kind of priority.
Creditors who are fully secured rest their claims against the security held by them and not against the trustee.
Any surplus realized on the property held must be turned over to the trustee for the benefit of unsecured creditors.
The general rule in the case of a lien is that the remedy against the property must be exhausted first before any
creditor may share with the unsecured creditors. When all the property has been realized upon and all the cash
which has come into the hands of the trustee has been disbursed in satisfaction of the claims of the various
creditors, the trustee’s duties are at an end and his records may be closed up.
Statement of Affairs
While having no legal status in this country, the statement of affairs, as it is called, is used to serve certain
purposes in connection with matters in insolvency proceedings. Under the English bankruptcy laws such a
statement is required of every insolvent debtor. Its complementary schedule, known as the deficiency account, is
also required. In this country the chief significance of these two forms of statement is found in the examinations
set by the various state boards of certified public accountants. They may, however, serve some additional purposes,
chief of which are the following:
1. To show whether a receiver in equity should be appointed to manage the affairs
of the business.
2. To show whether the creditors should advance funds in order to allow the
business to continue, and perhaps in this way be able to meet its debts in full.
3. To show whether bankruptcy should be forced.
4. It may prove a valuable method of showing the exact condition of affairs to an
incoming partner or investor.
The statement of affairs presents lists of all assets at their book values and also at the values which they might
fairly be expected to realize upon a forced sale. Against this showing of the assets, an analysis is set up of all the
claims against the business by its outside creditors on the basis of the various classes of creditors referred to above,
namely, preference creditors, fully secured creditors, partially secured creditors, and unsecured creditors. Such a
statement gives information in such form that it can be used for the purposes enumerated above. There are two
forms of presenting this information. In the one the liabilities are shown on the left-hand side and the assets on the
right-hand side, as is the case with the English form of balance sheet. The reason sometimes given for this is either
that it is analogous to the English form of balance sheet or that in such a case the liabilities may be expected to
exceed the assets and are therefore of prime importance. In the other form the assets are shown on the left and the
liabilities on the right, as in the usual form of balance sheet. This latter form is the one shown here. The statement
of affairs thus ties together the values shown on the balance sheet as taken from the books, with a fair estimate of
Page 509
the values which may be realized, and so indicates the shrinkage in value expected by forced realization of the
assets.
Basis of Valuations in Statement of Affairs
The basis for the estimate of valuations is the same as in the case of bankruptcy proceedings where appraisers
are appointed to determine the value of properties. Here, however, the matter is not under court control and the
best appraisal possible must be made by the parties concerned, although if proceedings have progressed to the
point where the appraisers’ report is available, these values may be incorporated. The order of marshalling the
assets and liabilities in the statement is not standardized although it would seem best to follow the customary
balance sheet order for the assets, running perhaps from the most liquid to the fixed. With the liabilities, those
entirely unsecured may be shown first, followed by the partly secured, the fully secured, and the preferred
creditors. A comparison of the total values expected to be realized from the sale of the assets with the total of the
unsecured creditors gives some indication of the share which each creditor in the unsecured class may expect to
receive. The student is referred to the type solution and form shown on pages 635-638.
Statement of Affairs
Expected Expect’d Loss
Book
Assets Items to on
Values
Realize Realizat’n
Cash
Notes Receivable (see Schedule 1)
Accounts Receivable (see Schedule 2)
Good $.....
Doubtful .....
Bad .....
Merchandise
Securities on Hand (see Schedule 3)
Securities Pledged with Creditors:
Partly Secured $.....
Fully Secured .....
Deducted contra
Excess of Pledged Securities over
Claims of Creditors Fully
Secured (see contra)
Other Properties (see Schedule 4)
Total Unpledged Assets $......
Less Preferential Claims (see contra) ......
Net Free Assets for Unsecured Claims $......
Deficiency (see Deficiency Account)
Expected
Book
Liabilities Items to
Values
Rank
Creditors Unsecured (see Schedule 5) $. . . . . .
assets.
Basis of Valuations in Statement of Affairs
The basis for the estimate of valuations is the same as in the case of bankruptcy proceedings where appraisers
are appointed to determine the value of properties. Here, however, the matter is not under court control and the
best appraisal possible must be made by the parties concerned, although if proceedings have progressed to the
point where the appraisers’ report is available, these values may be incorporated. The order of marshalling the
assets and liabilities in the statement is not standardized although it would seem best to follow the customary
balance sheet order for the assets, running perhaps from the most liquid to the fixed. With the liabilities, those
entirely unsecured may be shown first, followed by the partly secured, the fully secured, and the preferred
creditors. A comparison of the total values expected to be realized from the sale of the assets with the total of the
unsecured creditors gives some indication of the share which each creditor in the unsecured class may expect to
receive. The student is referred to the type solution and form shown on pages 635-638.
Statement of Affairs
Expected Expect’d Loss
Book
Assets Items to on
Values
Realize Realizat’n
Cash
Notes Receivable (see Schedule 1)
Accounts Receivable (see Schedule 2)
Good $.....
Doubtful .....
Bad .....
Merchandise
Securities on Hand (see Schedule 3)
Securities Pledged with Creditors:
Partly Secured $.....
Fully Secured .....
Deducted contra
Excess of Pledged Securities over
Claims of Creditors Fully
Secured (see contra)
Other Properties (see Schedule 4)
Total Unpledged Assets $......
Less Preferential Claims (see contra) ......
Net Free Assets for Unsecured Claims $......
Deficiency (see Deficiency Account)
Expected
Book
Liabilities Items to
Values
Rank
Creditors Unsecured (see Schedule 5) $. . . . . .
Page 510
Expected
Book
Liabilities Items to
Values
Rank
Creditors Partly Secured (see Schedule 6) $. . . . . .
Less Securities Held (see contra) ......
Portion Unsecured ......
Creditors Fully Secured (see Schedule 7) $. . . . . .
Less Securities Held ......
Excess Carried contra $. . . . . .
Contingent Liabilities (see Schedule 8)
Preferential Creditors (see Schedule 9):
Deducted contra ......
Capital
Surplus
Deficiency Account
It is customary to support the statement of affairs by a deficiency account, which bears somewhat the same
relation to the statement of affairs that the profit and loss account does to the balance sheet, i.e., it is a statement of
the expected losses incurred upon realization of the assets and must prove against the losses or deficiency as
shown by the statement of affairs. Sometimes on the asset side of the statement of affairs a third column is shown
in which is indicated in detail the expected loss on realization for each asset. Where this is done the information
which makes up the deficiency account is readily available. On the debit side of the deficiency account appears
such items as losses on trading, shrinkages in value of the assets, and, if a partnership, withdrawals of capital. On
the credit side appear the capital as shown by the books. The difference between the two sides is the amount of
deficiency as shown by the statement of affairs. It may sometimes happen that the assets will realize more than
enough to meet the claims of all creditors, leaving a remainder to be distributed among the owners. Where such is
the case the deficiency account, instead of being technically described as such, is sometimes called an impairment
of capital account—carrying, however, essentially the same information. The balance of the account is on the
opposite side and indicates the present capital as impaired by the losses incurred. The skeleton form on page 633
and that given below show the way in which the various items may be presented.
Deficiency Account
Detailed Shrinkage in Appreciation in Values as
Values as per Statement per Statement of Affairs
of Affairs Capital
(Net Impairment of Capital) Surplus
Net Deficiency as per
Statement of Affairs
Illustration of Statement of Affairs and Deficiency Account
Book
Liabilities Items to
Values
Rank
Creditors Partly Secured (see Schedule 6) $. . . . . .
Less Securities Held (see contra) ......
Portion Unsecured ......
Creditors Fully Secured (see Schedule 7) $. . . . . .
Less Securities Held ......
Excess Carried contra $. . . . . .
Contingent Liabilities (see Schedule 8)
Preferential Creditors (see Schedule 9):
Deducted contra ......
Capital
Surplus
Deficiency Account
It is customary to support the statement of affairs by a deficiency account, which bears somewhat the same
relation to the statement of affairs that the profit and loss account does to the balance sheet, i.e., it is a statement of
the expected losses incurred upon realization of the assets and must prove against the losses or deficiency as
shown by the statement of affairs. Sometimes on the asset side of the statement of affairs a third column is shown
in which is indicated in detail the expected loss on realization for each asset. Where this is done the information
which makes up the deficiency account is readily available. On the debit side of the deficiency account appears
such items as losses on trading, shrinkages in value of the assets, and, if a partnership, withdrawals of capital. On
the credit side appear the capital as shown by the books. The difference between the two sides is the amount of
deficiency as shown by the statement of affairs. It may sometimes happen that the assets will realize more than
enough to meet the claims of all creditors, leaving a remainder to be distributed among the owners. Where such is
the case the deficiency account, instead of being technically described as such, is sometimes called an impairment
of capital account—carrying, however, essentially the same information. The balance of the account is on the
opposite side and indicates the present capital as impaired by the losses incurred. The skeleton form on page 633
and that given below show the way in which the various items may be presented.
Deficiency Account
Detailed Shrinkage in Appreciation in Values as
Values as per Statement per Statement of Affairs
of Affairs Capital
(Net Impairment of Capital) Surplus
Net Deficiency as per
Statement of Affairs
Illustration of Statement of Affairs and Deficiency Account
Page 511
Problem. The following balance sheet shows the condition of the A B C Company as on December 31, 1918.
A B C Company
Balance Sheet, December 31, 1918
Cash $ 3,000.00 Notes Payable $ 25,000.00
Notes Receivable 55,000.00 Accounts Payable 310,000.00;
Accts. Rec. $255,000 Accrued Expenses 10,000.00
Res. for Bad Debts 5,000 250,000.00 Bonds Payable 175,000.00
Merchandise 77,000.00 Total Liabilities $520,000.00
X Y Co. Stock 30,000.00
Mach. & Equip $ 95,000 Capital Stock 250,000.00
Depr. Res 25,000 70,000.00 Surplus 25,000.00
Buildings $ 88,000
Depr. Res 13,000 75,000.00
Land 110,000.00
Good-Will 125,000.00
$795,000.00 $795,000.00
The company has had difficulty in meeting its current claims. Interest to the amount of $5,000 on its bonds is
past due. On January 10, 1919, it would become liable for $30,000 on accommodation paper to that amount,
because of the bankruptcy of the makers. It is estimated that the creditors will receive 50% of their claims. At a
meeting of its creditors, where this condition of affairs was disclosed, it was decided to have a statement prepared
to show the condition of the company on a liquidating basis, any action respecting a petition in bankruptcy to be
deferred until after receipt of such statement. An appraisal committee made the following report, to be used as the
basis for the statement.
In the cash are found I O U memos, not collectible, $500. The notes receivable, all estimated good, are pledged
with creditors on open account to secure claims of $61,000. Of the accounts receivable, $100,000 are good,
$80,000 doubtful, estimated at 50% of their value, and the remainder bad. The merchandise is estimated to bring in
$50,000, the machinery $20,000, and the land $125,000. The land and buildings are expected to yield no surplus
above the claims of bondholders. The X Y Co. stock is pledged with the holders of notes payable and should
produce a surplus of $10,000. The accrued expenses comprise taxes $1,500, unpaid pay-roll $3,500, and bond
interest $5,000.
Solution
A B C Company
Statement of Affairs
Expected
Book
Assets Items to Shrin
Values
Realize
$ 3,000.00 Cash $ 2,500.00 $
250,000.00 Accounts Receivable:
Good $100,000.00 100,000.00
Doubtful—worth 50% 80,000.00 40,000.00 40
A B C Company
Balance Sheet, December 31, 1918
Cash $ 3,000.00 Notes Payable $ 25,000.00
Notes Receivable 55,000.00 Accounts Payable 310,000.00;
Accts. Rec. $255,000 Accrued Expenses 10,000.00
Res. for Bad Debts 5,000 250,000.00 Bonds Payable 175,000.00
Merchandise 77,000.00 Total Liabilities $520,000.00
X Y Co. Stock 30,000.00
Mach. & Equip $ 95,000 Capital Stock 250,000.00
Depr. Res 25,000 70,000.00 Surplus 25,000.00
Buildings $ 88,000
Depr. Res 13,000 75,000.00
Land 110,000.00
Good-Will 125,000.00
$795,000.00 $795,000.00
The company has had difficulty in meeting its current claims. Interest to the amount of $5,000 on its bonds is
past due. On January 10, 1919, it would become liable for $30,000 on accommodation paper to that amount,
because of the bankruptcy of the makers. It is estimated that the creditors will receive 50% of their claims. At a
meeting of its creditors, where this condition of affairs was disclosed, it was decided to have a statement prepared
to show the condition of the company on a liquidating basis, any action respecting a petition in bankruptcy to be
deferred until after receipt of such statement. An appraisal committee made the following report, to be used as the
basis for the statement.
In the cash are found I O U memos, not collectible, $500. The notes receivable, all estimated good, are pledged
with creditors on open account to secure claims of $61,000. Of the accounts receivable, $100,000 are good,
$80,000 doubtful, estimated at 50% of their value, and the remainder bad. The merchandise is estimated to bring in
$50,000, the machinery $20,000, and the land $125,000. The land and buildings are expected to yield no surplus
above the claims of bondholders. The X Y Co. stock is pledged with the holders of notes payable and should
produce a surplus of $10,000. The accrued expenses comprise taxes $1,500, unpaid pay-roll $3,500, and bond
interest $5,000.
Solution
A B C Company
Statement of Affairs
Expected
Book
Assets Items to Shrin
Values
Realize
$ 3,000.00 Cash $ 2,500.00 $
250,000.00 Accounts Receivable:
Good $100,000.00 100,000.00
Doubtful—worth 50% 80,000.00 40,000.00 40
Page 512
Expected
Book
Assets Items to Shrin
Values
Realize
Bad $75,000.00
Less Reserve 5,000.00 70,000.00 70
$250,000.00
30,000.00 Claim Against Accommodated Party
(Estimated to yield 50%) 15,000.00 15
77,000.00 Merchandise 50,000.00 27
70,000.00 Machinery 20,000.00 50
Securities Pledged with Creditors:
Partly Secured:
55,000.00 Notes Receivable (Deducted contra) $ 55.000 00
Fully Secured:
75,000.00 Buildings $ 55,000.00 20
110,000.00 Land (at market) 125,000.00 [76]15
Deducted contra $ 180,000.00
30,000.00 X Y Co. Stock (at market) 35,000.00 [77] 5
Deducted contra
Excess over Claims against it 10,000.00
125,000.00 Good-Will. 125
Total Unpledged Assets $237,500.00
Less Preferential Creditors
(see contra) 5,000.00
Net Free Assets for Unsecured Claims $232,500.00
Deficiency
see Deficiency Account) 52,500.00
$825,000.00 $285,000.00 $327,5
A B C Company
Statement of Affairs
(Continued)
Expected
Book
Liabilities Items to
Values
Rank
Unsecured Creditors:
$249,000.00 Accounts Payable $310,000.00
Less Partly Secured 61,000.00 $249,000.00
Partly Secured Creditors:
61,000.00 Accounts Payable $61,000.00
Less Notes Receivable Held as Security 55,000.00 6,000.00
Book
Assets Items to Shrin
Values
Realize
Bad $75,000.00
Less Reserve 5,000.00 70,000.00 70
$250,000.00
30,000.00 Claim Against Accommodated Party
(Estimated to yield 50%) 15,000.00 15
77,000.00 Merchandise 50,000.00 27
70,000.00 Machinery 20,000.00 50
Securities Pledged with Creditors:
Partly Secured:
55,000.00 Notes Receivable (Deducted contra) $ 55.000 00
Fully Secured:
75,000.00 Buildings $ 55,000.00 20
110,000.00 Land (at market) 125,000.00 [76]15
Deducted contra $ 180,000.00
30,000.00 X Y Co. Stock (at market) 35,000.00 [77] 5
Deducted contra
Excess over Claims against it 10,000.00
125,000.00 Good-Will. 125
Total Unpledged Assets $237,500.00
Less Preferential Creditors
(see contra) 5,000.00
Net Free Assets for Unsecured Claims $232,500.00
Deficiency
see Deficiency Account) 52,500.00
$825,000.00 $285,000.00 $327,5
A B C Company
Statement of Affairs
(Continued)
Expected
Book
Liabilities Items to
Values
Rank
Unsecured Creditors:
$249,000.00 Accounts Payable $310,000.00
Less Partly Secured 61,000.00 $249,000.00
Partly Secured Creditors:
61,000.00 Accounts Payable $61,000.00
Less Notes Receivable Held as Security 55,000.00 6,000.00
Page 513
Expected
Book
Liabilities Items to
Values
Rank
Fully Secured Creditors:
25,000.00 Notes Payable $25,000.00
X Y Co. Stock Held as Security 35,000.00
Excess of Security Carried contra $10,000.00
Bonds Payable. $175,000.00
Accrued Interest on Bonds 5,000.00 $180,000.00
Land & Buildings Held as Security 180,000.00
Contingent Liabilities:
30,000.00 Accommodation Notes.
Maker, now bankrupt, will pay 50% 30,000.00
Preferential Creditors:
1,500.00 Taxes $1,500.00
3,500.00 Wages 3,500.00
Deducted contra $5,000.00
250,000.00 Capital Stock
25,000.00 Surplus
$825,000.00 $285,000.00
ABC Co. will be able to pay, on the basis of the above showing, 81.6 cents on the dollar of all unsecured
claims.
A B C Company
Deficiency Account, December 31, 1918
Estimated Shrinkages in Value: Estimated Increments in Value:
Cash $ 500.00 Land $ 15,000.00
Accounts Receivable. 110,000.00 X Y Co. Stock 5,000.00
Claim against Accommodated Party 15,000.00 Capital Sunk:
Capital Stock 250,000.00
Merchandise 27,000.00 Surplus 25,000.00
Machinery 50,000.00 Net Deficiency to be
Buildings 20,000.00 borne by Creditors
Good-Will 125,000.00 (see Statement of Affairs) 52,500.00
$347,500.00 $347,500.00
Comments on Problem. From the above solution it will be noted that the order of showing the assets is not
quite the same as would be ordinarily followed on a balance sheet. A separate group is made to indicate the
securities pledged with creditors, shown under the two heads “Partly Secured,” and “Fully Secured.” It is to be
further noted that the securities in the hands of partly secured creditors have no realizable value applicable to
general unsecured creditors; hence, they are always shown deducted on the liability side of the statement from the
claims of partly secured creditors, the difference giving the amount of such claims which must rank with other
unsecured creditors. In the case of fully secured creditors, if the value of the security held is estimated to exceed
Book
Liabilities Items to
Values
Rank
Fully Secured Creditors:
25,000.00 Notes Payable $25,000.00
X Y Co. Stock Held as Security 35,000.00
Excess of Security Carried contra $10,000.00
Bonds Payable. $175,000.00
Accrued Interest on Bonds 5,000.00 $180,000.00
Land & Buildings Held as Security 180,000.00
Contingent Liabilities:
30,000.00 Accommodation Notes.
Maker, now bankrupt, will pay 50% 30,000.00
Preferential Creditors:
1,500.00 Taxes $1,500.00
3,500.00 Wages 3,500.00
Deducted contra $5,000.00
250,000.00 Capital Stock
25,000.00 Surplus
$825,000.00 $285,000.00
ABC Co. will be able to pay, on the basis of the above showing, 81.6 cents on the dollar of all unsecured
claims.
A B C Company
Deficiency Account, December 31, 1918
Estimated Shrinkages in Value: Estimated Increments in Value:
Cash $ 500.00 Land $ 15,000.00
Accounts Receivable. 110,000.00 X Y Co. Stock 5,000.00
Claim against Accommodated Party 15,000.00 Capital Sunk:
Capital Stock 250,000.00
Merchandise 27,000.00 Surplus 25,000.00
Machinery 50,000.00 Net Deficiency to be
Buildings 20,000.00 borne by Creditors
Good-Will 125,000.00 (see Statement of Affairs) 52,500.00
$347,500.00 $347,500.00
Comments on Problem. From the above solution it will be noted that the order of showing the assets is not
quite the same as would be ordinarily followed on a balance sheet. A separate group is made to indicate the
securities pledged with creditors, shown under the two heads “Partly Secured,” and “Fully Secured.” It is to be
further noted that the securities in the hands of partly secured creditors have no realizable value applicable to
general unsecured creditors; hence, they are always shown deducted on the liability side of the statement from the
claims of partly secured creditors, the difference giving the amount of such claims which must rank with other
unsecured creditors. In the case of fully secured creditors, if the value of the security held is estimated to exceed
Page 514
the claims against it, this excess will be shown on the asset side of the statement as property to which the
unsecured creditors may look for the satisfaction of their claims.
It should be noted that the amount of net worth is included in the Book Values column of the liabilities, chiefly
for the purpose of showing a complete balance sheet. This makes possible an easy estimate of the deficiency
figure, as shown on the face of the statement. The estimate is made by subtracting the figure of net worth from the
total of the Shrinkages column. This is, of course, the same figure as shown in the Deficiency account and is
arrived at in practically the same way. In the solution given, the two items indicated by asterisk in the Shrinkages
column represent increments in value, and in arriving at the total of that column these are, of course, subtracted
from the total shrinkages.
Inasmuch as the accommodation notes were not previously carried on the books of the bankrupt, they must
here be inserted in the balance sheet columns both as an asset and a liability.
It is to be noted that the amount due the preferential creditors must be shown deducted from the total
unpledged assets because the creditors have no claim against any specific asset although a first claim against all
unpledged assets. After deducting the amount from the total unpledged assets, the figure of net free assets which
can be applied to the claims of unsecured creditors is arrived at. A comparison of this figure of net free assets with
the total amount due unsecured creditors gives the percentage which the creditors may expect on their claims. It is
to be understood that the expenses of winding up the business will also be a charge against the net assets before the
creditors can receive anything. It therefore usually happens that the estimate of this percentage is higher than is
actually realized at the time of final settlement.
Realization and Liquidation Account
The realization and liquidation account is a statement which has played a somewhat prominent part in C. P. A.
examinations. It is never used in practice and has no value other than to test the ability of the student to analyze
and present in logical form facts and activities which are sometimes difficult to analyze and present in a condensed
form and in such fashion as to show the relation of the various items. Presumptively, the purpose of the statement
is to show the activities of the trustee after the appraisal of the bankrupt’s estate. In some instances the realization
and liquidation statement takes the values of the assets as appraised by the trustee or other party making up the
statement of affairs and shows the activities carried on through the realization of the assets and the liquidation of
the liabilities. In other cases the realization and liquidation account is tied up with the values at which the assets
are carried on the account books. There is no principle at issue as between the two methods. It seems perhaps more
logical to look upon the two accounts, namely, the statement of affairs and the realization and liquidation account,
as a unit statement covering the entire bankruptcy proceedings. Under that interpretation the “expected-to-realize”
value as shown by the statement of affairs would form the basis for the realization and liquidation account, but, as
stated above, either method is correct and no accounting or legal principle is involved.
Evolution of the Realization and Liquidation Account
The development of the realization and liquidation account through its various stages seems to have been based
on three theories. When first used it was supposed to represent an account actually opened on the books of the
bankrupt through which his assets and liabilities were shown transferred to the receiver or trustee.
The theory underlying the account was that it represented the trustee, who was to be charged with all the assets
turned over to him and credited with the liabilities assumed. During the process of realization and liquidation he
was to be credited in the same account with the assets at the amount realized therefrom, and debited with the
liabilities as liquidated. Under this theory, strangely enough, the account was charged also with the expenses
incurred by the trustee and credited with any income items received during his trusteeship. The balance of the
account was the profit or loss on the realization and liquidation transactions. This theory of the realization and
liquidation account as an account actually opened on the books has given place to a second theory, though the
account itself as set up for showing solutions to problems set in certified public accountants’ examinations is still
sometimes constructed according to this first theory.
The advocates of the second theory maintain that the realization and liquidation account represents the trustee’s
report to the court, accounting for the charges and credits therein on that basis. The nature of such a report has
been explained earlier in the chapter, from which it is seen that the formal realization and liquidation account as
usually set up cannot represent nor take the place of the trustee’s report to the court.
unsecured creditors may look for the satisfaction of their claims.
It should be noted that the amount of net worth is included in the Book Values column of the liabilities, chiefly
for the purpose of showing a complete balance sheet. This makes possible an easy estimate of the deficiency
figure, as shown on the face of the statement. The estimate is made by subtracting the figure of net worth from the
total of the Shrinkages column. This is, of course, the same figure as shown in the Deficiency account and is
arrived at in practically the same way. In the solution given, the two items indicated by asterisk in the Shrinkages
column represent increments in value, and in arriving at the total of that column these are, of course, subtracted
from the total shrinkages.
Inasmuch as the accommodation notes were not previously carried on the books of the bankrupt, they must
here be inserted in the balance sheet columns both as an asset and a liability.
It is to be noted that the amount due the preferential creditors must be shown deducted from the total
unpledged assets because the creditors have no claim against any specific asset although a first claim against all
unpledged assets. After deducting the amount from the total unpledged assets, the figure of net free assets which
can be applied to the claims of unsecured creditors is arrived at. A comparison of this figure of net free assets with
the total amount due unsecured creditors gives the percentage which the creditors may expect on their claims. It is
to be understood that the expenses of winding up the business will also be a charge against the net assets before the
creditors can receive anything. It therefore usually happens that the estimate of this percentage is higher than is
actually realized at the time of final settlement.
Realization and Liquidation Account
The realization and liquidation account is a statement which has played a somewhat prominent part in C. P. A.
examinations. It is never used in practice and has no value other than to test the ability of the student to analyze
and present in logical form facts and activities which are sometimes difficult to analyze and present in a condensed
form and in such fashion as to show the relation of the various items. Presumptively, the purpose of the statement
is to show the activities of the trustee after the appraisal of the bankrupt’s estate. In some instances the realization
and liquidation statement takes the values of the assets as appraised by the trustee or other party making up the
statement of affairs and shows the activities carried on through the realization of the assets and the liquidation of
the liabilities. In other cases the realization and liquidation account is tied up with the values at which the assets
are carried on the account books. There is no principle at issue as between the two methods. It seems perhaps more
logical to look upon the two accounts, namely, the statement of affairs and the realization and liquidation account,
as a unit statement covering the entire bankruptcy proceedings. Under that interpretation the “expected-to-realize”
value as shown by the statement of affairs would form the basis for the realization and liquidation account, but, as
stated above, either method is correct and no accounting or legal principle is involved.
Evolution of the Realization and Liquidation Account
The development of the realization and liquidation account through its various stages seems to have been based
on three theories. When first used it was supposed to represent an account actually opened on the books of the
bankrupt through which his assets and liabilities were shown transferred to the receiver or trustee.
The theory underlying the account was that it represented the trustee, who was to be charged with all the assets
turned over to him and credited with the liabilities assumed. During the process of realization and liquidation he
was to be credited in the same account with the assets at the amount realized therefrom, and debited with the
liabilities as liquidated. Under this theory, strangely enough, the account was charged also with the expenses
incurred by the trustee and credited with any income items received during his trusteeship. The balance of the
account was the profit or loss on the realization and liquidation transactions. This theory of the realization and
liquidation account as an account actually opened on the books has given place to a second theory, though the
account itself as set up for showing solutions to problems set in certified public accountants’ examinations is still
sometimes constructed according to this first theory.
The advocates of the second theory maintain that the realization and liquidation account represents the trustee’s
report to the court, accounting for the charges and credits therein on that basis. The nature of such a report has
been explained earlier in the chapter, from which it is seen that the formal realization and liquidation account as
usually set up cannot represent nor take the place of the trustee’s report to the court.
Page 515
Under a third theory the realization and liquidation account is looked upon simply as a condensed summary of
the trustee’s activities analyzed into sections, the purpose of which is to present all the information needed for
almost any report which the trustee may have to make. The theory of its debits and credits is not so important here
and in some cases may not apply, the effort being simply to arrange the data in such fashion that a full accounting
can be given for all the properties turned over to the trustee and all the liabilities assumed by him, the whole being
supported by a statement of the trustee’s operations. This information is set up in account form and brought
together in one account supplementary to which there must be carried also a summary of the trustee’s cash
transactions. The information as given in these two accounts provides the data for any reports which the trustee
may have to make. The two forms are shown in skeleton form just below:
Realization and Liquidation Statement—
Usual Form
Assets to be Realized Liabilities to be Liquidated
(In detail) (In detail)
New Assets Acquired New Liabilities Assumed
(In detail) (In detail)
Liabilities Liquidated Assets Realized
(In detail) (In detail)
Supplementary Charges Supplementary Credits
(In detail) (In detail)
Liabilities Not Liquidated Assets Not Realized
(In detail) (In detail)
Gain on Realization Loss on Realization
Assets to be Realized Liabilities to be Liquidated
(Balance brought down) (Balance brought down)
Realization and Liquidation Statement—
Improved Form
Assets Taken Over Liabilities Assumed
(Original and after-acquired) (Original and after-acquired)
(In detail) (In detail)
Disposition of Liabilities Disposition of Assets
(A full accounting for all values (A full accounting for all values
assumed as above, per contra) assumed as above, per contra)
Operations of the Trustee: Operations of the Trustee:
Expenses Income
(In detail) (In detail)
Values Continued or Returned Values Continued or Returned
to the Owner: to the Owner:
Assets Liabilities
(In detail) (In detail)
the trustee’s activities analyzed into sections, the purpose of which is to present all the information needed for
almost any report which the trustee may have to make. The theory of its debits and credits is not so important here
and in some cases may not apply, the effort being simply to arrange the data in such fashion that a full accounting
can be given for all the properties turned over to the trustee and all the liabilities assumed by him, the whole being
supported by a statement of the trustee’s operations. This information is set up in account form and brought
together in one account supplementary to which there must be carried also a summary of the trustee’s cash
transactions. The information as given in these two accounts provides the data for any reports which the trustee
may have to make. The two forms are shown in skeleton form just below:
Realization and Liquidation Statement—
Usual Form
Assets to be Realized Liabilities to be Liquidated
(In detail) (In detail)
New Assets Acquired New Liabilities Assumed
(In detail) (In detail)
Liabilities Liquidated Assets Realized
(In detail) (In detail)
Supplementary Charges Supplementary Credits
(In detail) (In detail)
Liabilities Not Liquidated Assets Not Realized
(In detail) (In detail)
Gain on Realization Loss on Realization
Assets to be Realized Liabilities to be Liquidated
(Balance brought down) (Balance brought down)
Realization and Liquidation Statement—
Improved Form
Assets Taken Over Liabilities Assumed
(Original and after-acquired) (Original and after-acquired)
(In detail) (In detail)
Disposition of Liabilities Disposition of Assets
(A full accounting for all values (A full accounting for all values
assumed as above, per contra) assumed as above, per contra)
Operations of the Trustee: Operations of the Trustee:
Expenses Income
(In detail) (In detail)
Values Continued or Returned Values Continued or Returned
to the Owner: to the Owner:
Assets Liabilities
(In detail) (In detail)
Page 516
In the first example, which may be termed the usual form, the net balance of the account indicates the profit or
loss incurred in winding up the business. If the values used as the basis for the statement are those of the statement
of affairs, this profit or loss is in addition to the expected loss shown by the deficiency account. If, however, the
book values are used as the basis for the statement, the profit or loss will be the net profit or loss on the entire
realization and liquidation. Under the new and second form a full accounting is made for the value at which every
asset is brought into the statement so that a separate figure of profit or loss is not shown excepting in so far as that
is made a part of the operating section of the statement. Sometimes a third form is used which is not a formal
statement but consists rather of the auditor’s working sheet. In this, columns are used to show the assets taken over
by the trustee; the new assets acquired by him; the realization of the assets; the losses incurred on realization; the
net assets remaining to be realized or to be returned to the owner; a similar statement in columnar form showing
the liabilities to be liquidated; the full or partial liquidation of the liabilities; and the portion turned back to the
owner or continued for further liquidation.
Supporting Schedules
Where the first form of the realization and liquidation statement is made use of, the profit or loss as shown by
that statement should be explained by means of a supporting statement known as the realization and liquidation
profit and loss account in which will be shown the losses on realization of the assets and any other items which
have entered into profit or loss as shown by the realization and liquidation statement. Another schedule known as
the trustee’s cash account is also usually presented. In this appears a more or less summarized statement of cash
receipts and disbursements, indicating the main lines of activity of the trustee and their results.
The Question of Cash
It is sometimes maintained that inasmuch as cash is a realized asset it has no place in the realization and
liquidation statement. Accordingly, under that theory the cash appears only in the trustee’s cash account. There is a
good reason, however, for the insistence of some that the realization and liquidation statement should show all the
assets taken over by the trustee or receiver and a full accounting for them. Therefore, the cash taken over by the
trustee and all subsequent cash acquired by him must be shown in the realization and liquidation statement and
fully accounted for as disbursed or still on hand. Inasmuch as the statement has no foundation in practice, it has no
standardized form and therefore such matters of opinion will largely be left to the individual student except so far
as the force of logic may in the course of time indicate the best method of treatment.
The Handling of Valuation Reserves
In both the statement of affairs and the realization and liquidation statement the handling of valuation reserves
presents some difficulty. Either they must be included among the liabilities, which is awkward inasmuch as they
cannot be shown as belonging to any of the classes of creditors, or the asset value as set up in the Book Value
column must be the value after deducting the reserve therefrom. This latter method, which seems to present the
least difficulties and raise the fewest objections, is the one followed here.
Illustration of Realization and Liquidation Statement
Problem. The Kay Corporation became embarrassed because of the tying up of current funds in fixed
properties. A friendly receiver was appointed to operate the plant until the assets could be realized upon
sufficiently to reduce the most pressing of the claims against the insolvent corporation. At the time the receiver
took possession, the balance sheet of the company showed as follows, in summarized form:
Kay Corporation
Balance Sheet
Assets Liabilities and Capital
Cash $ 4,000.00 Notes Payable $ 80,000.00
Accounts Receivable 120,000.00 Accounts Payable 110,000.00
loss incurred in winding up the business. If the values used as the basis for the statement are those of the statement
of affairs, this profit or loss is in addition to the expected loss shown by the deficiency account. If, however, the
book values are used as the basis for the statement, the profit or loss will be the net profit or loss on the entire
realization and liquidation. Under the new and second form a full accounting is made for the value at which every
asset is brought into the statement so that a separate figure of profit or loss is not shown excepting in so far as that
is made a part of the operating section of the statement. Sometimes a third form is used which is not a formal
statement but consists rather of the auditor’s working sheet. In this, columns are used to show the assets taken over
by the trustee; the new assets acquired by him; the realization of the assets; the losses incurred on realization; the
net assets remaining to be realized or to be returned to the owner; a similar statement in columnar form showing
the liabilities to be liquidated; the full or partial liquidation of the liabilities; and the portion turned back to the
owner or continued for further liquidation.
Supporting Schedules
Where the first form of the realization and liquidation statement is made use of, the profit or loss as shown by
that statement should be explained by means of a supporting statement known as the realization and liquidation
profit and loss account in which will be shown the losses on realization of the assets and any other items which
have entered into profit or loss as shown by the realization and liquidation statement. Another schedule known as
the trustee’s cash account is also usually presented. In this appears a more or less summarized statement of cash
receipts and disbursements, indicating the main lines of activity of the trustee and their results.
The Question of Cash
It is sometimes maintained that inasmuch as cash is a realized asset it has no place in the realization and
liquidation statement. Accordingly, under that theory the cash appears only in the trustee’s cash account. There is a
good reason, however, for the insistence of some that the realization and liquidation statement should show all the
assets taken over by the trustee or receiver and a full accounting for them. Therefore, the cash taken over by the
trustee and all subsequent cash acquired by him must be shown in the realization and liquidation statement and
fully accounted for as disbursed or still on hand. Inasmuch as the statement has no foundation in practice, it has no
standardized form and therefore such matters of opinion will largely be left to the individual student except so far
as the force of logic may in the course of time indicate the best method of treatment.
The Handling of Valuation Reserves
In both the statement of affairs and the realization and liquidation statement the handling of valuation reserves
presents some difficulty. Either they must be included among the liabilities, which is awkward inasmuch as they
cannot be shown as belonging to any of the classes of creditors, or the asset value as set up in the Book Value
column must be the value after deducting the reserve therefrom. This latter method, which seems to present the
least difficulties and raise the fewest objections, is the one followed here.
Illustration of Realization and Liquidation Statement
Problem. The Kay Corporation became embarrassed because of the tying up of current funds in fixed
properties. A friendly receiver was appointed to operate the plant until the assets could be realized upon
sufficiently to reduce the most pressing of the claims against the insolvent corporation. At the time the receiver
took possession, the balance sheet of the company showed as follows, in summarized form:
Kay Corporation
Balance Sheet
Assets Liabilities and Capital
Cash $ 4,000.00 Notes Payable $ 80,000.00
Accounts Receivable 120,000.00 Accounts Payable 110,000.00
Page 517
Merchandise 60,000.00 Accrued Expenses 14,000.00
Other Property 500,000.00 Bonds Payable 200,000.00
Capital Stock 250,000.00
Surplus 30,000.00
$684,000.00 $684,000.00
A summary of the receiver’s transactions showed that he made sales of $131,000, of which $51,000 were for
cash. He purchased $70,000 worth of merchandise for which he paid $12,500 cash, $25,000 in notes of the
corporation, and the rest was carried on account. He bought other property for $20,000, giving therefor $10,000
cash and $10,000 notes. He collected $100,000 cash from customers and wrote off $25,000 as uncollectible. Other
property carried on the books at $75,000 was sold for $69,000 cash. He collected from rentals $1,000. Selling
expenses amounted to $10,000 and the receiver’s administrative expenses were $7,500, both of which were paid.
Of the liabilities he liquidated $70,000 of notes payable and $100,500 of accounts payable. All the accrued
expenses were paid. The inventory of merchandise was $20,000 when the receiver turned the property back to the
owners.
Set up a realization and liquidation statement and receiver’s cash summary to show the receiver’s stewardship
and result of his operations.
Solution
Kay Corporation
Realization and Liquidation Account
Acquired under
Original Total
Receivership
Assets Taken Over:
Cash
(see Receiver’s Cash Account) $ 4,000.00 $221,000.00 $225,000.00
Accounts Receivable 120,000.00 80,000.00 200,000.00
Merchandise 60,000.00 70,000.00 130,000.00
Other Property 500,000.00 20,000.00 520,000.00;
$684,000.00 $391,000.00 $1,075,000.00
Liquidated Continued
Disposition of Liabilities:
Notes Payable $ 70,000.00 $ 45,000.00 115,000.00
Accounts Payable 100,500.00 42,000.00 142,500.00
Accrued Expenses 14,000.00 14,000.00
Bonds Payable 200,000.00 200,000.00
$184,500.00 $287,000.00 $1,546,500.00
Operations of the Receiver:
Expenses:
Merchandise originally taken over $60,000.00
Purchases 70,000.00 $130,000.00
Merchandise Returned to Owner 20,000.00
Cost of Goods Sold $110,000.00
Other Property 500,000.00 Bonds Payable 200,000.00
Capital Stock 250,000.00
Surplus 30,000.00
$684,000.00 $684,000.00
A summary of the receiver’s transactions showed that he made sales of $131,000, of which $51,000 were for
cash. He purchased $70,000 worth of merchandise for which he paid $12,500 cash, $25,000 in notes of the
corporation, and the rest was carried on account. He bought other property for $20,000, giving therefor $10,000
cash and $10,000 notes. He collected $100,000 cash from customers and wrote off $25,000 as uncollectible. Other
property carried on the books at $75,000 was sold for $69,000 cash. He collected from rentals $1,000. Selling
expenses amounted to $10,000 and the receiver’s administrative expenses were $7,500, both of which were paid.
Of the liabilities he liquidated $70,000 of notes payable and $100,500 of accounts payable. All the accrued
expenses were paid. The inventory of merchandise was $20,000 when the receiver turned the property back to the
owners.
Set up a realization and liquidation statement and receiver’s cash summary to show the receiver’s stewardship
and result of his operations.
Solution
Kay Corporation
Realization and Liquidation Account
Acquired under
Original Total
Receivership
Assets Taken Over:
Cash
(see Receiver’s Cash Account) $ 4,000.00 $221,000.00 $225,000.00
Accounts Receivable 120,000.00 80,000.00 200,000.00
Merchandise 60,000.00 70,000.00 130,000.00
Other Property 500,000.00 20,000.00 520,000.00;
$684,000.00 $391,000.00 $1,075,000.00
Liquidated Continued
Disposition of Liabilities:
Notes Payable $ 70,000.00 $ 45,000.00 115,000.00
Accounts Payable 100,500.00 42,000.00 142,500.00
Accrued Expenses 14,000.00 14,000.00
Bonds Payable 200,000.00 200,000.00
$184,500.00 $287,000.00 $1,546,500.00
Operations of the Receiver:
Expenses:
Merchandise originally taken over $60,000.00
Purchases 70,000.00 $130,000.00
Merchandise Returned to Owner 20,000.00
Cost of Goods Sold $110,000.00
Page 518
Acquired under
Original Total
Receivership
Profit on Sales (carried down) 21,000.00
$131,000.00
Selling Expenses $10,000.00
Expenses of Receiver’s Adm. 7,500.00
Losses on Realization:
Accounts Receivable: 25,000.00
Other Property 6,000.00 $48,500.00
Values Returned to Owner: $48,500.00
Cash $ 500.00
Accounts Receivable 75,000.00
Merchandise 20,000.00
Other Property 445,000.00
$540,500.00
Kay Corporation
Realization and Liquidation Account
(Continued)
Acquired under
Original Total
Receivership
Liabilities Assumed:
Notes Payable $ 80,000.00 $ 35,000.00 $115,000.00
Accounts Payable 110,000.00 32,500.00 142,500.00
Accrued Expenses 14,000.00 14,000.00
Bonds Payable 200,000.00 200,000.00
$404,000.00 $67,500.00 $471,500.00
Disposed of Continued
Disposition of Assets:
Cash (see Receiver’s Cash Acct.) $224,500.00 $ 500.00 225,000.00
Accounts Receivable:
Amount Collected $100,000.00
Loss on Bad Debts 25,000.00 125,000.00 75,000.00 200,000.00
Merchandise:
Sold for (see next section) $131,000.00
Profit on 21,000.00 110,000.00 20,000.00 130,000.00
Other Property:
Sold for $ 69,000.00
Loss on 6,000.00 75,000.00 445,000.00 520,000.00
Original Total
Receivership
Profit on Sales (carried down) 21,000.00
$131,000.00
Selling Expenses $10,000.00
Expenses of Receiver’s Adm. 7,500.00
Losses on Realization:
Accounts Receivable: 25,000.00
Other Property 6,000.00 $48,500.00
Values Returned to Owner: $48,500.00
Cash $ 500.00
Accounts Receivable 75,000.00
Merchandise 20,000.00
Other Property 445,000.00
$540,500.00
Kay Corporation
Realization and Liquidation Account
(Continued)
Acquired under
Original Total
Receivership
Liabilities Assumed:
Notes Payable $ 80,000.00 $ 35,000.00 $115,000.00
Accounts Payable 110,000.00 32,500.00 142,500.00
Accrued Expenses 14,000.00 14,000.00
Bonds Payable 200,000.00 200,000.00
$404,000.00 $67,500.00 $471,500.00
Disposed of Continued
Disposition of Assets:
Cash (see Receiver’s Cash Acct.) $224,500.00 $ 500.00 225,000.00
Accounts Receivable:
Amount Collected $100,000.00
Loss on Bad Debts 25,000.00 125,000.00 75,000.00 200,000.00
Merchandise:
Sold for (see next section) $131,000.00
Profit on 21,000.00 110,000.00 20,000.00 130,000.00
Other Property:
Sold for $ 69,000.00
Loss on 6,000.00 75,000.00 445,000.00 520,000.00
Page 519
Acquired under
Original Total
Receivership
$534.500.00 $540,500.00 $1,546,500.00
Operations of the Receiver:
Income:
Sales $131,000.00
$131,000.00
Profit on Sales (brought down) $21,000.00
Rental 1,000.00
Decrease in Value of Business
under Receivership 26,500.00
$48,500.00
Values Returned to Owner:
Notes Payable $ 45,000.00
Accounts Payable 42,000.00
Bonds Payable 200,000.00
$287,000.00
Receiver’s Cash Account
Balance Taken Over by Receiver $ 4,000.00 Purchase $ 12,500.00
Sales $ 51,000 Other Property 10,000.00
Accts. Rec. 100,000 Selling Expenses. 10,000.00
Other Property 69,000 Receiver’s Administration 7,500
Rentals 1,000 Accrued Expenses 14,000.00
Notes Payable 70,000.00
Cash Acquired under Accounts Payable 100,500.00
Receivership 221,000.00 Balance Returned to Owner 500.00
$225,000.00 $225,000.00
Comments on Problem. Under the method of solution presented here, it will be noted that the trustee is held to
an accounting for both the original assets which have been turned over to him, and all new assets acquired during
the course of his receivership. Inasmuch as all income items, usually from sales and, in this case, from rentals also,
are reflected in the assets acquired under the receivership, the receiver is thus charged with the income received by
him.
In rendering his accounting for the assets acquired, he must make a full accounting for all values turned over to
him. Accordingly, in the “Disposition of Assets” section are shown not only the amount realized from the sale of
the assets, but also the loss incurred in their sale. This makes possible the tying up of the assets accounted for with
the value at which they were turned over to the receiver. It is to be noted that in the case of merchandise there is a
profit on sales and not a loss. This is shown by setting up the merchandise disposed of at its sales figure—as is also
Original Total
Receivership
$534.500.00 $540,500.00 $1,546,500.00
Operations of the Receiver:
Income:
Sales $131,000.00
$131,000.00
Profit on Sales (brought down) $21,000.00
Rental 1,000.00
Decrease in Value of Business
under Receivership 26,500.00
$48,500.00
Values Returned to Owner:
Notes Payable $ 45,000.00
Accounts Payable 42,000.00
Bonds Payable 200,000.00
$287,000.00
Receiver’s Cash Account
Balance Taken Over by Receiver $ 4,000.00 Purchase $ 12,500.00
Sales $ 51,000 Other Property 10,000.00
Accts. Rec. 100,000 Selling Expenses. 10,000.00
Other Property 69,000 Receiver’s Administration 7,500
Rentals 1,000 Accrued Expenses 14,000.00
Notes Payable 70,000.00
Cash Acquired under Accounts Payable 100,500.00
Receivership 221,000.00 Balance Returned to Owner 500.00
$225,000.00 $225,000.00
Comments on Problem. Under the method of solution presented here, it will be noted that the trustee is held to
an accounting for both the original assets which have been turned over to him, and all new assets acquired during
the course of his receivership. Inasmuch as all income items, usually from sales and, in this case, from rentals also,
are reflected in the assets acquired under the receivership, the receiver is thus charged with the income received by
him.
In rendering his accounting for the assets acquired, he must make a full accounting for all values turned over to
him. Accordingly, in the “Disposition of Assets” section are shown not only the amount realized from the sale of
the assets, but also the loss incurred in their sale. This makes possible the tying up of the assets accounted for with
the value at which they were turned over to the receiver. It is to be noted that in the case of merchandise there is a
profit on sales and not a loss. This is shown by setting up the merchandise disposed of at its sales figure—as is also
Page 520
indicated in the next section below under the head of “Operations of the Receiver: Income”—and deducting from
it the profit made as shown by the next section contra under the head of “Operations of the Receiver: Expenses.”
The difference between these two figures of merchandise at sales price and the profit on the merchandise gives the
value of the merchandise with which the receiver is charged. By showing in parallel columns the values disposed
of and the values still on hand, the final column accounts for the full value with which the receiver has been
charged contra.
As a supplement to his accounting for the assets and liabilities, the receiver’s expenses and income are
incorporated as a part of the statement. This is done not with the idea that he is to be charged with the one and
credited with the other, for the principles of debit and credit, as stated above, have little logical application to the
statement, but in order to bring onto the face of the statement informational data which are essential to an
intelligent reading of his accounting.
The difference between the two sides of this section of the statement—in this case $26,500—is the decrease in
net worth of the business during the period of the receivership. This figure is capable of proof by comparing the
net worth of the business as originally turned over to the receiver with the net worth as turned back by him. In the
one case it is $280,000, as shown by the difference between total assets of $684,000 and liabilities of $404,000. In
the other case it is $253,500, as shown by the difference between the total assets of $540,500 returned to the owner
and the total liabilities of $287,000 turned back.
When this information is given in the one statement, the latter becomes somewhat complex, but by careful
analysis all the information desired can be secured from it and the attached receiver’s cash summary.
Uses to which Realization and Liquidation Statement May be Put
The realization and liquidation statement is frequently used also to analyze the activities of a receiver in equity.
Where such is the case, the final section of the statement shows the assets and liabilities returned to the business at
the close of the term of the receivership. The statement is sometimes used also to summarize by instalments a
trustee’s activities, in which case at the end of the first period (at which time the realization and liquidation have
been only partially completed) the final section of the statement will be the inventories of the assets yet to be
realized and the liabilities yet to be liquidated which are carried over to the second instalment period. The
statement for the second instalment period follows exactly the lines of that presented for the first period.
It should be understood always that the statement has no basis in practice, is purely theoretical, and any
discussion of it is largely academic. It is presented here only because it is so frequently met in the formal
examinations for the C. P. A. certificate.
Liquidation of a Partnership
by Instalments
Nature of the Problem
In connection with the problem of realization and liquidation, a similar problem is sometimes met upon the
voluntary dissolution of a partnership. This, as stated in Volume I, Chapter XLIV, is briefly:
Where the process of liquidation is of long duration, the partners may desire to receive what is due them by
instalments rather than wait until the termination of proceedings and receive their respective shares in one amount.
If the profit and loss sharing ratios of the partners are the same as their capital ratios, no trouble will be
encountered in making the liquidating dividends on capital account as the dividends will be in the profit and loss
sharing ratio. Trouble is encountered, however, when the two ratios are different inasmuch as it is not known at the
time the various instalments, except the last, are made what the expenses and losses will be in the end. Because of
the fact that these expenses and losses are shared in a different ratio from the capital ratios, their capital ratios are
constantly changing after the losses and expenses to be borne by the various partners are charged in each case.
Liquidating dividends are always made on the basis of capital investment ratios rather than profit and loss ratios.
By this is meant simply that after all expenses and losses have been determined and charged to the partners in their
profit and loss sharing ratios, their capital accounts show their respective interests in the business, and upon
dissolution payment must be made to them in accordance with the showing of their capital accounts. Where,
however, payment is made in instalments, neither the capital ratio nor the profit and loss sharing ratio, if these are
different, gives the correct basis for making the distribution of the instalment. If payment of the instalments is
made on some arbitrary basis or on the ratio of the profit and loss or of their capitals, it may result in an
it the profit made as shown by the next section contra under the head of “Operations of the Receiver: Expenses.”
The difference between these two figures of merchandise at sales price and the profit on the merchandise gives the
value of the merchandise with which the receiver is charged. By showing in parallel columns the values disposed
of and the values still on hand, the final column accounts for the full value with which the receiver has been
charged contra.
As a supplement to his accounting for the assets and liabilities, the receiver’s expenses and income are
incorporated as a part of the statement. This is done not with the idea that he is to be charged with the one and
credited with the other, for the principles of debit and credit, as stated above, have little logical application to the
statement, but in order to bring onto the face of the statement informational data which are essential to an
intelligent reading of his accounting.
The difference between the two sides of this section of the statement—in this case $26,500—is the decrease in
net worth of the business during the period of the receivership. This figure is capable of proof by comparing the
net worth of the business as originally turned over to the receiver with the net worth as turned back by him. In the
one case it is $280,000, as shown by the difference between total assets of $684,000 and liabilities of $404,000. In
the other case it is $253,500, as shown by the difference between the total assets of $540,500 returned to the owner
and the total liabilities of $287,000 turned back.
When this information is given in the one statement, the latter becomes somewhat complex, but by careful
analysis all the information desired can be secured from it and the attached receiver’s cash summary.
Uses to which Realization and Liquidation Statement May be Put
The realization and liquidation statement is frequently used also to analyze the activities of a receiver in equity.
Where such is the case, the final section of the statement shows the assets and liabilities returned to the business at
the close of the term of the receivership. The statement is sometimes used also to summarize by instalments a
trustee’s activities, in which case at the end of the first period (at which time the realization and liquidation have
been only partially completed) the final section of the statement will be the inventories of the assets yet to be
realized and the liabilities yet to be liquidated which are carried over to the second instalment period. The
statement for the second instalment period follows exactly the lines of that presented for the first period.
It should be understood always that the statement has no basis in practice, is purely theoretical, and any
discussion of it is largely academic. It is presented here only because it is so frequently met in the formal
examinations for the C. P. A. certificate.
Liquidation of a Partnership
by Instalments
Nature of the Problem
In connection with the problem of realization and liquidation, a similar problem is sometimes met upon the
voluntary dissolution of a partnership. This, as stated in Volume I, Chapter XLIV, is briefly:
Where the process of liquidation is of long duration, the partners may desire to receive what is due them by
instalments rather than wait until the termination of proceedings and receive their respective shares in one amount.
If the profit and loss sharing ratios of the partners are the same as their capital ratios, no trouble will be
encountered in making the liquidating dividends on capital account as the dividends will be in the profit and loss
sharing ratio. Trouble is encountered, however, when the two ratios are different inasmuch as it is not known at the
time the various instalments, except the last, are made what the expenses and losses will be in the end. Because of
the fact that these expenses and losses are shared in a different ratio from the capital ratios, their capital ratios are
constantly changing after the losses and expenses to be borne by the various partners are charged in each case.
Liquidating dividends are always made on the basis of capital investment ratios rather than profit and loss ratios.
By this is meant simply that after all expenses and losses have been determined and charged to the partners in their
profit and loss sharing ratios, their capital accounts show their respective interests in the business, and upon
dissolution payment must be made to them in accordance with the showing of their capital accounts. Where,
however, payment is made in instalments, neither the capital ratio nor the profit and loss sharing ratio, if these are
different, gives the correct basis for making the distribution of the instalment. If payment of the instalments is
made on some arbitrary basis or on the ratio of the profit and loss or of their capitals, it may result in an
Page 521
overpayment of some of the partners and an underpayment of others. Accordingly, the only safe method of
handling the situation is to pay the first instalments to those partners whose capital ratios are in excess of their
profit and loss ratios until their capitals are reduced to the point where the capital ratios of all the partners are the
same as their profit and loss ratios. Thereafter further instalment payments are made in the profit and loss ratio, not
because it is the profit and loss ratio but because now the capital ratios are the same as the profit and loss ratios so
that whatever loss or expense must ultimately be cared for will automatically be distributed to the partners’
accounts in this way.
The solution of the problem is perhaps best handled, at the time of the first instalment, by deducting the
amount of the first instalment from the total net capitals of the partners at that time. This leaves the capital
remaining after payment of the instalment. A distribution of this net remaining capital is made in the profit and loss
ratio. A comparison of the former capital to the credit of each partner with his new capital as derived by means of
the distribution just made in profit and loss ratio indicates the share each partner is to receive of the first
instalment. If the first instalment is sufficiently large to adjust the partners’ capital ratios to their profit and loss
sharing ratios, no trouble will be experienced with future instalments. However, it very frequently happens that the
first instalment is not sufficiently large to adjust the capitals to the profit and loss sharing basis. To do this would
require the contribution of additional capital by those partners whose capital ratio is less than their profit and loss
ratio, and it is doubtful if such a contribution would ever be made. Accordingly, it becomes necessary to distribute
the instalments only to those partners whose capital ratios are in excess of their profit and loss ratios.
A new problem is met here, namely, the determination of the respective shares of the deficiency which must be
borne by partners sharing the first instalment. How this is to be treated can perhaps be seen best in the illustrative
problem on page 654. There it is seen that with the distribution in profit and loss ratio of the capital remaining after
the first instalment, a deficiency of $6,000 arises representing the amount of C’s capital deficiency. This $6,000
must be borne by A and B and their shares therein are based on their relative profit and loss sharing ratios. Since A
bears 25% of the profits or losses and B 35%, A should bear ⁵/₁₂ of C’s capital deficiency and B ⁷/₁₂—amounting to
$2,500 for A and $3,500 for B. This reduces their shares in the first instalment to $3,000 each, as shown in the
columns headed “Actual Distribution.” Similarly, the second instalment still results in a capital deficiency for C of
$2,700 which must be borne by A and B in the amounts indicated. The third instalment is sufficiently large to give
all of them something and at the same time reduce their capital ratios to a profit and loss sharing ratio. Thereafter
all instalments are distributed on the profit and loss sharing basis.
After the final instalment is distributed, it will be noted that a net loss results on liquidation of $20,000 which
is distributed automatically to the partners in the sums of $5,000 to A, $7,000 to B, and $8,000 to C, which
represent their profit and loss sharing ratios. In conclusion it should be said that the problem is theoretical and
academic and will perhaps seldom, if ever, be met in practice because of the objections which the partner whose
account shows a deficiency would raise to non-participation in all instalments until his capital deficiency had been
eliminated. It may be said that where such objections are raised the only course of the liquidating partner or agent
is to refuse distribution of any instalment until a sufficiently large sum has accumulated to place the partners’
capitals on a profit and loss sharing basis. Such is the exact situation in strict theory. In practice, however, any
agreement which the partners might make as among themselves would have to be carried out by the liquidating
partner and would, of course, protect him in case of ultimate overpayment to any of the partners.
Illustration of Liquidation by Instalments
To illustrate the liquidation of a partnership by instalments, a typical problem is appended shown in
summarized form.
Problem. A, B, and C, sharing profits in the ratios of 25%, 35%, and 40% respectively, decide to dissolve
partnership and distribute the net assets by instalments as realized. A balance sheet as on the date of dissolution
showed net worth of $100,000, in which A’s interest was $30,000, B’s $40,000, and C’s $30,000. The liquidator
distributed a first instalment of $10,000, a second instalment of $8,250, a third instalment of $15,000, a fourth
instalment of $16,750, and a final instalment of $30,000. Show the shares which each of the partners will have in
the various instalments.
Solution
handling the situation is to pay the first instalments to those partners whose capital ratios are in excess of their
profit and loss ratios until their capitals are reduced to the point where the capital ratios of all the partners are the
same as their profit and loss ratios. Thereafter further instalment payments are made in the profit and loss ratio, not
because it is the profit and loss ratio but because now the capital ratios are the same as the profit and loss ratios so
that whatever loss or expense must ultimately be cared for will automatically be distributed to the partners’
accounts in this way.
The solution of the problem is perhaps best handled, at the time of the first instalment, by deducting the
amount of the first instalment from the total net capitals of the partners at that time. This leaves the capital
remaining after payment of the instalment. A distribution of this net remaining capital is made in the profit and loss
ratio. A comparison of the former capital to the credit of each partner with his new capital as derived by means of
the distribution just made in profit and loss ratio indicates the share each partner is to receive of the first
instalment. If the first instalment is sufficiently large to adjust the partners’ capital ratios to their profit and loss
sharing ratios, no trouble will be experienced with future instalments. However, it very frequently happens that the
first instalment is not sufficiently large to adjust the capitals to the profit and loss sharing basis. To do this would
require the contribution of additional capital by those partners whose capital ratio is less than their profit and loss
ratio, and it is doubtful if such a contribution would ever be made. Accordingly, it becomes necessary to distribute
the instalments only to those partners whose capital ratios are in excess of their profit and loss ratios.
A new problem is met here, namely, the determination of the respective shares of the deficiency which must be
borne by partners sharing the first instalment. How this is to be treated can perhaps be seen best in the illustrative
problem on page 654. There it is seen that with the distribution in profit and loss ratio of the capital remaining after
the first instalment, a deficiency of $6,000 arises representing the amount of C’s capital deficiency. This $6,000
must be borne by A and B and their shares therein are based on their relative profit and loss sharing ratios. Since A
bears 25% of the profits or losses and B 35%, A should bear ⁵/₁₂ of C’s capital deficiency and B ⁷/₁₂—amounting to
$2,500 for A and $3,500 for B. This reduces their shares in the first instalment to $3,000 each, as shown in the
columns headed “Actual Distribution.” Similarly, the second instalment still results in a capital deficiency for C of
$2,700 which must be borne by A and B in the amounts indicated. The third instalment is sufficiently large to give
all of them something and at the same time reduce their capital ratios to a profit and loss sharing ratio. Thereafter
all instalments are distributed on the profit and loss sharing basis.
After the final instalment is distributed, it will be noted that a net loss results on liquidation of $20,000 which
is distributed automatically to the partners in the sums of $5,000 to A, $7,000 to B, and $8,000 to C, which
represent their profit and loss sharing ratios. In conclusion it should be said that the problem is theoretical and
academic and will perhaps seldom, if ever, be met in practice because of the objections which the partner whose
account shows a deficiency would raise to non-participation in all instalments until his capital deficiency had been
eliminated. It may be said that where such objections are raised the only course of the liquidating partner or agent
is to refuse distribution of any instalment until a sufficiently large sum has accumulated to place the partners’
capitals on a profit and loss sharing basis. Such is the exact situation in strict theory. In practice, however, any
agreement which the partners might make as among themselves would have to be carried out by the liquidating
partner and would, of course, protect him in case of ultimate overpayment to any of the partners.
Illustration of Liquidation by Instalments
To illustrate the liquidation of a partnership by instalments, a typical problem is appended shown in
summarized form.
Problem. A, B, and C, sharing profits in the ratios of 25%, 35%, and 40% respectively, decide to dissolve
partnership and distribute the net assets by instalments as realized. A balance sheet as on the date of dissolution
showed net worth of $100,000, in which A’s interest was $30,000, B’s $40,000, and C’s $30,000. The liquidator
distributed a first instalment of $10,000, a second instalment of $8,250, a third instalment of $15,000, a fourth
instalment of $16,750, and a final instalment of $30,000. Show the shares which each of the partners will have in
the various instalments.
Solution
Page 522
Net A, 25%
Capital Theoretical Actual
of the firm Distribution Distribution
Original Capital $100,000.00 $30,000.00 $30,000.00
First Instalment 10,000.00
Net Capital $90,000.00 22,500.00
$ 7,500.00
Instalment Deficiency
to be borne by A & B 2,500.00 5,000.00
$25,000.00 $25,000.00
2nd Instalment 8,250.00
Net Capital $81,750.00 20,437.50
$ 4,562.50
Instalment Deficiency
to be borne by A & B 1,125.00 3,437.50
3rd Instalment. 15,000.00 $21,562.50 $21,562.50
Net Capital $66,750.00 16,687.50 4,875.00
$16,687.50
4th Instalment 16,750.00 4,187.50
Net Capital $50,000.00 $12,500.00
Final Instalment. 30,000.00 7,500.00
Net Loss on Liquidation $20,000.00 $5,000.00
Net B, 35%
Capital Theoretical Actual
of the firm Distribution Distribution
Original Capital $100,000.00 $40,000.00 $40,000.00
First Instalment 10,000.00
Net Capital $90,000.00 31,500.00
$ 8,500.00
Instalment Deficiency
to be borne by A & B 3,500.00 5,000.00
$35,000.00 $35,000.00
2nd Instalment 8,250.00
Net Capital $81,750.00 28,612.50
$ 6,387.50
Instalment Deficiency
to be borne by A & B 1,575.00 4,812.50
3rd Instalment. 15,000.00 $30,187.50 $30,187.50
Net Capital $66,750.00 23,362.50 6,825.00
$23,362.500
Capital Theoretical Actual
of the firm Distribution Distribution
Original Capital $100,000.00 $30,000.00 $30,000.00
First Instalment 10,000.00
Net Capital $90,000.00 22,500.00
$ 7,500.00
Instalment Deficiency
to be borne by A & B 2,500.00 5,000.00
$25,000.00 $25,000.00
2nd Instalment 8,250.00
Net Capital $81,750.00 20,437.50
$ 4,562.50
Instalment Deficiency
to be borne by A & B 1,125.00 3,437.50
3rd Instalment. 15,000.00 $21,562.50 $21,562.50
Net Capital $66,750.00 16,687.50 4,875.00
$16,687.50
4th Instalment 16,750.00 4,187.50
Net Capital $50,000.00 $12,500.00
Final Instalment. 30,000.00 7,500.00
Net Loss on Liquidation $20,000.00 $5,000.00
Net B, 35%
Capital Theoretical Actual
of the firm Distribution Distribution
Original Capital $100,000.00 $40,000.00 $40,000.00
First Instalment 10,000.00
Net Capital $90,000.00 31,500.00
$ 8,500.00
Instalment Deficiency
to be borne by A & B 3,500.00 5,000.00
$35,000.00 $35,000.00
2nd Instalment 8,250.00
Net Capital $81,750.00 28,612.50
$ 6,387.50
Instalment Deficiency
to be borne by A & B 1,575.00 4,812.50
3rd Instalment. 15,000.00 $30,187.50 $30,187.50
Net Capital $66,750.00 23,362.50 6,825.00
$23,362.500
Page 523
Net B, 35%
Capital Theoretical Actual
of the firm Distribution Distribution
4th Instalment 16,750.00 5,862.50
Net Capital $50,000.00 $17,500.00
Final Instalment. 30,000.00 10,500.00
Net Loss on Liquidation $20,000.00 $7,000.00
Net C, 40%
Capital Theoretical Actual
of the firm Distribution Distribution
Original Capital $100,000.00 $30,000.00 $30,000.00
First Instalment 10,000.00
Net Capital $90,000.00 36,000.00
[78]$6,000.00
Instalment Deficiency
to be borne by A & B
$30,000.00 $30,000.00
2nd Instalment 8,250.00
Net Capital $81,750.00 32,700.00
[79]$2,700.00
Instalment Deficiency
to be borne by A & B
$30,000.00 $30,000.00
3rd Instalment. 15,000.00
Net Capital $66,750.00 26,700.00 3,300.00
$26,700.00
4th Instalment 16,750.00 6,700.00
Net Capital $50,000.00 $20,000.00
Final Instalment. 30,000.00 12,000.00
Net Loss on Liquidation $20,000.00 $8,000.00
Capital Theoretical Actual
of the firm Distribution Distribution
4th Instalment 16,750.00 5,862.50
Net Capital $50,000.00 $17,500.00
Final Instalment. 30,000.00 10,500.00
Net Loss on Liquidation $20,000.00 $7,000.00
Net C, 40%
Capital Theoretical Actual
of the firm Distribution Distribution
Original Capital $100,000.00 $30,000.00 $30,000.00
First Instalment 10,000.00
Net Capital $90,000.00 36,000.00
[78]$6,000.00
Instalment Deficiency
to be borne by A & B
$30,000.00 $30,000.00
2nd Instalment 8,250.00
Net Capital $81,750.00 32,700.00
[79]$2,700.00
Instalment Deficiency
to be borne by A & B
$30,000.00 $30,000.00
3rd Instalment. 15,000.00
Net Capital $66,750.00 26,700.00 3,300.00
$26,700.00
4th Instalment 16,750.00 6,700.00
Net Capital $50,000.00 $20,000.00
Final Instalment. 30,000.00 12,000.00
Net Loss on Liquidation $20,000.00 $8,000.00
Page 524
APPENDIX A
PRACTICE WORK FOR STUDENT—
FIRST HALF-YEAR
Instead of the student’s practice work appearing at the close of each chapter of the text as in
Volume I, it has seemed best in this volume to place this material in a separate appendix at the end of
the text because of the impracticability of dividing the text matter into uniform sections with one or
two chapters constituting a lesson assignment. In some classes more practice work may be undertaken
than in others. The practice work is, however, laid out in fairly uniform portions and it is expected that
the student will be able to handle one practice assignment for each hour of class work. Thus, if the
lecture period is of two hours’ duration, two assignments of work should be set.
The practice work is given in three parts. Appendix A will be found to contain sufficient material
for the first semester of approximately 30 hours of lecture work. This appendix, in the main, is
comprised of a formal set of accounts relating to a manufacturing corporation, to be worked out with
suitable blanks. A few miscellaneous problems bearing particularly on some portions of the text are
also provided. Appendix A should be covered in connection with the first twenty-seven chapters of the
text.
Appendix B contains a series of well-graded problems more or less closely connected, illustrating,
by means of its method of keeping accounts, the growth of the business. Single entry is changed to
double entry, a simple trading business into a complex manufacturing concern, and many of the
problems peculiar to such types of business organization are incorporated. Some unrelated problems
illustrating special forms of statements, combinations, capitalization, and the consolidated balance
sheet are also included.
Appendix C contains a group of unrelated, miscellaneous problems, taken mostly from C. P. A.
examinations. These can be used to supplement the assignments from Appendices A and B and to give
variety to the work during succeeding years.
I
Problems
1. J. B. Rogers and B. R. Jay, owners of similar businesses, agree to consolidate under a
partnership agreement whereby each turns over his business as it stands, subject to the liabilities
shown, and the deficient partner contributes sufficient cash to equalize their capitals. Rogers’ standing
is: cash $750; merchandise $3,900; notes receivable $1,000, with interest accrued on same $10.25;
accounts receivable $750, estimated as worth $725; furniture $975; notes payable $1,000, being his
personal non-interest bearing note at 60 days discounted at 8% with 20 days yet to run; accounts
payable $325. Jay’s standing is: cash $365; merchandise $4,500; accounts receivable $1,350,
guaranteed as good; furniture $825; delivery equipment $325, valued at $300; accounts payable $265;
notes payable $1,200, with accrued interest of $8.69; salaries earned but unpaid $50. The furniture in
each case is taken in at its face value.
Make the opening journal entry and balance sheet for the new firm. Make journal entries for each
partner to close his old set of books.
PRACTICE WORK FOR STUDENT—
FIRST HALF-YEAR
Instead of the student’s practice work appearing at the close of each chapter of the text as in
Volume I, it has seemed best in this volume to place this material in a separate appendix at the end of
the text because of the impracticability of dividing the text matter into uniform sections with one or
two chapters constituting a lesson assignment. In some classes more practice work may be undertaken
than in others. The practice work is, however, laid out in fairly uniform portions and it is expected that
the student will be able to handle one practice assignment for each hour of class work. Thus, if the
lecture period is of two hours’ duration, two assignments of work should be set.
The practice work is given in three parts. Appendix A will be found to contain sufficient material
for the first semester of approximately 30 hours of lecture work. This appendix, in the main, is
comprised of a formal set of accounts relating to a manufacturing corporation, to be worked out with
suitable blanks. A few miscellaneous problems bearing particularly on some portions of the text are
also provided. Appendix A should be covered in connection with the first twenty-seven chapters of the
text.
Appendix B contains a series of well-graded problems more or less closely connected, illustrating,
by means of its method of keeping accounts, the growth of the business. Single entry is changed to
double entry, a simple trading business into a complex manufacturing concern, and many of the
problems peculiar to such types of business organization are incorporated. Some unrelated problems
illustrating special forms of statements, combinations, capitalization, and the consolidated balance
sheet are also included.
Appendix C contains a group of unrelated, miscellaneous problems, taken mostly from C. P. A.
examinations. These can be used to supplement the assignments from Appendices A and B and to give
variety to the work during succeeding years.
I
Problems
1. J. B. Rogers and B. R. Jay, owners of similar businesses, agree to consolidate under a
partnership agreement whereby each turns over his business as it stands, subject to the liabilities
shown, and the deficient partner contributes sufficient cash to equalize their capitals. Rogers’ standing
is: cash $750; merchandise $3,900; notes receivable $1,000, with interest accrued on same $10.25;
accounts receivable $750, estimated as worth $725; furniture $975; notes payable $1,000, being his
personal non-interest bearing note at 60 days discounted at 8% with 20 days yet to run; accounts
payable $325. Jay’s standing is: cash $365; merchandise $4,500; accounts receivable $1,350,
guaranteed as good; furniture $825; delivery equipment $325, valued at $300; accounts payable $265;
notes payable $1,200, with accrued interest of $8.69; salaries earned but unpaid $50. The furniture in
each case is taken in at its face value.
Make the opening journal entry and balance sheet for the new firm. Make journal entries for each
partner to close his old set of books.
Page 525
2. From the following information take a trial balance, make closing journal entries and summary
statements as of December 31.
Notes receivable on hand $3,000; accounts receivable $7,500; notes payable $2,100; accounts
payable $4,600; real estate $6,000; plant and machinery $8,000; rent and taxes $600; general expense
$2,000; salaries $1,500; wages $600; freight $150; duty $200; cash on hand $150; cash in bank
$1,800; bad debts written off $140; goods on hand at beginning of year $9,500; purchases $26,000;
sales $40,000; interest paid $210; furniture $600; Jas. Buckham, partner, invested $10,000, withdrew
$1,450; E. J. Cockburn invested $14,000, withdrew $1,300; the merchandise on hand is valued at
$9,000; rent unpaid $250; insurance unexpired $140; interest accrued on notes receivable $25; wages
accrued $115. Allow 10% depreciation on plant and machinery, and 12½% on furniture. Estimate
losses from bad debts as 5% of accounts and notes outstanding. Losses and gains are divided ⁴/₇ to
Cockburn and ³/₇ to Buckham. Interest on capitals at 6% is to be allowed.
3. At the end of the first year of a partnership, Wilson has an interest of $18,000 and Peters of
$9,000, each drawing profits in proportion to his capital.
They decide to admit Johnson into the partnership, selling him a one-quarter interest, valuing their
good-will at $3,000. Under the conditions named, in what two ways may Johnson secure his interest?
What will be the amount of his investment in each case?
Instructions
Problem 1. The student is referred to Volume I, pages 458-459, where a similar problem is
illustrated.
Problem 2. See Volume I, pages 285-286.
II
Problems
1. The Ibex Manufacturing Co. is incorporated with an authorized capital stock of $500,000
common and $250,000 6% preferred; $150,000 of the preferred is subscribed for and paid in full.
One-half of the common is subscribed for and 50% paid in, the balance to be paid in five monthly
instalments. The remaining preferred stock is later subscribed for at 101 and 50% paid, and half of the
remaining common is subscribed for at 90 and paid in full. After operating for six months the
remaining common is sold at 102 to provide funds for enlargement, one-half paid in cash and the
balance in one month. Balance of preferred subscriptions are paid in cash. Show all the above
transactions by means of journal entries.
2. At the close of the first year, the Ibex Manufacturing Co., being short of ready funds and not
desiring to extend its credit further, secures from its stockholders a donation of $50,000 common and
$10,000 preferred, one-half of which is immediately sold at 90 and 101 respectively. At the end of the
second year the remainder of the donated stock was disbursed to the stockholders as a dividend, net
profits for the year amounting to $45,000. Journalize all the above transactions, showing ultimate
disposition of the working capital.
3. The Smith Brooks Publishing Co. has a capital stock of $750,000, of which one-third is 6%
cumulative preferred stock. The company has a surplus of $65,000. It has an outstanding bond issue
of $200,000 at 4½% interest. The profits for the year are $61,392.75. No profits have been distributed
for three years. The directors pay the bond interest, declare a 3% dividend on common, and carry
$7,500 to the sinking fund. Bring all of the above onto your books.
statements as of December 31.
Notes receivable on hand $3,000; accounts receivable $7,500; notes payable $2,100; accounts
payable $4,600; real estate $6,000; plant and machinery $8,000; rent and taxes $600; general expense
$2,000; salaries $1,500; wages $600; freight $150; duty $200; cash on hand $150; cash in bank
$1,800; bad debts written off $140; goods on hand at beginning of year $9,500; purchases $26,000;
sales $40,000; interest paid $210; furniture $600; Jas. Buckham, partner, invested $10,000, withdrew
$1,450; E. J. Cockburn invested $14,000, withdrew $1,300; the merchandise on hand is valued at
$9,000; rent unpaid $250; insurance unexpired $140; interest accrued on notes receivable $25; wages
accrued $115. Allow 10% depreciation on plant and machinery, and 12½% on furniture. Estimate
losses from bad debts as 5% of accounts and notes outstanding. Losses and gains are divided ⁴/₇ to
Cockburn and ³/₇ to Buckham. Interest on capitals at 6% is to be allowed.
3. At the end of the first year of a partnership, Wilson has an interest of $18,000 and Peters of
$9,000, each drawing profits in proportion to his capital.
They decide to admit Johnson into the partnership, selling him a one-quarter interest, valuing their
good-will at $3,000. Under the conditions named, in what two ways may Johnson secure his interest?
What will be the amount of his investment in each case?
Instructions
Problem 1. The student is referred to Volume I, pages 458-459, where a similar problem is
illustrated.
Problem 2. See Volume I, pages 285-286.
II
Problems
1. The Ibex Manufacturing Co. is incorporated with an authorized capital stock of $500,000
common and $250,000 6% preferred; $150,000 of the preferred is subscribed for and paid in full.
One-half of the common is subscribed for and 50% paid in, the balance to be paid in five monthly
instalments. The remaining preferred stock is later subscribed for at 101 and 50% paid, and half of the
remaining common is subscribed for at 90 and paid in full. After operating for six months the
remaining common is sold at 102 to provide funds for enlargement, one-half paid in cash and the
balance in one month. Balance of preferred subscriptions are paid in cash. Show all the above
transactions by means of journal entries.
2. At the close of the first year, the Ibex Manufacturing Co., being short of ready funds and not
desiring to extend its credit further, secures from its stockholders a donation of $50,000 common and
$10,000 preferred, one-half of which is immediately sold at 90 and 101 respectively. At the end of the
second year the remainder of the donated stock was disbursed to the stockholders as a dividend, net
profits for the year amounting to $45,000. Journalize all the above transactions, showing ultimate
disposition of the working capital.
3. The Smith Brooks Publishing Co. has a capital stock of $750,000, of which one-third is 6%
cumulative preferred stock. The company has a surplus of $65,000. It has an outstanding bond issue
of $200,000 at 4½% interest. The profits for the year are $61,392.75. No profits have been distributed
for three years. The directors pay the bond interest, declare a 3% dividend on common, and carry
$7,500 to the sinking fund. Bring all of the above onto your books.
Page 526
4. A corporation has been formed with an authorized capital stock of $200,000, one-fourth of
which is 7% cumulative preferred. The entire issue of preferred is subscribed for at par and 50% paid
in. When the balance is paid, one share of common is to be given as a bonus with every five shares of
preferred. The promoter of the company is given $15,000 in common for his services. The company
paid cash $250 for a set of stock records; $25 for corporate seal; $500 for lawyer’s fees in
incorporating; $250 for state charter, and $375 for sundry expenses in organizing. $75,000 of the
common stock has been subscribed for at par to be paid in five monthly instalments. The balance has
been paid on the preferred stock and three instalments on the common. Make journal entries covering
the above transactions.
Instructions
For the opening entries of a corporation, the student is referred to Volume I, Chapter XLIX, in
addition to Chapter I of the present volume.
Problem 1. Make entries covering the five monthly instalments.
Problem 2. Assume that no preferred dividend was paid during the first year.
III
Problems
1. Draw up a form of voucher check suitable for a professional man.
2. Draw up a form of voucher check suitable for a trading concern.
3. Draw up a form of voucher register for a manufacturing concern desiring to segregate
manufacturing, trading, and general expenses under which there are twelve, ten, and fifteen
subdivisions of expense, respectively. Provide for other possible expenditures. Treat purchase
discounts as a reduction of cost price.
4. Using the voucher register you drew up for Problem 3, from your own data make at least one
entry in each column and three in the Sundries column. Show the register footed, closed, and posted.
5. What change would you make in the form of a voucher register in order to treat purchase
discount as a financial management item?
6. Using your own data for a purchase ledger in which there are at least six open accounts, show
the entries necessary to close it and open a voucher register to take its place.
Instructions
See Chapter II where all these points are discussed.
IV
Problem
Caxton & Dolton began business January 1, 1916. Caxton invested $12,000, and Dolton invested
$11,000. May 1, 1916, Caxton withdrew $3,000, and Dolton invested $1,000. July 1, 1917, Evans was
admitted to the partnership, investing $8,000. October 1, 1917, Evans invested $4,000 more, and
Dolton withdrew $2,000. July 1, 1918, Dolton and Evans purchased Caxton’s interest in the business.
On that date their books showed the following financial condition: cash $19,364.50; merchandise
$17,500; notes receivable $10,000; accounts receivable $8,945; interest receivable $248.50; real estate
$6,500; accounts payable $14,000; notes payable $5,130; interest payable $167.40; accrued expenses
$325.60. For the purpose of the sale good-will was estimated at $5,000; depreciation on real estate
which is 7% cumulative preferred. The entire issue of preferred is subscribed for at par and 50% paid
in. When the balance is paid, one share of common is to be given as a bonus with every five shares of
preferred. The promoter of the company is given $15,000 in common for his services. The company
paid cash $250 for a set of stock records; $25 for corporate seal; $500 for lawyer’s fees in
incorporating; $250 for state charter, and $375 for sundry expenses in organizing. $75,000 of the
common stock has been subscribed for at par to be paid in five monthly instalments. The balance has
been paid on the preferred stock and three instalments on the common. Make journal entries covering
the above transactions.
Instructions
For the opening entries of a corporation, the student is referred to Volume I, Chapter XLIX, in
addition to Chapter I of the present volume.
Problem 1. Make entries covering the five monthly instalments.
Problem 2. Assume that no preferred dividend was paid during the first year.
III
Problems
1. Draw up a form of voucher check suitable for a professional man.
2. Draw up a form of voucher check suitable for a trading concern.
3. Draw up a form of voucher register for a manufacturing concern desiring to segregate
manufacturing, trading, and general expenses under which there are twelve, ten, and fifteen
subdivisions of expense, respectively. Provide for other possible expenditures. Treat purchase
discounts as a reduction of cost price.
4. Using the voucher register you drew up for Problem 3, from your own data make at least one
entry in each column and three in the Sundries column. Show the register footed, closed, and posted.
5. What change would you make in the form of a voucher register in order to treat purchase
discount as a financial management item?
6. Using your own data for a purchase ledger in which there are at least six open accounts, show
the entries necessary to close it and open a voucher register to take its place.
Instructions
See Chapter II where all these points are discussed.
IV
Problem
Caxton & Dolton began business January 1, 1916. Caxton invested $12,000, and Dolton invested
$11,000. May 1, 1916, Caxton withdrew $3,000, and Dolton invested $1,000. July 1, 1917, Evans was
admitted to the partnership, investing $8,000. October 1, 1917, Evans invested $4,000 more, and
Dolton withdrew $2,000. July 1, 1918, Dolton and Evans purchased Caxton’s interest in the business.
On that date their books showed the following financial condition: cash $19,364.50; merchandise
$17,500; notes receivable $10,000; accounts receivable $8,945; interest receivable $248.50; real estate
$6,500; accounts payable $14,000; notes payable $5,130; interest payable $167.40; accrued expenses
$325.60. For the purpose of the sale good-will was estimated at $5,000; depreciation on real estate
Page 527
5%; bad debts at 3% of the outstanding notes and accounts. Each partner was to share in profits on the
basis of capital and the length of time the capital was invested. Of the purchase price of Caxton’s
share, Dolton and Evans were to pay such amounts respectively as would make their new capitals
equal. Set up the partners’ ledger accounts and show all entries to them in order to take effect of all the
above data.
Instructions
For explanation of this method of sharing profits, see Volume I, pages 281-284.
V
Practice Data
This set contains material for the student’s practice work in keeping the records of a corporation
engaged in trading and manufacture. Two blank books will be used for the record. Of the “Journals,”
pages 1-32 comprise the general journal; pages 34-44 the cash book; pages 45-48, the sales journal;
page 49 the sales returns and allowances journal; page 51 the purchase journal (to be used for the
month of September only); and pages 54-57 the voucher register (to be used after the purchase journal
is discontinued). Pages 58-60 are to be used for the record of continuous trial balances. Of the
“Ledger” blank, pages 1-44 comprise the general ledger; pages 45-51 the sales ledger; and pages 52-
56 the purchase ledger. Column headings for the different journals are given in the blanks.
It is expected that the student has already acquired correct habits of the daily posting of
customers’ and creditors’ accounts. In addition to a training in some peculiarities of manufacturing
accounts, the purpose of the course is to give the student practice in handling some of the larger
problems of accounting which are not of daily occurrence. For the first few assignments considerable
detail is given to provide a necessary minimum of practice in the summarization and posting of the
different books of original entry. After this the ordinary transactions are given in condensed form to
save unnecessary repetition and burdening the student. In the use of the analytical general journal, the
student must be very careful to make entries in the proper column, as otherwise trouble will be
experienced with the controlling accounts. (See Volume I, pages 410, 430, and 431.)
Open the following accounts in the various ledgers as indicated. The numeral preceding the
account title indicates the ledger folio on which the particular account is to be opened.
General Ledger—Give one-third page to each account except Notes
Receivable, Trade Debtors, Merchandise Inventory, Notes Payable, Vouchers
Payable, and Subscribers, for each of which allow 4 additional lines, shortening
the allowance for the account next following in each case.
1. Drew National Bank
1. Petty Cash
1. Sinking Fund Trustee
2. Notes Receivable
2. Notes Receivable Discounted
2. Notes Receivable Special
3. Trade Debtors
3. Reserve for Doubtful Accounts
3. Accounts Receivable Special
4. Prepayment on Purchases
basis of capital and the length of time the capital was invested. Of the purchase price of Caxton’s
share, Dolton and Evans were to pay such amounts respectively as would make their new capitals
equal. Set up the partners’ ledger accounts and show all entries to them in order to take effect of all the
above data.
Instructions
For explanation of this method of sharing profits, see Volume I, pages 281-284.
V
Practice Data
This set contains material for the student’s practice work in keeping the records of a corporation
engaged in trading and manufacture. Two blank books will be used for the record. Of the “Journals,”
pages 1-32 comprise the general journal; pages 34-44 the cash book; pages 45-48, the sales journal;
page 49 the sales returns and allowances journal; page 51 the purchase journal (to be used for the
month of September only); and pages 54-57 the voucher register (to be used after the purchase journal
is discontinued). Pages 58-60 are to be used for the record of continuous trial balances. Of the
“Ledger” blank, pages 1-44 comprise the general ledger; pages 45-51 the sales ledger; and pages 52-
56 the purchase ledger. Column headings for the different journals are given in the blanks.
It is expected that the student has already acquired correct habits of the daily posting of
customers’ and creditors’ accounts. In addition to a training in some peculiarities of manufacturing
accounts, the purpose of the course is to give the student practice in handling some of the larger
problems of accounting which are not of daily occurrence. For the first few assignments considerable
detail is given to provide a necessary minimum of practice in the summarization and posting of the
different books of original entry. After this the ordinary transactions are given in condensed form to
save unnecessary repetition and burdening the student. In the use of the analytical general journal, the
student must be very careful to make entries in the proper column, as otherwise trouble will be
experienced with the controlling accounts. (See Volume I, pages 410, 430, and 431.)
Open the following accounts in the various ledgers as indicated. The numeral preceding the
account title indicates the ledger folio on which the particular account is to be opened.
General Ledger—Give one-third page to each account except Notes
Receivable, Trade Debtors, Merchandise Inventory, Notes Payable, Vouchers
Payable, and Subscribers, for each of which allow 4 additional lines, shortening
the allowance for the account next following in each case.
1. Drew National Bank
1. Petty Cash
1. Sinking Fund Trustee
2. Notes Receivable
2. Notes Receivable Discounted
2. Notes Receivable Special
3. Trade Debtors
3. Reserve for Doubtful Accounts
3. Accounts Receivable Special
4. Prepayment on Purchases
Page 528
4. Merchandise Inventory
4. Raw Materials Inventory
5. Goods in Process Inventory
5. Plant and Sundry Assets
5. Jackson, Edwards, Hansen, Vendors
6. Delivery Equipment
6. Depreciation Reserve Delivery Equipment
7. Patterns
7. Depreciation Reserve Patterns
8. Furniture and Fixtures
8. Depreciation Reserve Furniture and Fixtures
9. Power Equipment
9. Depreciation Reserve Power Equipment
10. Factory Buildings
10. Depreciation Reserve Factory Buildings
10. Tools
11. Machinery
11. Depreciation Reserve Machinery
11. Factory Land
12. Patents and Trade-Marks
12. Good-Will
12. Organization Expense
13. Notes Payable
13. Vouchers Payable
13. Boston Office Company
14. Dividends on Common
14. Dividends on First Preferred
14. Dividends on Second Preferred
15. Purchase Money Mortgage on Machinery
15. Bonds Payable (Authorized Issue $20,000)[A]
15. Discount on Bonds
16. Subscribers
16. Call No. 1
16. Call No. 2
17. Capital Stock Subscriptions
17. Capital Stock Common (Authorized Issue $100,000)[80]
17. Capital Stock First Preferred (Authorized Issue $50,000)[81]
18. Capital Stock Second Preferred (Authorized Issue $25,000)[82]
18. Discount on Stock
18. Treasury Stock
19. Surplus
19. Donated Working Capital
4. Raw Materials Inventory
5. Goods in Process Inventory
5. Plant and Sundry Assets
5. Jackson, Edwards, Hansen, Vendors
6. Delivery Equipment
6. Depreciation Reserve Delivery Equipment
7. Patterns
7. Depreciation Reserve Patterns
8. Furniture and Fixtures
8. Depreciation Reserve Furniture and Fixtures
9. Power Equipment
9. Depreciation Reserve Power Equipment
10. Factory Buildings
10. Depreciation Reserve Factory Buildings
10. Tools
11. Machinery
11. Depreciation Reserve Machinery
11. Factory Land
12. Patents and Trade-Marks
12. Good-Will
12. Organization Expense
13. Notes Payable
13. Vouchers Payable
13. Boston Office Company
14. Dividends on Common
14. Dividends on First Preferred
14. Dividends on Second Preferred
15. Purchase Money Mortgage on Machinery
15. Bonds Payable (Authorized Issue $20,000)[A]
15. Discount on Bonds
16. Subscribers
16. Call No. 1
16. Call No. 2
17. Capital Stock Subscriptions
17. Capital Stock Common (Authorized Issue $100,000)[80]
17. Capital Stock First Preferred (Authorized Issue $50,000)[81]
18. Capital Stock Second Preferred (Authorized Issue $25,000)[82]
18. Discount on Stock
18. Treasury Stock
19. Surplus
19. Donated Working Capital
Page 529
19. Sinking Fund Reserve
20. Manufacturing
21. Profit and Loss
22. Desks and Tables Sales
22. Desks and Tables Sales Returns and Allowances
22. Bookcases and Filing Cabinets Sales
23. Bookcases and Filing Cabinets Sales Returns and Allowances
23. Sundry Office Supplies Sales
23. Sundry Office Supplies Sales Returns and Allowances
24. Knoxfraud Sales
24. Knoxfraud Sales Returns and Allowances
24. Desks and Tables Purchases
25. Bookcases and Filing Cabinets Purchases
25. Sundry Office Supplies Purchases
25. Raw Materials Purchases
26. Knoxfrauds Manufactured
26. In-Freight and Delivery
26. Receiving and Shipping Room Expense
27. Direct Labor
27. Indirect Labor
27. Factory Supplies
28. Light, Heat, and Power
28. Building Maintenance and Repairs
28. Machinery Repairs
29. Assembling and Setting Up Expense
29. Depreciation
29. Sundry Factory Expense
30. Royalties
30. Experimental Expense
31. Salesmen’s Salaries
31. Salesmen’s Commissions
31. Salesmen’s Traveling Expense
32. Delivery Expense
32. Warehouse Expense
32. Warehouse Rent
33. Sundry Selling Expense
33. Advertising
34. Office Salaries
34. Stationery and Printing
34. Telephone, Telegraph, and Postage
35. Sundry Office Expense
35. Insurance
20. Manufacturing
21. Profit and Loss
22. Desks and Tables Sales
22. Desks and Tables Sales Returns and Allowances
22. Bookcases and Filing Cabinets Sales
23. Bookcases and Filing Cabinets Sales Returns and Allowances
23. Sundry Office Supplies Sales
23. Sundry Office Supplies Sales Returns and Allowances
24. Knoxfraud Sales
24. Knoxfraud Sales Returns and Allowances
24. Desks and Tables Purchases
25. Bookcases and Filing Cabinets Purchases
25. Sundry Office Supplies Purchases
25. Raw Materials Purchases
26. Knoxfrauds Manufactured
26. In-Freight and Delivery
26. Receiving and Shipping Room Expense
27. Direct Labor
27. Indirect Labor
27. Factory Supplies
28. Light, Heat, and Power
28. Building Maintenance and Repairs
28. Machinery Repairs
29. Assembling and Setting Up Expense
29. Depreciation
29. Sundry Factory Expense
30. Royalties
30. Experimental Expense
31. Salesmen’s Salaries
31. Salesmen’s Commissions
31. Salesmen’s Traveling Expense
32. Delivery Expense
32. Warehouse Expense
32. Warehouse Rent
33. Sundry Selling Expense
33. Advertising
34. Office Salaries
34. Stationery and Printing
34. Telephone, Telegraph, and Postage
35. Sundry Office Expense
35. Insurance
Page 530
35. Taxes
36. Rent
36. Interest and Discount
36. Collection Expense
37. Bond Interest
37. Sales Discount
37. Bad Debts
38. Purchase Discount
38. Rent Income
38. Commission Income
39. Loss from Sale of Power Equipment
39. Fire Loss
39. Strike Costs
40. Damage Claims
40. Damage Claims Reserve
Sales Ledger—Allow one-third page to each account.
45. Smith Brooks Stationery Co.
The Brush Co.
The Kistler Stationery Co.
46. C. F. Hoeckle Office Supply Co.
John Bach & Sons
T. J. Stewart Office Specialties Co.
47. Saxon Edwards
47. T. C. Macie & Co.
The Alexander Jacobs Co.
48. Field & Co.
Sundry Customers
49. Salesmen Advances
New Method Manufacturing Co.
General Ledger Adjustment
Purchase Ledger—Allow one-third page to each account.
52. P. J. Johnson Mills Co.
B. F. Brainard & Co.
Jackson City Supply Co.
53. F. C. Good Rubber Co.
53. B. A. Franklin Press
Brickley Desk Co.
36. Rent
36. Interest and Discount
36. Collection Expense
37. Bond Interest
37. Sales Discount
37. Bad Debts
38. Purchase Discount
38. Rent Income
38. Commission Income
39. Loss from Sale of Power Equipment
39. Fire Loss
39. Strike Costs
40. Damage Claims
40. Damage Claims Reserve
Sales Ledger—Allow one-third page to each account.
45. Smith Brooks Stationery Co.
The Brush Co.
The Kistler Stationery Co.
46. C. F. Hoeckle Office Supply Co.
John Bach & Sons
T. J. Stewart Office Specialties Co.
47. Saxon Edwards
47. T. C. Macie & Co.
The Alexander Jacobs Co.
48. Field & Co.
Sundry Customers
49. Salesmen Advances
New Method Manufacturing Co.
General Ledger Adjustment
Purchase Ledger—Allow one-third page to each account.
52. P. J. Johnson Mills Co.
B. F. Brainard & Co.
Jackson City Supply Co.
53. F. C. Good Rubber Co.
53. B. A. Franklin Press
Brickley Desk Co.
Page 531
54. R. M. Goddard Furniture Co. City of Hoboken
The column headings for the different books are given in the blanks with a few exceptions. The
fourth columns of the sales and sales returns and allowances journals are left blank. The student
should write in here “Sundry Office Supplies.” This will be used till October 31, 1916, at which time
it will be necessary to write in its place, “Knoxfrauds.” The heading for voucher register, column No.
5, which is left blank, must be written in as above, “Sundry Office Supplies Purchases,” for use until
October 31, when “Raw Materials Purchases” will be substituted.
Messrs. Stanley Jackson, J. T. Edwards, and P. Hansen, on September 1, 1915, made application as
incorporators to the Secretary of State for a certificate of incorporation authorizing the Acme Office
Furnishings Co. to transact a general business of all kinds in trading, manufacturing, and printing, as
principals or as agents, to acquire and trade in real estate, patents, trade-marks, licenses, and the like,
and to act as promotion and financial agents. The customary certifications were made, the
organization tax of $50 was paid, and the certificate duly issued. The authorized capital stock was
$100,000, divided into 1,000 shares of common stock only, of par value $100 each. Subscriptions at
par to capital stock had been made as follows:
Stanley Jackson 225 shares
J. T. Edwards 162 ”
P. Hansen 113 ”
T. J. Noble 100 ”
A. H. Lawrence 75 ”
H. C. McCullough 50 ”
At the first meeting of the incorporators and subscribers, after the adoption of a set of by-laws and
organization thereunder, a proposal of sale made by the Jackson, Edwards, Hansen firm of their
business and good-will at a stated figure of $50,120.97 was referred to the board of directors for their
consideration and investigation, with authority to act. After looking over the properties, all of which it
was found would be advantageous to the company, the proposal was accepted and transfer was made.
A committee from the board was appointed to make a careful appraisal of the purchased properties
and report as soon as possible. Accordingly, on September 15, the following report of valuation was
made and accepted and authority given for the opening up of a set of accounting records with the
stated values of the properties. The services of a public accountant were secured to plan and install a
system that would meet the needs of the proposed business and to open the books.
The properties acquired were: cash $5,269.14; accounts receivable, as per schedule following,
$10,125.61; notes receivable $1,250; desks and tables inventory $15,694; bookcases and filing
cabinets inventory $18,392; sundry office supplies inventory $8,196.27; rent prepaid $125; insurance
unexpired $95.36; delivery equipment $492.50; store furniture and fixtures $526; office furniture and
fixtures $274; good-will $4,500.
The liabilities assumed were: accounts payable, as per schedule following, $10,126.73; notes
payable $4,692.18. Upon the guaranty by Jackson, Edwards, Hansen of the accounts and notes
receivable taken over, the company assumed the contingent liability on notes receivable under
discount amounting to $250. No cognizance was taken of prepaid discount.
Payment was made to Jackson, Edwards, Hansen by the cancellation of indebtedness on their
subscription contracts in the amounts severally shown, and in cash for the balance (distributed in the
ratio of their subscriptions)—Jackson $54.44, Edwards $39.19, and Hansen $27.34.
The column headings for the different books are given in the blanks with a few exceptions. The
fourth columns of the sales and sales returns and allowances journals are left blank. The student
should write in here “Sundry Office Supplies.” This will be used till October 31, 1916, at which time
it will be necessary to write in its place, “Knoxfrauds.” The heading for voucher register, column No.
5, which is left blank, must be written in as above, “Sundry Office Supplies Purchases,” for use until
October 31, when “Raw Materials Purchases” will be substituted.
Messrs. Stanley Jackson, J. T. Edwards, and P. Hansen, on September 1, 1915, made application as
incorporators to the Secretary of State for a certificate of incorporation authorizing the Acme Office
Furnishings Co. to transact a general business of all kinds in trading, manufacturing, and printing, as
principals or as agents, to acquire and trade in real estate, patents, trade-marks, licenses, and the like,
and to act as promotion and financial agents. The customary certifications were made, the
organization tax of $50 was paid, and the certificate duly issued. The authorized capital stock was
$100,000, divided into 1,000 shares of common stock only, of par value $100 each. Subscriptions at
par to capital stock had been made as follows:
Stanley Jackson 225 shares
J. T. Edwards 162 ”
P. Hansen 113 ”
T. J. Noble 100 ”
A. H. Lawrence 75 ”
H. C. McCullough 50 ”
At the first meeting of the incorporators and subscribers, after the adoption of a set of by-laws and
organization thereunder, a proposal of sale made by the Jackson, Edwards, Hansen firm of their
business and good-will at a stated figure of $50,120.97 was referred to the board of directors for their
consideration and investigation, with authority to act. After looking over the properties, all of which it
was found would be advantageous to the company, the proposal was accepted and transfer was made.
A committee from the board was appointed to make a careful appraisal of the purchased properties
and report as soon as possible. Accordingly, on September 15, the following report of valuation was
made and accepted and authority given for the opening up of a set of accounting records with the
stated values of the properties. The services of a public accountant were secured to plan and install a
system that would meet the needs of the proposed business and to open the books.
The properties acquired were: cash $5,269.14; accounts receivable, as per schedule following,
$10,125.61; notes receivable $1,250; desks and tables inventory $15,694; bookcases and filing
cabinets inventory $18,392; sundry office supplies inventory $8,196.27; rent prepaid $125; insurance
unexpired $95.36; delivery equipment $492.50; store furniture and fixtures $526; office furniture and
fixtures $274; good-will $4,500.
The liabilities assumed were: accounts payable, as per schedule following, $10,126.73; notes
payable $4,692.18. Upon the guaranty by Jackson, Edwards, Hansen of the accounts and notes
receivable taken over, the company assumed the contingent liability on notes receivable under
discount amounting to $250. No cognizance was taken of prepaid discount.
Payment was made to Jackson, Edwards, Hansen by the cancellation of indebtedness on their
subscription contracts in the amounts severally shown, and in cash for the balance (distributed in the
ratio of their subscriptions)—Jackson $54.44, Edwards $39.19, and Hansen $27.34.
Page 532
A. H. Lawrence and H. C. McCullough on September 20 paid in cash 75% of their subscriptions,
the balance due in 30 days. Certificates of stock, properly executed, were issued September 20 to all
the above-mentioned parties, except Noble, in the amounts of their subscriptions.
Open the books and prepare a balance sheet of the company according to the data given.
Instructions
The fourth method illustrated in Volume I, pages 454 and 457, is to be used for opening the books.
Record the cash payment of organization tax as on September 1.
The purchase of the Jackson, Edwards, Hansen business is to be recorded under date of September
1, making use of the accounts “Jackson, Edwards, Hansen, Vendors” and “Plant and Sundry Assets.”
Upon receipt of the appraisal committee’s report, bring the detailed assets and liabilities onto the
books. It is to be noted that only one Inventory account is carried, in which the detail must be shown,
using one line for each kind of commodity. Bring the discounted note on the books. This is not
included in the amount given for notes receivable outstanding.
In a small corporation with stock closely held, certificates are sometimes issued although not yet
fully paid for.
VI
Practice Data
The following schedules support their respective titles found among the assets and liabilities taken
over and appraised by the Acme Office Furnishings Co.:
Accounts Receivable
Smith Brooks Stationery Co., June 24, $750; July 7, $100;
August 22, $113.14; 2/10 $963.14
The Brush Co., May 20, $825; August 15, $216.69; 2/10, 1/30 1,041.69
The Kistler Stationery Co., April 18, $1,000; June 15, $250;
August 20, $317.40; 2/10 1,567.40
C. F. Hoeckle Office Supply Co., March 12, $1,000;
July 18,$123.90 1,123.90
John Bach & Sons, June 13, $300; July 30, $119.36 419.36
T. J. Stewart Office Specialties Co., July 20, $319.45;
August 12, $523.12 842.57
Saxon Edwards, February 10, $585; May 23, $206.75 791.75
T. C. Macie & Co., May 11, $115.10; June 21, $210.15;
July 8, $450; August 25, $465.15; 2/10, n/30 1,240.40
The Alexander Jacobs Co., August 28, $362.25; 3/5, 2/10 362.25
Field & Co., June 15, $1,015.05; July 6, $250;
August 24, $508.10; 2/10, n/30 1,773.15
Accounts Payable
The P. J. Johnson Mills Co., January 15, $1,895.60;
August 5, $736.15; 1/30 $2,631.75
B. F. Brainard & Co., April 18, $590.10;
the balance due in 30 days. Certificates of stock, properly executed, were issued September 20 to all
the above-mentioned parties, except Noble, in the amounts of their subscriptions.
Open the books and prepare a balance sheet of the company according to the data given.
Instructions
The fourth method illustrated in Volume I, pages 454 and 457, is to be used for opening the books.
Record the cash payment of organization tax as on September 1.
The purchase of the Jackson, Edwards, Hansen business is to be recorded under date of September
1, making use of the accounts “Jackson, Edwards, Hansen, Vendors” and “Plant and Sundry Assets.”
Upon receipt of the appraisal committee’s report, bring the detailed assets and liabilities onto the
books. It is to be noted that only one Inventory account is carried, in which the detail must be shown,
using one line for each kind of commodity. Bring the discounted note on the books. This is not
included in the amount given for notes receivable outstanding.
In a small corporation with stock closely held, certificates are sometimes issued although not yet
fully paid for.
VI
Practice Data
The following schedules support their respective titles found among the assets and liabilities taken
over and appraised by the Acme Office Furnishings Co.:
Accounts Receivable
Smith Brooks Stationery Co., June 24, $750; July 7, $100;
August 22, $113.14; 2/10 $963.14
The Brush Co., May 20, $825; August 15, $216.69; 2/10, 1/30 1,041.69
The Kistler Stationery Co., April 18, $1,000; June 15, $250;
August 20, $317.40; 2/10 1,567.40
C. F. Hoeckle Office Supply Co., March 12, $1,000;
July 18,$123.90 1,123.90
John Bach & Sons, June 13, $300; July 30, $119.36 419.36
T. J. Stewart Office Specialties Co., July 20, $319.45;
August 12, $523.12 842.57
Saxon Edwards, February 10, $585; May 23, $206.75 791.75
T. C. Macie & Co., May 11, $115.10; June 21, $210.15;
July 8, $450; August 25, $465.15; 2/10, n/30 1,240.40
The Alexander Jacobs Co., August 28, $362.25; 3/5, 2/10 362.25
Field & Co., June 15, $1,015.05; July 6, $250;
August 24, $508.10; 2/10, n/30 1,773.15
Accounts Payable
The P. J. Johnson Mills Co., January 15, $1,895.60;
August 5, $736.15; 1/30 $2,631.75
B. F. Brainard & Co., April 18, $590.10;
Page 533
July 11, $802.15 1,392.25
Jackson City Supply Co., June 10, $512.60;
June 25, $428.20; July 18, $622 1,562.80
F. C. Good Rubber Co., July 1, $175.19;
August 13, $300; 2/10, 1/30 475.19
B. A. Franklin Press, May 2, $850; June 22, $262.15 1,112.15
Brickley Desk Co., March 8, $912.50; May 6, $1,500;
August 16, $540.09; 2/10, 1/30 2,952.59
Notes Receivable
John Bach & Sons, dated July 3, for 3 months with interest
at 6% and discounted at the Drew National Bank,
August 16, at 8%. Face of note $250.
Andrew Jackson, dated August 25 for 60 days, without interest.
Face $750.
The Brush Co., dated July 29, for 2 months, with interest
at 6%. Face $500.
Notes Payable
No. 91, favor Second National Bank for $2,500, dated July 15,
at 3 months, discounted at 6%.
No. 95, favor Brickley Desk Co. for $1,261.40, dated August 20,
at 4 months, interest 6%.
No. 96, favor B. F. Brainard & Co., for $930.78, dated
August 25, at 60 days, interest 6%.
The new system provides for a voucher register, but due to
delay on the part of the printer, a creditors ledger will
have to be opened temporarily. Open the sales and purchase
ledgers according to the data given.
Instructions
Record the above data directly (i.e., not via journal) in the various ledgers. The details of the
various sales and purchases should be shown, and not just the total to be charged or credited to each
account.
VII
Practice Data
The board, having completed negotiations with T. J. Noble, authorizes the purchase from him of
the whole of his right, title, and interest in a patent device known as Knoxfraud to be used for the
purpose of preventing the raising of the amounts of commercial paper. The transfer is made, including
the trade-mark covering “Knoxfraud,” and payment to Noble is made by the cancellation of 90 shares
on his subscription contract and full-paid stock is issued him therefor. Make the entry under date of
September 20.
In order to avoid detail, all additional customers will be handled under a collective account in the
sales ledger called “Sundry Customers.” Transactions will be grouped and summarized wherever
Jackson City Supply Co., June 10, $512.60;
June 25, $428.20; July 18, $622 1,562.80
F. C. Good Rubber Co., July 1, $175.19;
August 13, $300; 2/10, 1/30 475.19
B. A. Franklin Press, May 2, $850; June 22, $262.15 1,112.15
Brickley Desk Co., March 8, $912.50; May 6, $1,500;
August 16, $540.09; 2/10, 1/30 2,952.59
Notes Receivable
John Bach & Sons, dated July 3, for 3 months with interest
at 6% and discounted at the Drew National Bank,
August 16, at 8%. Face of note $250.
Andrew Jackson, dated August 25 for 60 days, without interest.
Face $750.
The Brush Co., dated July 29, for 2 months, with interest
at 6%. Face $500.
Notes Payable
No. 91, favor Second National Bank for $2,500, dated July 15,
at 3 months, discounted at 6%.
No. 95, favor Brickley Desk Co. for $1,261.40, dated August 20,
at 4 months, interest 6%.
No. 96, favor B. F. Brainard & Co., for $930.78, dated
August 25, at 60 days, interest 6%.
The new system provides for a voucher register, but due to
delay on the part of the printer, a creditors ledger will
have to be opened temporarily. Open the sales and purchase
ledgers according to the data given.
Instructions
Record the above data directly (i.e., not via journal) in the various ledgers. The details of the
various sales and purchases should be shown, and not just the total to be charged or credited to each
account.
VII
Practice Data
The board, having completed negotiations with T. J. Noble, authorizes the purchase from him of
the whole of his right, title, and interest in a patent device known as Knoxfraud to be used for the
purpose of preventing the raising of the amounts of commercial paper. The transfer is made, including
the trade-mark covering “Knoxfraud,” and payment to Noble is made by the cancellation of 90 shares
on his subscription contract and full-paid stock is issued him therefor. Make the entry under date of
September 20.
In order to avoid detail, all additional customers will be handled under a collective account in the
sales ledger called “Sundry Customers.” Transactions will be grouped and summarized wherever
Page 534
possible. Make record under proper dates. (Figures at beginning of paragraphs signify September
dates.)
September 1. Received check for $311.05 from Kistler Stationery Co. in payment of their
bill of August 20, $317.40, less $6.35 discount.
3. Alexander Jacobs Co. paid their bill of August 28, $362.25 less $10.87 discount. Sold the
Brush Co. at 2/10, n/30, desks and tables $875.40, and bookcases $469.75.
4. Drew petty cash check for $150 and placed it in petty cash drawer in charge of
bookkeeper. Field & Co. paid their bill of August 24, $508.10 less $10.16 discount, and
$500 on account.
5. Paid P. J. Johnson Mills Co. bill of August 5, $736.15 less discount $7.36, and $500 on
account. Smith Brooks Stationery Co., paid their bill of August 25, $113.14 less $2.26
discount. T. C. Macie & Co. paid their bill of August 25, $465.15 less $9.30.
6. Bought of R. M. Goddard Furniture Co. at 1/30, n/60, desks and tables $5,912.60,
bookcases $3,190.10, and office supplies $837.40. Sold C. F. Hoeckle Office Supply
Co. n/30, desks $1,512.75, filing cabinets $647.80, office supplies $215.69.
8. C. F. Hoeckle Office Supply Co. paid $750 on account.
9. Paid B. F. Brainard & Co. bill of April 18, $590.10. Sold T. C. Macie & Co. at 2/5, 1/10,
tables $1,575.50, filing cabinets $440.25, office supplies $175.30.
11. Paid Jackson City Supply Co. bill of June 10, $512.60.
12. Sold C. F. Hoeckle Office Supply Co. at 1/30, n/60, tables and desks $1,895, bookcases
$625.30, office supplies $110.85.
13. Paid F. C. Good Rubber Co. bill of August 13, $300 less $3 discount. Jno. Bach & Sons
paid $250 on account. The Brush Co. paid their bill of September 3, $1,345.15 less
$26.90 discount.
15. Paid Brickley Desk Co. bill of August 16, $540.09 less $5.40 discount, and bill of
March 8, $912.50 less special discount of $12.50 in consideration of giving our note
No. 1, for $1,500 at 6%, payable in 6 months, in settlement of bill of May 6, $1,500.
Brush Co. paid bill of August 15, $216.69 less $2.17 discount. Sold Jno. Bach & Sons at
2/10, n/30, desks $1,680, filing cabinets $725.90, office supplies $240.60.
16. Bought of P. J. Johnson Mills Co., at 2/10, n/30, tables $3,085.95, bookcases and filing
cabinets $5,293.85, office supplies $1,750.90.
18. T. J. Stewart Office Specialties Co. paid their bill of July 20, $319.45. Sold Alexander
Jacobs Co., at 1/30, n/60, desks $1,465.85, bookcases $625.95, office supplies $145.60.
19. T. C. Macie & Co. paid their bill of September 9, $2,191.05 less $21.91 discount.
21. Sold Saxon Edwards at 2/5, 1/10, tables and desks $1,327.85, bookcases $842.60, office
supplies $222.60.
24. Sold Field & Co. at 1/30, n/60, tables and desks $1,825, bookcases and filing cabinets
$735, office supplies $246.
25. Saxon Edwards paid on account $500.
26. Bought of B. F. Brainard & Co., at 1/30, n/60, desks $4,675, filing cabinets $5,080,
office supplies $1,280. Jno. Bach & Sons paid bill of September 15, $2,646.50 less
dates.)
September 1. Received check for $311.05 from Kistler Stationery Co. in payment of their
bill of August 20, $317.40, less $6.35 discount.
3. Alexander Jacobs Co. paid their bill of August 28, $362.25 less $10.87 discount. Sold the
Brush Co. at 2/10, n/30, desks and tables $875.40, and bookcases $469.75.
4. Drew petty cash check for $150 and placed it in petty cash drawer in charge of
bookkeeper. Field & Co. paid their bill of August 24, $508.10 less $10.16 discount, and
$500 on account.
5. Paid P. J. Johnson Mills Co. bill of August 5, $736.15 less discount $7.36, and $500 on
account. Smith Brooks Stationery Co., paid their bill of August 25, $113.14 less $2.26
discount. T. C. Macie & Co. paid their bill of August 25, $465.15 less $9.30.
6. Bought of R. M. Goddard Furniture Co. at 1/30, n/60, desks and tables $5,912.60,
bookcases $3,190.10, and office supplies $837.40. Sold C. F. Hoeckle Office Supply
Co. n/30, desks $1,512.75, filing cabinets $647.80, office supplies $215.69.
8. C. F. Hoeckle Office Supply Co. paid $750 on account.
9. Paid B. F. Brainard & Co. bill of April 18, $590.10. Sold T. C. Macie & Co. at 2/5, 1/10,
tables $1,575.50, filing cabinets $440.25, office supplies $175.30.
11. Paid Jackson City Supply Co. bill of June 10, $512.60.
12. Sold C. F. Hoeckle Office Supply Co. at 1/30, n/60, tables and desks $1,895, bookcases
$625.30, office supplies $110.85.
13. Paid F. C. Good Rubber Co. bill of August 13, $300 less $3 discount. Jno. Bach & Sons
paid $250 on account. The Brush Co. paid their bill of September 3, $1,345.15 less
$26.90 discount.
15. Paid Brickley Desk Co. bill of August 16, $540.09 less $5.40 discount, and bill of
March 8, $912.50 less special discount of $12.50 in consideration of giving our note
No. 1, for $1,500 at 6%, payable in 6 months, in settlement of bill of May 6, $1,500.
Brush Co. paid bill of August 15, $216.69 less $2.17 discount. Sold Jno. Bach & Sons at
2/10, n/30, desks $1,680, filing cabinets $725.90, office supplies $240.60.
16. Bought of P. J. Johnson Mills Co., at 2/10, n/30, tables $3,085.95, bookcases and filing
cabinets $5,293.85, office supplies $1,750.90.
18. T. J. Stewart Office Specialties Co. paid their bill of July 20, $319.45. Sold Alexander
Jacobs Co., at 1/30, n/60, desks $1,465.85, bookcases $625.95, office supplies $145.60.
19. T. C. Macie & Co. paid their bill of September 9, $2,191.05 less $21.91 discount.
21. Sold Saxon Edwards at 2/5, 1/10, tables and desks $1,327.85, bookcases $842.60, office
supplies $222.60.
24. Sold Field & Co. at 1/30, n/60, tables and desks $1,825, bookcases and filing cabinets
$735, office supplies $246.
25. Saxon Edwards paid on account $500.
26. Bought of B. F. Brainard & Co., at 1/30, n/60, desks $4,675, filing cabinets $5,080,
office supplies $1,280. Jno. Bach & Sons paid bill of September 15, $2,646.50 less
Page 535
$52.93 discount. Paid P. J. Johnson Mills Co. bill of September 16, $10,130.70 less
$202.61 discount.
Instructions
For the transactions of September, the cash disbursements journal will be operated as a full
posting medium, i.e., all charges for cash paid out will be posted from it.
VIII
Practice Data
(Figures at beginning of paragraphs signify September dates.)
September 27. Sold Smith Brooks Stationery Co. at 2/5, 1/10, tables and desks $1,200, bookcases
and filing cabinets $1,150, office supplies $175.
28. Paid B. A. Franklin Press bill of May 2, $850.
29. Brush Co. paid their note of July 29, $500 with interest $5. The board of directors
authorized the purchase of a piece of land lying outside the city limits, with good
shipping and warehouse facilities, to be used as a site for a factory for the manufacture
of Knoxfrauds, paying the Hoboken Development Co. $10,000 cash (with the current
year’s taxes of $75 unpaid and due the City of Hoboken, February 1, 1916), and $125 to
J. N. Hicks for fees in connection with special search of title and recording of deed.
Plans and specifications which Noble had had prepared six months ago when
negotiations with him had been opened by Jackson in behalf of the Jackson, Edwards,
Hansen firm were adopted and ordered, placed with contractors for bids to be received
not later than October 6, the board reserving the right to accept any or reject all bids.
30. Sold Brush Co. at 2/5, 1/10, tables $1,475.80, bookcases $723.85, office supplies $340.
Paid salesmen’s salaries $2,500; commission to salesmen $500; salesmen’s traveling
expense $1,500; in-freight and delivery $525.69, delivery expense $200; rent September
15 to October 15, $250; receiving and shipping room expense $150; sundry office
expense $100.25; office salaries $600; advertising $275; petty cash voucher $137.10, of
which $45.50 was for telegraph, telephone and postage, $50 for office stationery, $25
for sundry selling expense, and $16.60 for sundry office expenses. Cash sales for the
month were: office supplies $1,325.40, bookcases $2,150, desks and tables $4,250.
Summarize and post completely all books of original entry. (See Volume I, page 431, for
general journal summary.) Take a trial balance, recording it in the first two columns on
pages 58-60, “Journal Blank.” Enter all accounts—whether needed for this trial balance
or not—in the order in which they are carried in the general ledger. Leave bottom and
top lines free for totals and forwarding where necessary.
Instructions
September 29. Record the accrued taxes on land in the general journal as a liability to the City of
Hoboken.
30. Distribute the cash sales through the sales journal, entering only the total for all
departments in the cash book.
IX
$202.61 discount.
Instructions
For the transactions of September, the cash disbursements journal will be operated as a full
posting medium, i.e., all charges for cash paid out will be posted from it.
VIII
Practice Data
(Figures at beginning of paragraphs signify September dates.)
September 27. Sold Smith Brooks Stationery Co. at 2/5, 1/10, tables and desks $1,200, bookcases
and filing cabinets $1,150, office supplies $175.
28. Paid B. A. Franklin Press bill of May 2, $850.
29. Brush Co. paid their note of July 29, $500 with interest $5. The board of directors
authorized the purchase of a piece of land lying outside the city limits, with good
shipping and warehouse facilities, to be used as a site for a factory for the manufacture
of Knoxfrauds, paying the Hoboken Development Co. $10,000 cash (with the current
year’s taxes of $75 unpaid and due the City of Hoboken, February 1, 1916), and $125 to
J. N. Hicks for fees in connection with special search of title and recording of deed.
Plans and specifications which Noble had had prepared six months ago when
negotiations with him had been opened by Jackson in behalf of the Jackson, Edwards,
Hansen firm were adopted and ordered, placed with contractors for bids to be received
not later than October 6, the board reserving the right to accept any or reject all bids.
30. Sold Brush Co. at 2/5, 1/10, tables $1,475.80, bookcases $723.85, office supplies $340.
Paid salesmen’s salaries $2,500; commission to salesmen $500; salesmen’s traveling
expense $1,500; in-freight and delivery $525.69, delivery expense $200; rent September
15 to October 15, $250; receiving and shipping room expense $150; sundry office
expense $100.25; office salaries $600; advertising $275; petty cash voucher $137.10, of
which $45.50 was for telegraph, telephone and postage, $50 for office stationery, $25
for sundry selling expense, and $16.60 for sundry office expenses. Cash sales for the
month were: office supplies $1,325.40, bookcases $2,150, desks and tables $4,250.
Summarize and post completely all books of original entry. (See Volume I, page 431, for
general journal summary.) Take a trial balance, recording it in the first two columns on
pages 58-60, “Journal Blank.” Enter all accounts—whether needed for this trial balance
or not—in the order in which they are carried in the general ledger. Leave bottom and
top lines free for totals and forwarding where necessary.
Instructions
September 29. Record the accrued taxes on land in the general journal as a liability to the City of
Hoboken.
30. Distribute the cash sales through the sales journal, entering only the total for all
departments in the cash book.
IX
Page 536
Practice Data
The directors plan to keep sufficient funds on hand to take advantage of all discounts offered on
purchases. All invoices will therefore be entered “net” in the Vouchers Payable column of the voucher
register. Extension will be “gross,” however. Postings to Purchase Discount account will be made
from the voucher register. Purchase Discount column in the cash book will be used as a memo column
of discounts actually taken. The difference between the totals of the purchase Discount columns in
voucher register and cash book at the end of a month (or other posting period) shows the amount of
unearned discount on that date. This should always be checked against the discounts entered in detail
in the voucher register, for the unpaid vouchers as shown in Unpaid Vouchers column of the register.
(Figures at beginning of paragraphs signify October dates.)
October 1. Delivery of the voucher register having been made, your accountant closes the
purchase ledger and opens the voucher register, transferring the balances thereto. The
Kistler Stationery Co. presented their bill for $150 ($95.50 for stock books, records,
etc., and $54.50 for stationery and printing). Paid New York Novelty Works $15 for
corporate seal. Paid Northwestern Fire Insurance Co. $125 for 1-year policy on stock of
goods.
3. Sold Jno. Bach & Sons at 2/10, n/30, desks $1,755, bookcases and filing cabinets
$658.90, office supplies $140. In order to raise money for the purpose of building and
equipping the Knoxfraud factory, the board of directors authorized the sale of the rest of
the unsubscribed stock at not less than 95. Accordingly subscriptions were received
from A. J. Scobey for 90 shares at 96, from A. K. Ladd for 125 shares at 95, and from J.
B. Gaynor for 60 shares at 97. One-half is received in cash, the rest due on October 25.
Certificates of stock are issued the new stockholders.
4. Smith Brooks Stationery Co. paid their bill of September 27, $2,525 less $50.50
discount.
5. The bank notified you John Bach & Son’s note for $250, dated July 3, for 3 months at 6%
and under discount with them since August 16, has gone to protest; you took up the
note, drawing your check in favor of the Drew National Bank for $256.25 including
protest fees, and notified John Bach & Sons. Paid R. M. Goddard Furniture Co. bill of
September 6, $9,940.10 less $99.40 discount.
6. Bought of Jackson City Supply Co. at 1/30, n/60, office supplies $3,028.95. Sold T. C.
Macie & Co. at 2/5, 1/10, desks $1,685, bookcases $642, office supplies $156. Paid
Hoboken Electric Co. light and power bill for September, $50 ($30 was for sign
display).
7. The bids for the construction of the factory were opened and all found to exceed the
architect’s estimate by $10,000 or more. It was accordingly decided to reject all bids
and construct the factory upon their own responsibility, retaining I. M. Builder as
supervising architect and appointing J. T. Noble as purchasing agent and general
superintendent during construction. All funds from the sale of stock were ordered placed
under a Building Fund account in the Drew National, subject to drawing by Hansen in
payment of all bills when passed for payment by Edwards and Noble. The transfer of
funds was accordingly made. Alexander Jacobs returned desks and tables $465.85 of
their purchase of September 18. Brush Co. paid their bill of September 30, $2,539.65
less $50.79 discount. C. F. Hoeckle Office Supply Co. paid their bill of September 6,
$2,376.24.
The directors plan to keep sufficient funds on hand to take advantage of all discounts offered on
purchases. All invoices will therefore be entered “net” in the Vouchers Payable column of the voucher
register. Extension will be “gross,” however. Postings to Purchase Discount account will be made
from the voucher register. Purchase Discount column in the cash book will be used as a memo column
of discounts actually taken. The difference between the totals of the purchase Discount columns in
voucher register and cash book at the end of a month (or other posting period) shows the amount of
unearned discount on that date. This should always be checked against the discounts entered in detail
in the voucher register, for the unpaid vouchers as shown in Unpaid Vouchers column of the register.
(Figures at beginning of paragraphs signify October dates.)
October 1. Delivery of the voucher register having been made, your accountant closes the
purchase ledger and opens the voucher register, transferring the balances thereto. The
Kistler Stationery Co. presented their bill for $150 ($95.50 for stock books, records,
etc., and $54.50 for stationery and printing). Paid New York Novelty Works $15 for
corporate seal. Paid Northwestern Fire Insurance Co. $125 for 1-year policy on stock of
goods.
3. Sold Jno. Bach & Sons at 2/10, n/30, desks $1,755, bookcases and filing cabinets
$658.90, office supplies $140. In order to raise money for the purpose of building and
equipping the Knoxfraud factory, the board of directors authorized the sale of the rest of
the unsubscribed stock at not less than 95. Accordingly subscriptions were received
from A. J. Scobey for 90 shares at 96, from A. K. Ladd for 125 shares at 95, and from J.
B. Gaynor for 60 shares at 97. One-half is received in cash, the rest due on October 25.
Certificates of stock are issued the new stockholders.
4. Smith Brooks Stationery Co. paid their bill of September 27, $2,525 less $50.50
discount.
5. The bank notified you John Bach & Son’s note for $250, dated July 3, for 3 months at 6%
and under discount with them since August 16, has gone to protest; you took up the
note, drawing your check in favor of the Drew National Bank for $256.25 including
protest fees, and notified John Bach & Sons. Paid R. M. Goddard Furniture Co. bill of
September 6, $9,940.10 less $99.40 discount.
6. Bought of Jackson City Supply Co. at 1/30, n/60, office supplies $3,028.95. Sold T. C.
Macie & Co. at 2/5, 1/10, desks $1,685, bookcases $642, office supplies $156. Paid
Hoboken Electric Co. light and power bill for September, $50 ($30 was for sign
display).
7. The bids for the construction of the factory were opened and all found to exceed the
architect’s estimate by $10,000 or more. It was accordingly decided to reject all bids
and construct the factory upon their own responsibility, retaining I. M. Builder as
supervising architect and appointing J. T. Noble as purchasing agent and general
superintendent during construction. All funds from the sale of stock were ordered placed
under a Building Fund account in the Drew National, subject to drawing by Hansen in
payment of all bills when passed for payment by Edwards and Noble. The transfer of
funds was accordingly made. Alexander Jacobs returned desks and tables $465.85 of
their purchase of September 18. Brush Co. paid their bill of September 30, $2,539.65
less $50.79 discount. C. F. Hoeckle Office Supply Co. paid their bill of September 6,
$2,376.24.
Page 537
8. Drew check for $500, advances to salesmen, which the bookkeeper charged to an account
entitled Salesmen’s Advances opened in the customers’ ledger. Paid N. G. Goodman,
accountant, $250 for services, in connection with installation of the system of accounts.
9. Sold Kistler Stationery Co. at 1/30, n/60, tables and desks $1,858.95, bookcases and
cabinets $720, and office supplies $248.
10. Took at cost price, furniture from stock for store and office (desks and tables, $150 for
office and $300 for store; bookcases and filing cabinets, $175 for office and $75 for
store).
11. Bought from the New Model Truck Co., delivery trucks for $3,000, giving our note with
6% interest at 6 months for $2,500 and $500 cash.
12. Sold C. F. Hoeckle Supply Co. at 1/30, n/60, tables and desks $1,625, bookcases and
cabinets $720, and office supplies $140.
13. Received J. T. Noble’s demand note without interest for $1,000 in payment of balance
of subscription contract. The C. F. Hoeckle Office Supply Co. paid bill of September 12,
$2,631.15 less $26.31 discount. T. C. Macie & Co. paid their bill of October 6, $2,483
less $49.66 discount.
15. Sold Alexander Jacobs Co. at 1/30, n/60, desks $1,825.85, bookcases $642, office
supplies $240. Paid note No. 91, $2,500. Jno. Bach & Sons paid their bill of 10/3,
$2,553.90 less $46.98 discount, and an allowance of $50 on bookcases and $155 on
tables account of damage.
16. Bought of R. M. Goddard Furniture Co. at 1/30, n/60, tables and desks $9,425,
bookcases and cabinets $8,227, office supplies $1,025.
18. Sold T. J. Stewart Office Specialties Co. at 2/5, 1/10, desks and tables $1,878,
bookcases and cabinets $580, office supplies $249.
19. Alexander Jacobs & Co. paid their bill of September 18, $1,771.55 less $17.72 discount.
20. T. J. Stewart Office Specialties Co. returned office supplies $49.50 and cabinets $75, of
their purchase of October 18. A. H. Lawrence and H. C. McCullough paid $3,125, the
balance on their subscriptions.
24. Andrew Jackson paid his note of August 25, $750. The T. J. Stewart Office Supplies Co.
paid their bill of October 18, $2,582.50 less $51.65. Sold Field & Co. at 1/30, n/60,
desks and tables $1,789, bookcases and cabinets $680, office supplies $348. Sold
Sundry Customers at n/30, desks and tables $1,100, bookcases and cabinets $860, office
supplies $350. Paid note No. 96, $930.78 with interest $9.31.
25. A. J. Scobey, A. K. Ladd, and J. B. Gaynor paid the balance on their subscriptions,
$13,167.50.
26. Bought from Brickley Desk Co. at 2/10, n/30, tables and desks $6,240, bookcases and
cabinets $3,780. Paid B. F. Brainard & Co. bill of September 26, $11,035 less $100.35.
R. M. Goddard Furniture Co. made us an allowance on purchase of October 16, of $200
on desks and $150 on cabinets due to latent defects.
27. Paid Kistler Stationery Co. bill of October 1, $150.
Instructions
entitled Salesmen’s Advances opened in the customers’ ledger. Paid N. G. Goodman,
accountant, $250 for services, in connection with installation of the system of accounts.
9. Sold Kistler Stationery Co. at 1/30, n/60, tables and desks $1,858.95, bookcases and
cabinets $720, and office supplies $248.
10. Took at cost price, furniture from stock for store and office (desks and tables, $150 for
office and $300 for store; bookcases and filing cabinets, $175 for office and $75 for
store).
11. Bought from the New Model Truck Co., delivery trucks for $3,000, giving our note with
6% interest at 6 months for $2,500 and $500 cash.
12. Sold C. F. Hoeckle Supply Co. at 1/30, n/60, tables and desks $1,625, bookcases and
cabinets $720, and office supplies $140.
13. Received J. T. Noble’s demand note without interest for $1,000 in payment of balance
of subscription contract. The C. F. Hoeckle Office Supply Co. paid bill of September 12,
$2,631.15 less $26.31 discount. T. C. Macie & Co. paid their bill of October 6, $2,483
less $49.66 discount.
15. Sold Alexander Jacobs Co. at 1/30, n/60, desks $1,825.85, bookcases $642, office
supplies $240. Paid note No. 91, $2,500. Jno. Bach & Sons paid their bill of 10/3,
$2,553.90 less $46.98 discount, and an allowance of $50 on bookcases and $155 on
tables account of damage.
16. Bought of R. M. Goddard Furniture Co. at 1/30, n/60, tables and desks $9,425,
bookcases and cabinets $8,227, office supplies $1,025.
18. Sold T. J. Stewart Office Specialties Co. at 2/5, 1/10, desks and tables $1,878,
bookcases and cabinets $580, office supplies $249.
19. Alexander Jacobs & Co. paid their bill of September 18, $1,771.55 less $17.72 discount.
20. T. J. Stewart Office Specialties Co. returned office supplies $49.50 and cabinets $75, of
their purchase of October 18. A. H. Lawrence and H. C. McCullough paid $3,125, the
balance on their subscriptions.
24. Andrew Jackson paid his note of August 25, $750. The T. J. Stewart Office Supplies Co.
paid their bill of October 18, $2,582.50 less $51.65. Sold Field & Co. at 1/30, n/60,
desks and tables $1,789, bookcases and cabinets $680, office supplies $348. Sold
Sundry Customers at n/30, desks and tables $1,100, bookcases and cabinets $860, office
supplies $350. Paid note No. 96, $930.78 with interest $9.31.
25. A. J. Scobey, A. K. Ladd, and J. B. Gaynor paid the balance on their subscriptions,
$13,167.50.
26. Bought from Brickley Desk Co. at 2/10, n/30, tables and desks $6,240, bookcases and
cabinets $3,780. Paid B. F. Brainard & Co. bill of September 26, $11,035 less $100.35.
R. M. Goddard Furniture Co. made us an allowance on purchase of October 16, of $200
on desks and $150 on cabinets due to latent defects.
27. Paid Kistler Stationery Co. bill of October 1, $150.
Instructions
Page 538
October 1. See page 39 for method of transferring purchase ledger accounts to voucher
register.
October 5. See Volume I, page 327, for handling Bach’s protested note. Here the record will
be partly in the voucher register and partly in the general journal.
October 7. Where a special bank account is kept temporarily, oftentimes a separate cash
book is used. One additional column on each side of the cash book will also serve to
segregate the charges and credits to it. Here, since receipts are few, they will be entered
in the regular bank column with an “X” placed in front of them to secure periodic
analysis. All disbursements will be made by regular voucher check, but recorded in the
first column of the cash disbursements journal instead of the regular bank column.
Inasmuch as only the one account is kept on the ledger with the bank, postings to it will
have to be made in two items—one the regular, the other the building fund—for both
receipts and disbursements. An alternative method is to carry the detail of the account
only in the cash book, posting only totals of all receipts and disbursements to the ledger
bank account. However handled, the cash book should show, when balanced, the
amounts in both funds and the trial balance should contain the same information.
To effect the transfer of cash to the Building Fund account at the bank, a
regular voucher check is drawn to order of Building Fund account. This is
distributed in the voucher register to Sundry columns as a charge to Voucher
Payable and must be entered on both sides of the cash book but, of course, not
posted.
October 8. Charge payment to Goodman to Organization Expense.
October 10. Distribute the merchandise taken from stock through the sales journal, with the
necessary correcting entry in the general journal. (See Volume I, pages 423 et seq.)
Since but one Furniture and Fixtures account is carried, the detail necessary for analysis
must be shown in it just as with Merchandise Inventory.
October 11. The Model Truck Co. transaction must be split, the cash portion being recorded
in the voucher register, the rest in the general journal. (See page 43 for method of
handling notes payable under the voucher system.)
October 13. Certificate of stock is issued to Noble.
October 20. These receipts from subscribers are regular items.
October 25. These receipts from subscribers are building fund items.
October 26. The student will perhaps detect at once that the discount of $100.35 on the
Brainard bill is incorrect. It is to be entered as given, however; correction will be made
later.
X
Practice Data
October 30. Sold Jno. Bach & Sons at 2/10, n/30, tables and desks $1,465, bookcases and cabinets
$456, office supplies $435. Sold Sundry Customers at n/30, desks and tables $1,800, bookcases and
cabinets $620, office supplies $300. Cash sales for the month were desks and tables $3,500,
bookcases and cabinets $2,832.60, office supplies $3,167.40. Office supplies drawn from stock for
use by the office, $350. Pay-roll check on Building Fund carried $1,950.70 for excavating and
foundation labor, Noble $200 salary, Builder $350 commission. Paid Hoboken City Hospital $50 bill
register.
October 5. See Volume I, page 327, for handling Bach’s protested note. Here the record will
be partly in the voucher register and partly in the general journal.
October 7. Where a special bank account is kept temporarily, oftentimes a separate cash
book is used. One additional column on each side of the cash book will also serve to
segregate the charges and credits to it. Here, since receipts are few, they will be entered
in the regular bank column with an “X” placed in front of them to secure periodic
analysis. All disbursements will be made by regular voucher check, but recorded in the
first column of the cash disbursements journal instead of the regular bank column.
Inasmuch as only the one account is kept on the ledger with the bank, postings to it will
have to be made in two items—one the regular, the other the building fund—for both
receipts and disbursements. An alternative method is to carry the detail of the account
only in the cash book, posting only totals of all receipts and disbursements to the ledger
bank account. However handled, the cash book should show, when balanced, the
amounts in both funds and the trial balance should contain the same information.
To effect the transfer of cash to the Building Fund account at the bank, a
regular voucher check is drawn to order of Building Fund account. This is
distributed in the voucher register to Sundry columns as a charge to Voucher
Payable and must be entered on both sides of the cash book but, of course, not
posted.
October 8. Charge payment to Goodman to Organization Expense.
October 10. Distribute the merchandise taken from stock through the sales journal, with the
necessary correcting entry in the general journal. (See Volume I, pages 423 et seq.)
Since but one Furniture and Fixtures account is carried, the detail necessary for analysis
must be shown in it just as with Merchandise Inventory.
October 11. The Model Truck Co. transaction must be split, the cash portion being recorded
in the voucher register, the rest in the general journal. (See page 43 for method of
handling notes payable under the voucher system.)
October 13. Certificate of stock is issued to Noble.
October 20. These receipts from subscribers are regular items.
October 25. These receipts from subscribers are building fund items.
October 26. The student will perhaps detect at once that the discount of $100.35 on the
Brainard bill is incorrect. It is to be entered as given, however; correction will be made
later.
X
Practice Data
October 30. Sold Jno. Bach & Sons at 2/10, n/30, tables and desks $1,465, bookcases and cabinets
$456, office supplies $435. Sold Sundry Customers at n/30, desks and tables $1,800, bookcases and
cabinets $620, office supplies $300. Cash sales for the month were desks and tables $3,500,
bookcases and cabinets $2,832.60, office supplies $3,167.40. Office supplies drawn from stock for
use by the office, $350. Pay-roll check on Building Fund carried $1,950.70 for excavating and
foundation labor, Noble $200 salary, Builder $350 commission. Paid Hoboken City Hospital $50 bill
Page 539
for workmen injured during construction. Paid regular pay-roll $5,769 (salesmen’s salaries $2,650;
salesmen’s commission $580; salesmen’s traveling expense $1,525.50; delivery men $250; receiving
and shipping clerks $163.50; office salaries $600); N. Y. C. Ry., freight-in $631.72; N. Y. Paper Co.
for sundry office expense $84.75; Ward & Gow Publicity Co. for advertising $280, and sundry selling
expense $50.25; petty cash voucher $144.95, of which $50.75 was for telegraph, telephone, and
postage, $5 to Bullinger Publicity Co. for entry in city directory, $62.50 for stationery and printing,
$10 for credit information to R. G. Dunn & Co., $16.70 for sundry office expenses. Paid the Builders
Testing Laboratories $50 for test of cement and concrete for use in factory construction. Paid J. P.
Landown rent, October 15 to November 15, $250. Sundry Customers returned tables $150, bookcases
$85, and sundry office supplies of $52.50 of their purchase of October 24 as not being what they had
ordered; we returned bookcases $500 to the Brickley Desk Co. of our purchase of October 26,
because of failure of patent doors to operate.
Summarize all the books of original entry and post completely. For method of summarizing the
voucher register, see page 36. Extend into the Unpaid Vouchers column all unpaid vouchers as shown
by the Manner of Payment column. Take a trial balance as of October 30, 1915, recording it in the
third and fourth columns of pages 58-60 of the journals. Be sure to show the two balances for cash,
the regular and the building fund.
When posting, make the sales ledger self-balancing and take a trial balance of it, recording it on
page 61, journal blank. (See Volume I, page 420, for method of making ledger self-balancing.)
Verify the balance of Vouchers Payable account by checking against the Unpaid Vouchers column
of the voucher register.
Instructions
Charge office supplies drawn from stock to Stationery and Printing.
Pay-roll checks are usually drawn to the order of treasurer or other company official. Make the
necessary distribution in the voucher register.
Bookcases, $500, returned to Brickley Desk Co. are priced at billed price, i.e., the net credit
allowed us will be $490 ($500 less 2%). Be careful to make the proper voucher register entry, as three
columns are affected, viz., Vouchers Payable, Purchase Discount, and Bookcases and Filing Cabinets
Purchases.
It should be noted that wherever an allowance is made, the figure given in the practice data will
always be the gross figure, unless specifically stated otherwise.
Charge credit information cost to Sundry Office Expense.
XI
Practice Data
Make the following detailed entries for transactions with customers and creditors under the dates
given:
November 2. Field & Co. gave their note for 1 year at 6% for $3,571.05 in payment of
invoices of July 6, September 24, and balance June 15. Gave P. J. Johnson Mills Co. our
note at 6 months for $1,462.59, which included $66.99 interest to date at 6% for balance
of bill of January 15, $1,395.60.
3. Kistler Stationery Co. honored our sight draft for $1,250 payment of bills of April 18 and
June 15.
salesmen’s commission $580; salesmen’s traveling expense $1,525.50; delivery men $250; receiving
and shipping clerks $163.50; office salaries $600); N. Y. C. Ry., freight-in $631.72; N. Y. Paper Co.
for sundry office expense $84.75; Ward & Gow Publicity Co. for advertising $280, and sundry selling
expense $50.25; petty cash voucher $144.95, of which $50.75 was for telegraph, telephone, and
postage, $5 to Bullinger Publicity Co. for entry in city directory, $62.50 for stationery and printing,
$10 for credit information to R. G. Dunn & Co., $16.70 for sundry office expenses. Paid the Builders
Testing Laboratories $50 for test of cement and concrete for use in factory construction. Paid J. P.
Landown rent, October 15 to November 15, $250. Sundry Customers returned tables $150, bookcases
$85, and sundry office supplies of $52.50 of their purchase of October 24 as not being what they had
ordered; we returned bookcases $500 to the Brickley Desk Co. of our purchase of October 26,
because of failure of patent doors to operate.
Summarize all the books of original entry and post completely. For method of summarizing the
voucher register, see page 36. Extend into the Unpaid Vouchers column all unpaid vouchers as shown
by the Manner of Payment column. Take a trial balance as of October 30, 1915, recording it in the
third and fourth columns of pages 58-60 of the journals. Be sure to show the two balances for cash,
the regular and the building fund.
When posting, make the sales ledger self-balancing and take a trial balance of it, recording it on
page 61, journal blank. (See Volume I, page 420, for method of making ledger self-balancing.)
Verify the balance of Vouchers Payable account by checking against the Unpaid Vouchers column
of the voucher register.
Instructions
Charge office supplies drawn from stock to Stationery and Printing.
Pay-roll checks are usually drawn to the order of treasurer or other company official. Make the
necessary distribution in the voucher register.
Bookcases, $500, returned to Brickley Desk Co. are priced at billed price, i.e., the net credit
allowed us will be $490 ($500 less 2%). Be careful to make the proper voucher register entry, as three
columns are affected, viz., Vouchers Payable, Purchase Discount, and Bookcases and Filing Cabinets
Purchases.
It should be noted that wherever an allowance is made, the figure given in the practice data will
always be the gross figure, unless specifically stated otherwise.
Charge credit information cost to Sundry Office Expense.
XI
Practice Data
Make the following detailed entries for transactions with customers and creditors under the dates
given:
November 2. Field & Co. gave their note for 1 year at 6% for $3,571.05 in payment of
invoices of July 6, September 24, and balance June 15. Gave P. J. Johnson Mills Co. our
note at 6 months for $1,462.59, which included $66.99 interest to date at 6% for balance
of bill of January 15, $1,395.60.
3. Kistler Stationery Co. honored our sight draft for $1,250 payment of bills of April 18 and
June 15.
Page 540
4. Wrote B. F. Brainard & Co. claiming a $10 adjustment on account of overpayment on
October 26 of bill of September 26, on which the discount allowed was $110.35.
5. Paid Jackson City Supply Co. bill of October 6, $3,028.95 less $30.29 discount. Gave
Brickley Desk Co., our note for $9,329.60 at four months at 6% for bill of October 26,
$10,020 less $190.40 discount and credit memo of October 30 for $500.
6. Field & Co. wrote stating that our monthly statement of account to them carried a charge
for October 24 of $2,817, whereas their bill of that date carried $2,310. An investigation
showed their contention correct, the error being due to a transposing of charges between
them and Sundry Customers for sales on October 24 when the sales journal entry was
made. The error was corrected and correct statements were sent out. The Brush Co. paid
their bill of May 20, $825.
7. Received credit memo from B. F. Brainard & Co. for $10 in reply to letter of November
4.
10. Kistler Stationery Co. gave their note for 6 months at 6% for $2,826.95, payment of bill
of October 9.
12. Jno. Bach & Sons paid their bill of October 30, $2,356 less $47.12. Saxon Edwards paid
their bill of May 23, $206.75, and balance on February 10, $85. Paid B. F. Brainard &
Co. bill of July 11, $802.15 less credit memo of November 7, $10.
15. Paid R. M. Goddard Furniture Co. bill of October 16, $18,677, less credit memo of
October 26 for $350 and discount of $183.27. C. F. Hoeckle Office Supply Co. paid
their bill of October 12, $2,485 less $24.85 discount.
18. Alexander Jacobs paid their bill of October 15, $2,707.85 less $27.08 discount.
21. Saxon Edwards paid their bill of September 21, $2,393.05.
24. Sundry Customers paid their bills of October 24, $2,529.50.
25. Field & Co. paid their bill of October 24, $2,310 less $23.10 discount.
27. T. C. Macie & Co. gave their note for $775.25 in payment of bills of May 11, June 21,
and July 8.
30. Sundry Customers paid their bills of October 30, $2,720. C. F. Hoeckle Office Supply
Co. paid their bill of July 18, $123.90, and balance on March 12, $250.
December 4. Paid Jackson City Supply Co. $1,050.20 for bills of June 25, and July 18.
9. Smith Brooks Stationery Co. gave their note for $873.15, including interest $23.15 on
unpaid bills of June 24 and July 7.
13. T. J. Stewart Office Specialties Co. honored sight draft for bill of August 12, $523.12.
17. Offered Field & Co. a discount of $71.05 from the face of their note of November 2 if
they would pay $2,000 cash and give a new note for $1,500 for the balance. Offer was
accepted and cash and new note for $1,500 received on December 20. (In making
adjustment take account of accrued interest on old note of $26.79.)
18. Paid F. C. Good Rubber Co. bill of July 1, $175.19.
20. Paid our note No. 95, $1,261.40, with $25.23 interest, held by the Brickley Desk Co.
23. Honored B. A. Franklin Press draft at sight for bill of June 22, $262.15. Bank’s
statement of account showed charges of $1.25 and 75c respectively for collection of
October 26 of bill of September 26, on which the discount allowed was $110.35.
5. Paid Jackson City Supply Co. bill of October 6, $3,028.95 less $30.29 discount. Gave
Brickley Desk Co., our note for $9,329.60 at four months at 6% for bill of October 26,
$10,020 less $190.40 discount and credit memo of October 30 for $500.
6. Field & Co. wrote stating that our monthly statement of account to them carried a charge
for October 24 of $2,817, whereas their bill of that date carried $2,310. An investigation
showed their contention correct, the error being due to a transposing of charges between
them and Sundry Customers for sales on October 24 when the sales journal entry was
made. The error was corrected and correct statements were sent out. The Brush Co. paid
their bill of May 20, $825.
7. Received credit memo from B. F. Brainard & Co. for $10 in reply to letter of November
4.
10. Kistler Stationery Co. gave their note for 6 months at 6% for $2,826.95, payment of bill
of October 9.
12. Jno. Bach & Sons paid their bill of October 30, $2,356 less $47.12. Saxon Edwards paid
their bill of May 23, $206.75, and balance on February 10, $85. Paid B. F. Brainard &
Co. bill of July 11, $802.15 less credit memo of November 7, $10.
15. Paid R. M. Goddard Furniture Co. bill of October 16, $18,677, less credit memo of
October 26 for $350 and discount of $183.27. C. F. Hoeckle Office Supply Co. paid
their bill of October 12, $2,485 less $24.85 discount.
18. Alexander Jacobs paid their bill of October 15, $2,707.85 less $27.08 discount.
21. Saxon Edwards paid their bill of September 21, $2,393.05.
24. Sundry Customers paid their bills of October 24, $2,529.50.
25. Field & Co. paid their bill of October 24, $2,310 less $23.10 discount.
27. T. C. Macie & Co. gave their note for $775.25 in payment of bills of May 11, June 21,
and July 8.
30. Sundry Customers paid their bills of October 30, $2,720. C. F. Hoeckle Office Supply
Co. paid their bill of July 18, $123.90, and balance on March 12, $250.
December 4. Paid Jackson City Supply Co. $1,050.20 for bills of June 25, and July 18.
9. Smith Brooks Stationery Co. gave their note for $873.15, including interest $23.15 on
unpaid bills of June 24 and July 7.
13. T. J. Stewart Office Specialties Co. honored sight draft for bill of August 12, $523.12.
17. Offered Field & Co. a discount of $71.05 from the face of their note of November 2 if
they would pay $2,000 cash and give a new note for $1,500 for the balance. Offer was
accepted and cash and new note for $1,500 received on December 20. (In making
adjustment take account of accrued interest on old note of $26.79.)
18. Paid F. C. Good Rubber Co. bill of July 1, $175.19.
20. Paid our note No. 95, $1,261.40, with $25.23 interest, held by the Brickley Desk Co.
23. Honored B. A. Franklin Press draft at sight for bill of June 22, $262.15. Bank’s
statement of account showed charges of $1.25 and 75c respectively for collection of
Page 541
Kistler Stationery Co. draft of November 3, and T. J. Stewart Office Specialties Co.
draft of December 13.
Instructions
November 2. Treat all sight drafts when honored as cash transactions.
November 6. Field & Co. adjustment is made in the general journal. Be careful to make
entry in proper columns.
November 7. The $10 allowance made us by B. F. Brainard & Co. must be recorded in red
in the voucher register close beside the next voucher which will be paid to Brainard—in
this case the bill for $802.15 dated October 1. No entry will need to be made in the
general journal to secure the proper posting of this item, as the entry in the voucher
register is merely a memo to prevent overpayment at time of next settlement. (See page
40 for discussion of the problem of returns and allowances.)
December 17. Handle the Field & Co. note transaction with care. The discount is a charge
to Interest and Discount.
December 23. Run the bank’s collection charges through on a voucher which must be
recorded in voucher register and cash book.
XII
Practice Data
The following transactions took place during the remainder of the fiscal year
which ended August 31, 1916, and are to be entered as of the given date:
January 3. A one year’s insurance policy at a cost of $250 cash was taken out on a stock of
merchandise which had been removed to a warehouse, as stated below.
February 1. The accrued taxes of $75 at date of purchase of factory site were paid.
March 1. On account of the flourishing condition of the sales, an interim dividend of 4%
was declared and paid. Noble’s was applied as a partial payment on his stock note.
June 15. The Boston Office Co. sent $5,000 of office specialties to be sold on a 5%
commission basis for their account.
July 1. A statement of affairs was received from Jno. Bach & Sons showing their insolvency
and copy of an agreement signed by several creditors to accept settlement of all claims
on a 40% basis. Your attorney, having been unable to collect and having investigated,
advised the acceptance by you of their offer. Accordingly on July 27, a check was
received from Bach & Sons for 40% of the balance as shown by your books. (Charge
Jackson, Edwards, Hansen with 60% of $169.36, the part guaranteed by them, and
Reserve for Doubtful Accounts with 60% of $256.25.)
On August 15, 1916, the factory building was completed. The following expenditures had been
made: for steel, concrete, brick and other materials $15,740.20; for labor of all sorts $11,579.35; for
insurance, injuries incurred during construction, legal expense in defense, and interest on moneys
borrowed for the building fund, $750; J. T. Noble’s salary $2,000; I. M. Builder’s fees and
commission $1,113.51; and Builders’ Testing Laboratories $250. The factory was largely of concrete
and numerous tests were necessary. Several purchases of cement had been returned as not being of the
required standard. The company’s note for $10,000 had been discounted for $9,800 and the proceeds
draft of December 13.
Instructions
November 2. Treat all sight drafts when honored as cash transactions.
November 6. Field & Co. adjustment is made in the general journal. Be careful to make
entry in proper columns.
November 7. The $10 allowance made us by B. F. Brainard & Co. must be recorded in red
in the voucher register close beside the next voucher which will be paid to Brainard—in
this case the bill for $802.15 dated October 1. No entry will need to be made in the
general journal to secure the proper posting of this item, as the entry in the voucher
register is merely a memo to prevent overpayment at time of next settlement. (See page
40 for discussion of the problem of returns and allowances.)
December 17. Handle the Field & Co. note transaction with care. The discount is a charge
to Interest and Discount.
December 23. Run the bank’s collection charges through on a voucher which must be
recorded in voucher register and cash book.
XII
Practice Data
The following transactions took place during the remainder of the fiscal year
which ended August 31, 1916, and are to be entered as of the given date:
January 3. A one year’s insurance policy at a cost of $250 cash was taken out on a stock of
merchandise which had been removed to a warehouse, as stated below.
February 1. The accrued taxes of $75 at date of purchase of factory site were paid.
March 1. On account of the flourishing condition of the sales, an interim dividend of 4%
was declared and paid. Noble’s was applied as a partial payment on his stock note.
June 15. The Boston Office Co. sent $5,000 of office specialties to be sold on a 5%
commission basis for their account.
July 1. A statement of affairs was received from Jno. Bach & Sons showing their insolvency
and copy of an agreement signed by several creditors to accept settlement of all claims
on a 40% basis. Your attorney, having been unable to collect and having investigated,
advised the acceptance by you of their offer. Accordingly on July 27, a check was
received from Bach & Sons for 40% of the balance as shown by your books. (Charge
Jackson, Edwards, Hansen with 60% of $169.36, the part guaranteed by them, and
Reserve for Doubtful Accounts with 60% of $256.25.)
On August 15, 1916, the factory building was completed. The following expenditures had been
made: for steel, concrete, brick and other materials $15,740.20; for labor of all sorts $11,579.35; for
insurance, injuries incurred during construction, legal expense in defense, and interest on moneys
borrowed for the building fund, $750; J. T. Noble’s salary $2,000; I. M. Builder’s fees and
commission $1,113.51; and Builders’ Testing Laboratories $250. The factory was largely of concrete
and numerous tests were necessary. Several purchases of cement had been returned as not being of the
required standard. The company’s note for $10,000 had been discounted for $9,800 and the proceeds
Page 542
placed in the Building Fund to finance the undertaking. The $200 discount is included in the $750
mentioned above.
Noble reported that orders for machinery and equipment had been placed with sundry firms and
that about three months would be required before the machinery could be placed and ready for
operation as some of the machines were of delicate and complex construction and would require
careful testing before acceptance. He suggested that orders for the raw materials used in the
manufacture of the Knoxfraud be now placed to take advantage of a low market. Accordingly $10,000
worth was ordered, an advance payment of $2,500 being made on August 25 and charged to New
Method Manufacturing Co. in the sales ledger to show our claim against them for the prepayment—
the balance to be paid when delivery is made, not earlier than October 31.
Due to lack of floor space in the sales department and the necessity of carrying a large assortment
of styles in stock at all times, on January 2, 1916, a warehouse was rented nearby for a monthly rental
of $100 payable in advance. Under date of August 31, 1916, enter a payment of $900.
The receiving and shipping room quarters were also removed to the warehouse. On March 1, a
portion of the warehouse was sublet at a monthly rental of $40 payable in advance. Enter a receipt of
$280 under date of August 31, 1916. Services of A. Pinkerton for $20 a month beginning March 1
were secured to watch store, warehouse, and factory. Record on August 31, 1916, a payment of $120.
It was decided to close out the division of sundry office supplies and dispose of the balance on
hand October 31 at a lump sum.
Instructions
February 1. Refer to Practice Data VIII for the original booking of this item.
March 1. Charge the interim dividend to Dividend account, since there is no Surplus on the
books against which to charge it.
June 15. No entry will be made of the Boston Office Co. consignment. (A memo entry in
the journal may be made, if desired. This would consist merely of a statement of the
receipt of the goods, with no extension of amount into the money column.)
July 1. Handle the Jno. Bach bankruptcy with care. The basis for the entries indicated rests
on the original sale agreement between the Acme Office Furnishings Co. and Jackson,
Edwards, Hansen, Vendors. (See Practice Data V.)
August 15. Record the discounted note for $10,000 as usual. Be careful not to post the
discount twice. All expenditures are cash items.
August 31. Charge A. Pinkerton’s salary to Warehouse Expense. This is not quite accurate,
but sufficiently so.
XIII
Practice Data
In addition to the special data given in Practice Data XII, the following transactions in due course
took place:
Make the record as of August 31, 1916 with summary entries.
Sales Journal—Sales to Sundry Customers were: desks and tables $200,670.20, bookcases and
filing cabinets $153,803.40, and sundry office supplies $16,115.26. Cash sales were: desks and tables
$35,000, bookcases and filing cabinets $21,500, and sundry office supplies $2,825.15. Return sales
mentioned above.
Noble reported that orders for machinery and equipment had been placed with sundry firms and
that about three months would be required before the machinery could be placed and ready for
operation as some of the machines were of delicate and complex construction and would require
careful testing before acceptance. He suggested that orders for the raw materials used in the
manufacture of the Knoxfraud be now placed to take advantage of a low market. Accordingly $10,000
worth was ordered, an advance payment of $2,500 being made on August 25 and charged to New
Method Manufacturing Co. in the sales ledger to show our claim against them for the prepayment—
the balance to be paid when delivery is made, not earlier than October 31.
Due to lack of floor space in the sales department and the necessity of carrying a large assortment
of styles in stock at all times, on January 2, 1916, a warehouse was rented nearby for a monthly rental
of $100 payable in advance. Under date of August 31, 1916, enter a payment of $900.
The receiving and shipping room quarters were also removed to the warehouse. On March 1, a
portion of the warehouse was sublet at a monthly rental of $40 payable in advance. Enter a receipt of
$280 under date of August 31, 1916. Services of A. Pinkerton for $20 a month beginning March 1
were secured to watch store, warehouse, and factory. Record on August 31, 1916, a payment of $120.
It was decided to close out the division of sundry office supplies and dispose of the balance on
hand October 31 at a lump sum.
Instructions
February 1. Refer to Practice Data VIII for the original booking of this item.
March 1. Charge the interim dividend to Dividend account, since there is no Surplus on the
books against which to charge it.
June 15. No entry will be made of the Boston Office Co. consignment. (A memo entry in
the journal may be made, if desired. This would consist merely of a statement of the
receipt of the goods, with no extension of amount into the money column.)
July 1. Handle the Jno. Bach bankruptcy with care. The basis for the entries indicated rests
on the original sale agreement between the Acme Office Furnishings Co. and Jackson,
Edwards, Hansen, Vendors. (See Practice Data V.)
August 15. Record the discounted note for $10,000 as usual. Be careful not to post the
discount twice. All expenditures are cash items.
August 31. Charge A. Pinkerton’s salary to Warehouse Expense. This is not quite accurate,
but sufficiently so.
XIII
Practice Data
In addition to the special data given in Practice Data XII, the following transactions in due course
took place:
Make the record as of August 31, 1916 with summary entries.
Sales Journal—Sales to Sundry Customers were: desks and tables $200,670.20, bookcases and
filing cabinets $153,803.40, and sundry office supplies $16,115.26. Cash sales were: desks and tables
$35,000, bookcases and filing cabinets $21,500, and sundry office supplies $2,825.15. Return sales
Page 543
and allowances to Sundry Customers were: desks and tables $4,240.15, bookcases and filing cabinets
$4,250.65, and sundry office supplies $675.50.
Cash Book—Received: from cash sales as above; from Sundry Customers $269,359.50 less sales
discount of $3,940.20; from notes receivable $5,000; from notes payable discounted $42,500 less
$350 discount; from notes receivable discounted $15,000 less discount of $50. Disbursed for vouchers
payable $359,720.40, of which $100 is chargeable to Building Fund (Noble’s salary).
Journal—Gave our notes to Sundry Creditors for $8,500; received notes from Sundry Customers
$25,200.50; notes receivable discounted were paid by makers at maturity $10,250; stationery was
drawn from stock $250 and used for advertising purposes.
Voucher Register—Bought desks and tables $99,842.95, bookcases and filing cabinets
$73,758.15, and sundry office supplies $12,684.40. Purchases discount was $2,153.40; in-freight and
delivery $3,740.28; receiving and shipping room expense $2,690.14; light, heat, and power $725.16;
salesmen’s salaries $65,840.20; salesmen’s commissions $20,730.30; traveling expenses $42,420.70;
advertising $12,280; sundry selling expense $940.03; delivery expense $7,280.90; warehouse expense
$50; office salaries $11,600; stationery and printing $450; collection and exchange $30.05; interest
and discount $1,096.27; sundry office expense $72.15; telephone, telegraph, and postage $475.03;
notes payable $47,250.19; rent $3,250; power equipment $5,000; taxes $160.15; Noble’s salary for
August $200. (Charge $100 to Factory Building and $100 to Power Equipment.)
Instructions
These transactions are listed in summarized form to avoid detailed entry and, at the same time, to
provide the necessary volume of business. They are to be entered as indicated. Use as little space as
possible.
Sales Journal—Use 2 lines for the entries. Enter returns and allowances in their proper journal.
Cash Book—Be careful to indicate by some distinctive mark all interest and discount items
recorded in the Sales Discount column. No purchase discount on paid vouchers is given inasmuch as
the cash book record of it is merely a memo, although providing data for checking the amount of
unearned discount at the close of a period. It will doubtless be found that in this summarized method
of stating transactions much detailed information is omitted (because not absolutely essential), that
would be available under ordinary conditions.
Journal—Treat stationery taken from stock as a credit to Sundry Office Supplies Sales; this is not
included in the sales journal data given above.
Voucher Register—For the sake of saving space, run all these transactions through on one
voucher, using just one line for the entry, except in Sundry column, where use as many as are needed.
$100 of Noble’s salary comes out of building fund cash, as indicated on page 675.
XIV
Practice Data
Summarize the various books and post completely. Be careful, in summarizing, to show any
extraneous items recorded, for the sake of convenience, in theoretically improper columns or books.
XV
Practice Data
Take a trial balance of the general and sales ledgers and record them as usual.
$4,250.65, and sundry office supplies $675.50.
Cash Book—Received: from cash sales as above; from Sundry Customers $269,359.50 less sales
discount of $3,940.20; from notes receivable $5,000; from notes payable discounted $42,500 less
$350 discount; from notes receivable discounted $15,000 less discount of $50. Disbursed for vouchers
payable $359,720.40, of which $100 is chargeable to Building Fund (Noble’s salary).
Journal—Gave our notes to Sundry Creditors for $8,500; received notes from Sundry Customers
$25,200.50; notes receivable discounted were paid by makers at maturity $10,250; stationery was
drawn from stock $250 and used for advertising purposes.
Voucher Register—Bought desks and tables $99,842.95, bookcases and filing cabinets
$73,758.15, and sundry office supplies $12,684.40. Purchases discount was $2,153.40; in-freight and
delivery $3,740.28; receiving and shipping room expense $2,690.14; light, heat, and power $725.16;
salesmen’s salaries $65,840.20; salesmen’s commissions $20,730.30; traveling expenses $42,420.70;
advertising $12,280; sundry selling expense $940.03; delivery expense $7,280.90; warehouse expense
$50; office salaries $11,600; stationery and printing $450; collection and exchange $30.05; interest
and discount $1,096.27; sundry office expense $72.15; telephone, telegraph, and postage $475.03;
notes payable $47,250.19; rent $3,250; power equipment $5,000; taxes $160.15; Noble’s salary for
August $200. (Charge $100 to Factory Building and $100 to Power Equipment.)
Instructions
These transactions are listed in summarized form to avoid detailed entry and, at the same time, to
provide the necessary volume of business. They are to be entered as indicated. Use as little space as
possible.
Sales Journal—Use 2 lines for the entries. Enter returns and allowances in their proper journal.
Cash Book—Be careful to indicate by some distinctive mark all interest and discount items
recorded in the Sales Discount column. No purchase discount on paid vouchers is given inasmuch as
the cash book record of it is merely a memo, although providing data for checking the amount of
unearned discount at the close of a period. It will doubtless be found that in this summarized method
of stating transactions much detailed information is omitted (because not absolutely essential), that
would be available under ordinary conditions.
Journal—Treat stationery taken from stock as a credit to Sundry Office Supplies Sales; this is not
included in the sales journal data given above.
Voucher Register—For the sake of saving space, run all these transactions through on one
voucher, using just one line for the entry, except in Sundry column, where use as many as are needed.
$100 of Noble’s salary comes out of building fund cash, as indicated on page 675.
XIV
Practice Data
Summarize the various books and post completely. Be careful, in summarizing, to show any
extraneous items recorded, for the sake of convenience, in theoretically improper columns or books.
XV
Practice Data
Take a trial balance of the general and sales ledgers and record them as usual.
Page 544
XVI
Practice Data
Draw up statements for the year, supporting both the profit and loss statement and the balance
sheet by schedules. (See Volume I, pages 411-412 and 509-510, for suggestive forms and instructions
as to methods of condensation of data.)
Take into consideration the following data:
Rent income received in advance $40; warehouse rent paid in advance $100; interest accrued on
notes receivable $50; salesmen’s salaries accrued $420; salesmen’s commissions accrued $125;
advertising bills unpaid $100; advertising paid in advance $250; stationery on hand $50.
Insurance: first policy, one year, bought October 1, cost $125, part unexpired $10.04; second
policy, one year, bought January 2, cost $250, ⁴/₁₂ unexpired $83.33. Taxes for the year 1916,
estimated $565.42, ⅔ used $376.95. Purchases discount not yet taken advantage of on unpaid
vouchers, $475.
The Knoxfraud patent had 15 years to run when purchased. Write off ¹/₁₅ of its value, it being the
policy of the company to maintain an experimental laboratory and so overcome any possible
supersession. Write off organization expense and good-will 5% each. Create reserves for: furniture
and fixtures 10%; delivery equipment 15%; doubtful accounts ½% on all sales gross. Take no account
of depreciation on factory building or power equipment.
Inventories of stock-in-trade: desks and tables $4,943.86, bookcases and filing cabinets $1,521.31,
sundry office supplies $3,197.20, total $9,662.37.
In-freight and delivery: charge $2,500 to Desks and Tables purchases, $2,100 to Bookcases and
Filing Cabinets Purchases, $297.69 to Sundry Office Supplies Purchases.
Light, heat, and power: charge ¾ to Selling, ¼ to General Administrative.
Receiving and shipping room: charge ¾ to Shipping, ¼ to Receiving, of which 50% to Desks and
Tables, 45% to Bookcases and Filing Cabinets, 5% to Sundry Office Supplies.
Rent: charge ⁴/₅ to Selling, ¹/₅ to General Administrative.
Insurance: charge $335.24 to Selling, $41.75 to General Administrative.
Taxes: charge all of the 1915 taxes ($160.15) Surplus.
Discount on stock: charge to Factory Buildings.
Instructions
Most of the above data are necessarily arbitrary, particularly the basis for distribution of the
various expense items. For many such items, even in practice, a more or less arbitrary basis must be
adopted. See Chapters III, XIV, and XXVII for a brief discussion of this point.
The student may object to the indicated methods of handling some of the items but is asked to
make the record as suggested. Any necessary corrections will be made later.
Draw up all formal statements, for presentation to the instructor, on blank paper, letter size, i.e.,
8½ x 11 inches.
XVII
Practice Data
Practice Data
Draw up statements for the year, supporting both the profit and loss statement and the balance
sheet by schedules. (See Volume I, pages 411-412 and 509-510, for suggestive forms and instructions
as to methods of condensation of data.)
Take into consideration the following data:
Rent income received in advance $40; warehouse rent paid in advance $100; interest accrued on
notes receivable $50; salesmen’s salaries accrued $420; salesmen’s commissions accrued $125;
advertising bills unpaid $100; advertising paid in advance $250; stationery on hand $50.
Insurance: first policy, one year, bought October 1, cost $125, part unexpired $10.04; second
policy, one year, bought January 2, cost $250, ⁴/₁₂ unexpired $83.33. Taxes for the year 1916,
estimated $565.42, ⅔ used $376.95. Purchases discount not yet taken advantage of on unpaid
vouchers, $475.
The Knoxfraud patent had 15 years to run when purchased. Write off ¹/₁₅ of its value, it being the
policy of the company to maintain an experimental laboratory and so overcome any possible
supersession. Write off organization expense and good-will 5% each. Create reserves for: furniture
and fixtures 10%; delivery equipment 15%; doubtful accounts ½% on all sales gross. Take no account
of depreciation on factory building or power equipment.
Inventories of stock-in-trade: desks and tables $4,943.86, bookcases and filing cabinets $1,521.31,
sundry office supplies $3,197.20, total $9,662.37.
In-freight and delivery: charge $2,500 to Desks and Tables purchases, $2,100 to Bookcases and
Filing Cabinets Purchases, $297.69 to Sundry Office Supplies Purchases.
Light, heat, and power: charge ¾ to Selling, ¼ to General Administrative.
Receiving and shipping room: charge ¾ to Shipping, ¼ to Receiving, of which 50% to Desks and
Tables, 45% to Bookcases and Filing Cabinets, 5% to Sundry Office Supplies.
Rent: charge ⁴/₅ to Selling, ¹/₅ to General Administrative.
Insurance: charge $335.24 to Selling, $41.75 to General Administrative.
Taxes: charge all of the 1915 taxes ($160.15) Surplus.
Discount on stock: charge to Factory Buildings.
Instructions
Most of the above data are necessarily arbitrary, particularly the basis for distribution of the
various expense items. For many such items, even in practice, a more or less arbitrary basis must be
adopted. See Chapters III, XIV, and XXVII for a brief discussion of this point.
The student may object to the indicated methods of handling some of the items but is asked to
make the record as suggested. Any necessary corrections will be made later.
Draw up all formal statements, for presentation to the instructor, on blank paper, letter size, i.e.,
8½ x 11 inches.
XVII
Practice Data
Page 545
Adjust and close the books in accordance with the information given in the preceding Practice
Data XVI.
The student is referred, for illustration of the work of adjusting and closing the books, to Volume I,
Chapters XXIX, XXX, and XLIII, and to certain portions of Chapters XIV and XIX of Volume II.
XVIII
Practice Data
The results for the year proving very unsatisfactory in comparison with the volume of business
transacted, N. G. Goodman was retained to make an audit of the year’s operations in an effort to
locate the trouble. In his report covering the audit, he called attention to the following items:
(a) In the Trade Debtors are included two charges, viz., advances to salesmen $500, and New
Method Manufacturing Co. for purchases $2,500, which are in no sense charges to customers.
(b) In the Notes Receivable is included Noble’s note given in payment of the balance on his
subscription to capital stock $1,000 but now reduced to $600 through the application of his March
dividend as a partial payment. This does not belong in Notes Receivable account.
(c) There is on the books no record of the Boston Office Co. consignment received on June 15,
1916. Investigation showed that on July 2, a sale of $4,500 was made from the consignment and the
balance was included in the Sundry Office Supplies Inventory, being there valued at $1,000. It was
ascertained that the freight and cartage paid on the incoming consigned goods amounted to $25.12,
and had been charged to the In-freight and Cartage account.
(d) The inadequacy of the purchases system was shown. Perhaps due to the fact that during the
year the main stock was withdrawn from the store and the immediate supervision of the responsible
head and placed in the warehouse, the stock had been allowed to run down so that it amounted at the
close of the year to only $9,662.37—correct value being $8,662.37 when allowance for the inclusion
of the Boston Office Co. consigned goods was made—as compared with $42,282.27 on hand at the
beginning. Suggestion for the installation of a distinct purchasing department and the introduction of a
stock record was made in order to keep track of the condition of the stock.
(e) The depreciation of good-will is to be reversed.
(f) The discount on capital stock, charged to Factory Building, is to be taken out and shown as a
separate item under its own name.
(g) An analysis of the sales developed that: on desks and tables sales gross profit was 47%, and
rate of turnover was 9+; on bookcases and filing cabinets gross profit was 38% and turnover 6.4+; and
on sundry office supplies a gross loss of 17+% was sustained and the turnover was only 3+. Taken as
a whole, the selling expense was too high, very probably due to salesmen’s abnormal traveling
expenses and commissions. The present commissions policy was severely condemned as tending to an
increase of sales without regard to the financial standing of the customer. For the purpose of
establishing a consistent policy of passing on credits and following up collections, the installation of a
department of credits and collections was advised.
(h) It was advised that the petty cash be taken out of the bookkeeper’s control.
(i) Of the 1915 taxes charged to Surplus, one-third should have been charged to Profit and Loss.
Make all of the entries necessary to adjust the books in accordance with the auditor’s suggestions.
Post, close, and draw up corrected statements, including the adjustments to Surplus. Supporting
schedules may be omitted; the condensed statements will be sufficient.
Data XVI.
The student is referred, for illustration of the work of adjusting and closing the books, to Volume I,
Chapters XXIX, XXX, and XLIII, and to certain portions of Chapters XIV and XIX of Volume II.
XVIII
Practice Data
The results for the year proving very unsatisfactory in comparison with the volume of business
transacted, N. G. Goodman was retained to make an audit of the year’s operations in an effort to
locate the trouble. In his report covering the audit, he called attention to the following items:
(a) In the Trade Debtors are included two charges, viz., advances to salesmen $500, and New
Method Manufacturing Co. for purchases $2,500, which are in no sense charges to customers.
(b) In the Notes Receivable is included Noble’s note given in payment of the balance on his
subscription to capital stock $1,000 but now reduced to $600 through the application of his March
dividend as a partial payment. This does not belong in Notes Receivable account.
(c) There is on the books no record of the Boston Office Co. consignment received on June 15,
1916. Investigation showed that on July 2, a sale of $4,500 was made from the consignment and the
balance was included in the Sundry Office Supplies Inventory, being there valued at $1,000. It was
ascertained that the freight and cartage paid on the incoming consigned goods amounted to $25.12,
and had been charged to the In-freight and Cartage account.
(d) The inadequacy of the purchases system was shown. Perhaps due to the fact that during the
year the main stock was withdrawn from the store and the immediate supervision of the responsible
head and placed in the warehouse, the stock had been allowed to run down so that it amounted at the
close of the year to only $9,662.37—correct value being $8,662.37 when allowance for the inclusion
of the Boston Office Co. consigned goods was made—as compared with $42,282.27 on hand at the
beginning. Suggestion for the installation of a distinct purchasing department and the introduction of a
stock record was made in order to keep track of the condition of the stock.
(e) The depreciation of good-will is to be reversed.
(f) The discount on capital stock, charged to Factory Building, is to be taken out and shown as a
separate item under its own name.
(g) An analysis of the sales developed that: on desks and tables sales gross profit was 47%, and
rate of turnover was 9+; on bookcases and filing cabinets gross profit was 38% and turnover 6.4+; and
on sundry office supplies a gross loss of 17+% was sustained and the turnover was only 3+. Taken as
a whole, the selling expense was too high, very probably due to salesmen’s abnormal traveling
expenses and commissions. The present commissions policy was severely condemned as tending to an
increase of sales without regard to the financial standing of the customer. For the purpose of
establishing a consistent policy of passing on credits and following up collections, the installation of a
department of credits and collections was advised.
(h) It was advised that the petty cash be taken out of the bookkeeper’s control.
(i) Of the 1915 taxes charged to Surplus, one-third should have been charged to Profit and Loss.
Make all of the entries necessary to adjust the books in accordance with the auditor’s suggestions.
Post, close, and draw up corrected statements, including the adjustments to Surplus. Supporting
schedules may be omitted; the condensed statements will be sufficient.
Page 546
Instructions
Study carefully all the suggestions made by Goodman and determine the proper correcting entries.
All necessary accounts have already been set up on the books.
The principles involved in suggestions (a) and (b) are covered in Chapter XII. For (c) see Volume
I, Chapter L, and Volume II, Chapter XIII. Take cognizance of the accrued commission. For (e) see
Chapter XVIII, and for (f) see Chapter XXI. For the surplus statement to show all adjustments made
through it, see Chapter XXIII.
XIX
Practice Data
September 2, 1916, the remainder of the Boston Office Co. consignment was sold for $1,250 cash
and our check sent for the balance due them. Desks and tables $575, and filing cabinets $250, were
taken from stock for use in the factory. Additional benching and racks were bought for $450 cash.
Shop and hand tools cost $875.25 cash.
September 10, 1916 a one-year fire insurance policy covering factory building and equipment was
bought from the Northwestern Fire Insurance Co. for $584.68.
At a meeting of the directors and stockholders for the purpose of reviewing Goodman’s report and
forecasting a policy for the coming year, the following items were thoroughly considered:
(a) In order to pursue a vigorous sales policy such as would now be necessary and along the lines
suggested by Goodman, immediate purchases in large amounts would have to be made.
(b) The company’s credit, at the present time, with more than $70,000 of current payables
outstanding, would not bear further expansion. Ready funds of at least $20,000 would have to be
provided within the next month to take up outstanding notes and the more pressing bills, to say
nothing of the amount needed to take advantage of all discounts offered on new purchases.
(c) The contracts entered into for purchases of machinery and raw materials would soon have to be
fulfilled, requiring an additional sum of $20,000 to $25,000.
(d) In view of the policy previously determined to close out the division of sundry office supplies
on October 31 and push with vigor the new Knoxfraud, a widespread advertising campaign was
decided upon for the next six months in order fully to present the need for the new device and its
merits. It was estimated that $15,000 or $20,000 would be required for this.
(e) The absolute necessity for additional capital was apparent. Before the company could hope
successfully to secure subscriptions to a new issue of stock, not only would that stock have to be made
attractive, but the company’s condition as to surplus would have to be improved. Accordingly, it was
voted to donate 10% of the capital stock into the treasury and offer it for sale first to the present
stockholders and then to the public at not less than 90. Then it was ordered that the capital stock be
increased by the issuance of $50,000 of first preferred 6% cumulative, and $25,000 of second
preferred 8% non-cumulative, both classes of stock to have further participation on the following
basis:
In the event of dividends in excess of the requirements for the preferred stock and 6% on the
common, the first preferred should share ⅓ and the common ⅔ of such excess for an additional
dividend until they should have received in all an 8% dividend and so be placed on an equality with
the second preferred. Of all further dividends the common was to share ¾ of the amount of such
excess dividends, and the two preferred classes the other ¼ distributable between them in the ratio
which the amount of each outstanding bore to the total of both classes outstanding. It was decided, at
Study carefully all the suggestions made by Goodman and determine the proper correcting entries.
All necessary accounts have already been set up on the books.
The principles involved in suggestions (a) and (b) are covered in Chapter XII. For (c) see Volume
I, Chapter L, and Volume II, Chapter XIII. Take cognizance of the accrued commission. For (e) see
Chapter XVIII, and for (f) see Chapter XXI. For the surplus statement to show all adjustments made
through it, see Chapter XXIII.
XIX
Practice Data
September 2, 1916, the remainder of the Boston Office Co. consignment was sold for $1,250 cash
and our check sent for the balance due them. Desks and tables $575, and filing cabinets $250, were
taken from stock for use in the factory. Additional benching and racks were bought for $450 cash.
Shop and hand tools cost $875.25 cash.
September 10, 1916 a one-year fire insurance policy covering factory building and equipment was
bought from the Northwestern Fire Insurance Co. for $584.68.
At a meeting of the directors and stockholders for the purpose of reviewing Goodman’s report and
forecasting a policy for the coming year, the following items were thoroughly considered:
(a) In order to pursue a vigorous sales policy such as would now be necessary and along the lines
suggested by Goodman, immediate purchases in large amounts would have to be made.
(b) The company’s credit, at the present time, with more than $70,000 of current payables
outstanding, would not bear further expansion. Ready funds of at least $20,000 would have to be
provided within the next month to take up outstanding notes and the more pressing bills, to say
nothing of the amount needed to take advantage of all discounts offered on new purchases.
(c) The contracts entered into for purchases of machinery and raw materials would soon have to be
fulfilled, requiring an additional sum of $20,000 to $25,000.
(d) In view of the policy previously determined to close out the division of sundry office supplies
on October 31 and push with vigor the new Knoxfraud, a widespread advertising campaign was
decided upon for the next six months in order fully to present the need for the new device and its
merits. It was estimated that $15,000 or $20,000 would be required for this.
(e) The absolute necessity for additional capital was apparent. Before the company could hope
successfully to secure subscriptions to a new issue of stock, not only would that stock have to be made
attractive, but the company’s condition as to surplus would have to be improved. Accordingly, it was
voted to donate 10% of the capital stock into the treasury and offer it for sale first to the present
stockholders and then to the public at not less than 90. Then it was ordered that the capital stock be
increased by the issuance of $50,000 of first preferred 6% cumulative, and $25,000 of second
preferred 8% non-cumulative, both classes of stock to have further participation on the following
basis:
In the event of dividends in excess of the requirements for the preferred stock and 6% on the
common, the first preferred should share ⅓ and the common ⅔ of such excess for an additional
dividend until they should have received in all an 8% dividend and so be placed on an equality with
the second preferred. Of all further dividends the common was to share ¾ of the amount of such
excess dividends, and the two preferred classes the other ¼ distributable between them in the ratio
which the amount of each outstanding bore to the total of both classes outstanding. It was decided, at
Page 547
the time of the application for an increase of capitalization, to change the name of the corporation to
the Knox-Davis Manufacturing Company.
The necessary legal requirements for increasing their capital having been met, the present
stockholders took all the treasury stock at 90, and the two classes of preferred were entirely
subscribed for at par, payable ½ down and the remainder subject to two equal calls at the end of 4 and
8 months respectively. Cash was received for treasury stock in full and for the preferred as indicated,
i.e., for the ½ down in cash at the date of subscription. Permission was granted to change the name of
the corporation as requested.
Make the entries to record the above data under date of October 25, 1916. (Charge the discount on
stock against the surplus received from donation.) Transfer the cash balance in the Building Fund into
the General Cash, there being no longer any need of the separation.
Instructions
September 2. Make careful calculation of the balance due Boston Office Co. Record in the general
journal the stock drawn for factory furniture and fixtures, as a credit to proper sales account.
October 25. Transfer of the balance of Building Fund cash back to General Cash is effected in the
same way as the original creation of the fund. Issue certificates of stock to new holders.
XX
Practice Data
By October 31, 1916, all of the sundry office supplies had been closed out for $2,000 cash.
The raw materials contracted and partially paid for on August 25, were received, and on
November 10 a check for the balance due less 2% discount on the contract, was sent to the New
Method Manufacturing Co. (Be sure to book the proper charge to Raw Materials.) Materials were
insured for one year at a cost of $175 cash.
On November 30, the last of the machinery was received from the Harvey Machine
Manufacturing Co. and installed. The invoice cost was $15,000, of which $12,000 was paid in cash
and the company’s note secured by mortgage on the machinery was given for the balance. In-freight
and delivery on the machinery amounted to $675.40, and placement expense (not including concrete
platforms and piers which had been charged to the building at a cost of $750) amounted to $225, all of
which were paid in cash. Noble’s salary for the three months while passing upon and superintending
the placing and erection of machinery is to be charged $400 to Machinery and $200 to Power
Equipment. The additional expenditure of connecting the machinery with the power—including
shafting, belting, labor, etc.—amounted to $550.50 cash.
On December 2 an insurance policy for one year covering machinery was purchased for $275.40
cash from the New Jersey Mutual.
Full factory operations were commenced on December 1, 1916, and orders were taken for
Knoxfrauds for delivery beginning with the first of the year.
It was determined to extend the current fiscal period and not close the books until December 31,
1917.
Call No. 1 on unpaid subscriptions to capital stock for one-half the outstanding was made on
February 25, 1917.
The advertising campaign was producing results so that to fill orders the factory had to work two
shifts of men beginning with March 1, 1917. As a result of seeming prosperity and a discontent
the Knox-Davis Manufacturing Company.
The necessary legal requirements for increasing their capital having been met, the present
stockholders took all the treasury stock at 90, and the two classes of preferred were entirely
subscribed for at par, payable ½ down and the remainder subject to two equal calls at the end of 4 and
8 months respectively. Cash was received for treasury stock in full and for the preferred as indicated,
i.e., for the ½ down in cash at the date of subscription. Permission was granted to change the name of
the corporation as requested.
Make the entries to record the above data under date of October 25, 1916. (Charge the discount on
stock against the surplus received from donation.) Transfer the cash balance in the Building Fund into
the General Cash, there being no longer any need of the separation.
Instructions
September 2. Make careful calculation of the balance due Boston Office Co. Record in the general
journal the stock drawn for factory furniture and fixtures, as a credit to proper sales account.
October 25. Transfer of the balance of Building Fund cash back to General Cash is effected in the
same way as the original creation of the fund. Issue certificates of stock to new holders.
XX
Practice Data
By October 31, 1916, all of the sundry office supplies had been closed out for $2,000 cash.
The raw materials contracted and partially paid for on August 25, were received, and on
November 10 a check for the balance due less 2% discount on the contract, was sent to the New
Method Manufacturing Co. (Be sure to book the proper charge to Raw Materials.) Materials were
insured for one year at a cost of $175 cash.
On November 30, the last of the machinery was received from the Harvey Machine
Manufacturing Co. and installed. The invoice cost was $15,000, of which $12,000 was paid in cash
and the company’s note secured by mortgage on the machinery was given for the balance. In-freight
and delivery on the machinery amounted to $675.40, and placement expense (not including concrete
platforms and piers which had been charged to the building at a cost of $750) amounted to $225, all of
which were paid in cash. Noble’s salary for the three months while passing upon and superintending
the placing and erection of machinery is to be charged $400 to Machinery and $200 to Power
Equipment. The additional expenditure of connecting the machinery with the power—including
shafting, belting, labor, etc.—amounted to $550.50 cash.
On December 2 an insurance policy for one year covering machinery was purchased for $275.40
cash from the New Jersey Mutual.
Full factory operations were commenced on December 1, 1916, and orders were taken for
Knoxfrauds for delivery beginning with the first of the year.
It was determined to extend the current fiscal period and not close the books until December 31,
1917.
Call No. 1 on unpaid subscriptions to capital stock for one-half the outstanding was made on
February 25, 1917.
The advertising campaign was producing results so that to fill orders the factory had to work two
shifts of men beginning with March 1, 1917. As a result of seeming prosperity and a discontent
Page 548
engendered by labor leaders who had recently unionized the works, a demand for a 15% increase in
wages was made and refused, resulting in a walk-out on March 30. A patrol against strike-breakers
was established on April 2, after about one-third of the full complement of workers needed for
operation had been secured. Some of these defected and the rest were quartered in the shops to
prevent violence. After three weeks of partial operation at an increased expense of $1,500 directly
attributed to the strike, one of the boilers exploded damaging the building and equipment, the
resulting fire consuming supplies and damaging raw materials. An investigation placed the blame on a
half-crazed workman whose sympathies were with the strikers. Hospital fees for injured workmen
amounted to $500. (Record these two items as cash expenditures for the purposes named under date of
April 20.) The insurance companies settled the losses as follows: the building and the power
equipment on which the estimated damage was $3,500 were placed in complete repair; the estimated
damage on materials, determined after an inventory and comparison with stock records, amounted to
$4,000 and was covered by $3,200 insurance which was paid. In making the estimate, scrap value of
damaged goods was placed at $1,000 but only realized $750 when sold; machinery costing $3,500 on
November 30, with a scrap value of $500, realized on sale by the company $650, the insurance
received being $2,000. (Depreciation on the machinery at the rate of 8⅓% annually on cost value is to
be taken into account, and the portion of the unexpired insurance—roughly estimated at $150—now
canceled by the payment of the insurance on both raw materials and machinery is to be considered in
making charges to the Fire Loss account.) Additional loss and expense due to decreased production
and cancellation of orders because of not being able to deliver goods when promised was estimated at
$7,500. The strike was finally settled by granting a 5% increase in wages.
The directors had under consideration the incorporation with the Knoxfraud of a patent listing and
adding device owned by J. Q. Osgood. In view of the need of some additional capital anyway due to
the strike losses, it was decided to incorporate the new device now, since it would be easier to make
the needed changes at this time than after operations had been resumed. Accordingly, a rearrangement
of the machinery was necessary to make room for the new machinery and place it for proper routing
of the product. This entailed a cash expenditure of $750 for the rearrangement, and $5,500 for new
machines to replace those disposed of and to manufacture the new device. (Make the record as of
April 30.) The contract entered into with Osgood was on a royalty basis per unit turned out by the
machines and for one year’s time beginning May 1, 1917. The directors decided on a continuation of
the advertising campaign. To provide funds for these purposes a bond issue was determined upon—
$20,000 20-year 6%, interest coupons redeemable November 1, and May 1,—secured by mortgage on
the factory and its equipment. The trust agreement provided for the payment at the close of each fiscal
year of $750 out of profits into the hands of the Guaranty Trust Co. for investment in securities until a
sinking fund sufficient to retire the bonds at their maturity shall have been established. $15,000 of the
bonds were offered for sale and were purchased at 95 for cash except one purchase on a note for $950.
The remaining $5,000 were held in the treasury until needed.
Record the above transactions as of the dates given—the bond transactions took place on May 1.
Instructions
October 31. The columns in sales journal, sales returns and allowances journal, and voucher
register headed “Sundry Office Supplies,” will now be given the headings “Knoxfraud” for the first
two journals, and “Raw Materials” for the voucher register.
November 10. A part of the charge to Raw Materials must be made in the general journal.
“Prepayment on Purchases” account will be closed.
November 30. Record the note payable secured by mortgage under the title “Purchase Money
Mortgage on Machinery.” Voucher the cash portion of this purchase of machinery. Transfer the cost of
concrete platforms from Buildings to Machinery account. This had previously been charged to
wages was made and refused, resulting in a walk-out on March 30. A patrol against strike-breakers
was established on April 2, after about one-third of the full complement of workers needed for
operation had been secured. Some of these defected and the rest were quartered in the shops to
prevent violence. After three weeks of partial operation at an increased expense of $1,500 directly
attributed to the strike, one of the boilers exploded damaging the building and equipment, the
resulting fire consuming supplies and damaging raw materials. An investigation placed the blame on a
half-crazed workman whose sympathies were with the strikers. Hospital fees for injured workmen
amounted to $500. (Record these two items as cash expenditures for the purposes named under date of
April 20.) The insurance companies settled the losses as follows: the building and the power
equipment on which the estimated damage was $3,500 were placed in complete repair; the estimated
damage on materials, determined after an inventory and comparison with stock records, amounted to
$4,000 and was covered by $3,200 insurance which was paid. In making the estimate, scrap value of
damaged goods was placed at $1,000 but only realized $750 when sold; machinery costing $3,500 on
November 30, with a scrap value of $500, realized on sale by the company $650, the insurance
received being $2,000. (Depreciation on the machinery at the rate of 8⅓% annually on cost value is to
be taken into account, and the portion of the unexpired insurance—roughly estimated at $150—now
canceled by the payment of the insurance on both raw materials and machinery is to be considered in
making charges to the Fire Loss account.) Additional loss and expense due to decreased production
and cancellation of orders because of not being able to deliver goods when promised was estimated at
$7,500. The strike was finally settled by granting a 5% increase in wages.
The directors had under consideration the incorporation with the Knoxfraud of a patent listing and
adding device owned by J. Q. Osgood. In view of the need of some additional capital anyway due to
the strike losses, it was decided to incorporate the new device now, since it would be easier to make
the needed changes at this time than after operations had been resumed. Accordingly, a rearrangement
of the machinery was necessary to make room for the new machinery and place it for proper routing
of the product. This entailed a cash expenditure of $750 for the rearrangement, and $5,500 for new
machines to replace those disposed of and to manufacture the new device. (Make the record as of
April 30.) The contract entered into with Osgood was on a royalty basis per unit turned out by the
machines and for one year’s time beginning May 1, 1917. The directors decided on a continuation of
the advertising campaign. To provide funds for these purposes a bond issue was determined upon—
$20,000 20-year 6%, interest coupons redeemable November 1, and May 1,—secured by mortgage on
the factory and its equipment. The trust agreement provided for the payment at the close of each fiscal
year of $750 out of profits into the hands of the Guaranty Trust Co. for investment in securities until a
sinking fund sufficient to retire the bonds at their maturity shall have been established. $15,000 of the
bonds were offered for sale and were purchased at 95 for cash except one purchase on a note for $950.
The remaining $5,000 were held in the treasury until needed.
Record the above transactions as of the dates given—the bond transactions took place on May 1.
Instructions
October 31. The columns in sales journal, sales returns and allowances journal, and voucher
register headed “Sundry Office Supplies,” will now be given the headings “Knoxfraud” for the first
two journals, and “Raw Materials” for the voucher register.
November 10. A part of the charge to Raw Materials must be made in the general journal.
“Prepayment on Purchases” account will be closed.
November 30. Record the note payable secured by mortgage under the title “Purchase Money
Mortgage on Machinery.” Voucher the cash portion of this purchase of machinery. Transfer the cost of
concrete platforms from Buildings to Machinery account. This had previously been charged to
Page 549
Buildings and is merely a transfer entry here. Run Noble’s salary through the voucher register as a
cash transaction, making the proper distribution of it. The payment of $550.50 for connecting power is
to be charged to Power Equipment.
April 20. Charge these two items as cash expenditures to Strike Costs. In accounting for the fire
losses, clear the accounts of their original values by transfer to Fire Loss account (Raw Materials
Purchases $5,000, and Machinery $3,500 less depreciation for 4⅔ months, i.e., from November 30 to
April 20). Credit Fire Loss from the cash book with the insurance received and with the cash received
from sale of scrap. Charge Fire Loss also with the canceled insurance premiums. Record all of this
under date of April 20. (The student is referred to Chapter XXXII for a full treatment of fire loss
adjustments.)
Indirect losses due to strike must not be brought onto the books.
No sinking fund entries will be made till the close of the fiscal year.
May 1. Handle the sale of bonds in cash book and general journal.
Treat the note received as a “Note Receivable Special.” No record will be
made of the unissued bonds.
XXI
Practice Data
The remaining data for the 16 months ending December 31, 1917, have been summarized in most
instances and were as follows: (In making record, use the dates given or December 31, where none are
given.)
June 1. A dynamo costing $525 on August 31, 1916, was sold for $415 and a larger one purchased
from the General Electric Co. at a cost of $975.50 installed. (Take into account depreciation at 12½%
per annum.) Additional motor trucks were purchased from the New Model Truck Co. for $1,790.
(Entry was made at $1,740, taking into account a special discount of $50 for payment within 10 days.
Through oversight the voucher was not paid till July 1, thus losing the discount.)
June 25. Call No. 2 was made for the balance of unpaid subscriptions to capital stock.
Voucher Register—Bought desks and tables $200,431.95, bookcases and filing cabinets
$149,878.79, raw materials $62,749.63. Purchases discount was $4,290.89; in-freight and delivery
$8,650; pay-roll, direct labor $99,475.50, indirect labor $11,900.17; engineers and firemen’s wages
$5,125.67; building maintenance and repairs $200; machinery repairs $193.50; receiving and shipping
clerks $1,550.20; assembling and setting up labor $500.80; salesmen’s salaries $173,790.25; traveling
expense $91,475.89; salesmen’s commissions $79,612.40; delivery men $3,500; office salaries
$15,900; patterns $1,250; factory work benches $75; experimental laboratory $2,500. Materials
purchased for building maintenance and repairs $326.40, for machinery repairs $85, for patterns $550.
Coal and water cost $11,193.40; sundry light, heat, and power expense $1,062.60; packing and
shipping supplies $4,469.70; delivery expense, including motor-truck repairs and maintenance,
$12,989.14; taxes for 1916 $585.43; factory supplies $1,124.17; sundry factory expense $750.28;
royalties $875; insurance, including employers’ liability insurance for factory workmen, $2,277.45;
warehouse expense $540; warehouse rent $850; sundry selling expense $2,196.40; rent $7,500;
stationery and printing $2,310.17; telephone, telegraph, and postage $1,092.15; sundry office expense;
$1,312.43; collection expense $1,025.43; interest and discount $902.20; bond interest $450; materials
for laboratory $1,500; legal expense in defending patents $175; street and sewer improvement tax on
factory site $525.60; advertising $123,470.10; notes payable paid $25,261.75; notes receivable
discounted but protested and charged back, $1,260.50; advances to salesmen $1,500.
cash transaction, making the proper distribution of it. The payment of $550.50 for connecting power is
to be charged to Power Equipment.
April 20. Charge these two items as cash expenditures to Strike Costs. In accounting for the fire
losses, clear the accounts of their original values by transfer to Fire Loss account (Raw Materials
Purchases $5,000, and Machinery $3,500 less depreciation for 4⅔ months, i.e., from November 30 to
April 20). Credit Fire Loss from the cash book with the insurance received and with the cash received
from sale of scrap. Charge Fire Loss also with the canceled insurance premiums. Record all of this
under date of April 20. (The student is referred to Chapter XXXII for a full treatment of fire loss
adjustments.)
Indirect losses due to strike must not be brought onto the books.
No sinking fund entries will be made till the close of the fiscal year.
May 1. Handle the sale of bonds in cash book and general journal.
Treat the note received as a “Note Receivable Special.” No record will be
made of the unissued bonds.
XXI
Practice Data
The remaining data for the 16 months ending December 31, 1917, have been summarized in most
instances and were as follows: (In making record, use the dates given or December 31, where none are
given.)
June 1. A dynamo costing $525 on August 31, 1916, was sold for $415 and a larger one purchased
from the General Electric Co. at a cost of $975.50 installed. (Take into account depreciation at 12½%
per annum.) Additional motor trucks were purchased from the New Model Truck Co. for $1,790.
(Entry was made at $1,740, taking into account a special discount of $50 for payment within 10 days.
Through oversight the voucher was not paid till July 1, thus losing the discount.)
June 25. Call No. 2 was made for the balance of unpaid subscriptions to capital stock.
Voucher Register—Bought desks and tables $200,431.95, bookcases and filing cabinets
$149,878.79, raw materials $62,749.63. Purchases discount was $4,290.89; in-freight and delivery
$8,650; pay-roll, direct labor $99,475.50, indirect labor $11,900.17; engineers and firemen’s wages
$5,125.67; building maintenance and repairs $200; machinery repairs $193.50; receiving and shipping
clerks $1,550.20; assembling and setting up labor $500.80; salesmen’s salaries $173,790.25; traveling
expense $91,475.89; salesmen’s commissions $79,612.40; delivery men $3,500; office salaries
$15,900; patterns $1,250; factory work benches $75; experimental laboratory $2,500. Materials
purchased for building maintenance and repairs $326.40, for machinery repairs $85, for patterns $550.
Coal and water cost $11,193.40; sundry light, heat, and power expense $1,062.60; packing and
shipping supplies $4,469.70; delivery expense, including motor-truck repairs and maintenance,
$12,989.14; taxes for 1916 $585.43; factory supplies $1,124.17; sundry factory expense $750.28;
royalties $875; insurance, including employers’ liability insurance for factory workmen, $2,277.45;
warehouse expense $540; warehouse rent $850; sundry selling expense $2,196.40; rent $7,500;
stationery and printing $2,310.17; telephone, telegraph, and postage $1,092.15; sundry office expense;
$1,312.43; collection expense $1,025.43; interest and discount $902.20; bond interest $450; materials
for laboratory $1,500; legal expense in defending patents $175; street and sewer improvement tax on
factory site $525.60; advertising $123,470.10; notes payable paid $25,261.75; notes receivable
discounted but protested and charged back, $1,260.50; advances to salesmen $1,500.
Page 550
Sales Journal—Sales to sundry customers: desks and tables $290,721.15; bookcases and filing
cabinets $204,422.20, Knoxfrauds $351,622.50. Cash sales were: desks and tables $91,213.10,
bookcases and filing cabinets $71,253.20, Knoxfrauds $124,121.25. Sales returns and allowances
were: desks and tables $10,192.50; bookcases and filing cabinets $8,269.10, Knoxfrauds $21,569.65.
Cash Book—Received: from cash sales as above; from Sundry Customers $624,736.74 less sales
discount of $15,962.14; from interest $750; from notes receivable discounted $19,260.25 less bank
discount of $210.25; from notes receivable $10,192.60; from rent income $160—the sub-lease on the
warehouse was canceled because the room was needed for increased stock; from first call on
outstanding subscriptions to capital stock $18,250, from second call $18,000. Disbursed: for vouchers
payable $1,005,833.95.
Journal—Received notes from Sundry Customers $59,370.50. Gave notes to Sundry Creditors
$45,000. Notes receivable discounted were paid by makers at maturity $12,379.60. Trade debts
proved uncollectible from bankruptcy or other cause to the amount of $3,572.40.
Instructions
June 1. Charge the loss on sale of dynamo to Loss from Sale of Power Equipment. Accrued
depreciation for 9 months must be taken into account. Run the neglected discount item through on a
new voucher, making cross-reference to the original. Be sure to make proper distribution of it.
June 25. Call No. 2 is for $18,750.
Voucher Register. Make careful distribution of all items—particularly as between capital and
revenue charges. Discounted notes receivable protested will be charged to Sundry Customers.
Journal. Make here also the entry necessary to complete the record of the discounted notes which
went to protest, as indicated by the voucher register entry above.
XXII
Practice Data
Summarize and post the books and take a trial balance as of December 31, 1917. Record the trial
balance in the usual place.
XXIII
Problem
A trial balance taken from the general ledger of the Metal Bed Manufacturing Co. for December
31, 1917, showed as follows:
Bed Sales $325,198.67
Bed Sales Returns and Allowances $10,240.80
Bed Accessories Sales 192,460.90
Bed Accessories Sales Returns
and Allowances 8,175.25
Raw Material Inventory 25,240.16
In-Freight and Drayage 1,460.24
Beds in Process 15,970.20
cabinets $204,422.20, Knoxfrauds $351,622.50. Cash sales were: desks and tables $91,213.10,
bookcases and filing cabinets $71,253.20, Knoxfrauds $124,121.25. Sales returns and allowances
were: desks and tables $10,192.50; bookcases and filing cabinets $8,269.10, Knoxfrauds $21,569.65.
Cash Book—Received: from cash sales as above; from Sundry Customers $624,736.74 less sales
discount of $15,962.14; from interest $750; from notes receivable discounted $19,260.25 less bank
discount of $210.25; from notes receivable $10,192.60; from rent income $160—the sub-lease on the
warehouse was canceled because the room was needed for increased stock; from first call on
outstanding subscriptions to capital stock $18,250, from second call $18,000. Disbursed: for vouchers
payable $1,005,833.95.
Journal—Received notes from Sundry Customers $59,370.50. Gave notes to Sundry Creditors
$45,000. Notes receivable discounted were paid by makers at maturity $12,379.60. Trade debts
proved uncollectible from bankruptcy or other cause to the amount of $3,572.40.
Instructions
June 1. Charge the loss on sale of dynamo to Loss from Sale of Power Equipment. Accrued
depreciation for 9 months must be taken into account. Run the neglected discount item through on a
new voucher, making cross-reference to the original. Be sure to make proper distribution of it.
June 25. Call No. 2 is for $18,750.
Voucher Register. Make careful distribution of all items—particularly as between capital and
revenue charges. Discounted notes receivable protested will be charged to Sundry Customers.
Journal. Make here also the entry necessary to complete the record of the discounted notes which
went to protest, as indicated by the voucher register entry above.
XXII
Practice Data
Summarize and post the books and take a trial balance as of December 31, 1917. Record the trial
balance in the usual place.
XXIII
Problem
A trial balance taken from the general ledger of the Metal Bed Manufacturing Co. for December
31, 1917, showed as follows:
Bed Sales $325,198.67
Bed Sales Returns and Allowances $10,240.80
Bed Accessories Sales 192,460.90
Bed Accessories Sales Returns
and Allowances 8,175.25
Raw Material Inventory 25,240.16
In-Freight and Drayage 1,460.24
Beds in Process 15,970.20
Page 551
Finished Beds 42,490.70
Accessories Inventory 19,580.65
Direct Labor 35,918.60
Indirect Labor 10,372.40
Light, Heat, and Power 8,917.18
Manufacturing Expense 5,890.10
Rent 3,300.00
Machinery Repairs and Renewals 575.00
Raw Materials Purchases 175,460.18
Raw Materials Purchases Returns
and Allowances 9,840.60
Accessories Purchases 95,640.81
Accessories Purchases Returns
and Allowances 4,890.06
Advertising 4,800.00
Salesmen’s Salaries 13,690.75
Salesmen’s Commissions 4,610.15
Traveling Expense 10,111.25
Out-Freight and Shipping 790.20
Delivery Expense 3,816.25
Insurance on Sales Room Stock 475.00
Insurance on Factory Materials 820.00
Insurance on Buildings and Equipment 1,890.00
Miscellaneous Selling Expense 4,175.30
Office Salaries 15,210.40
Interest and Discount 3,620.55
Bank Expense 125.45
Office Furniture and Fixtures 1,240.00
Depreciation Reserve Office Furniture
and Fixtures 620.00
Office Supplies 720.20
Miscellaneous Office Expense 1,810.65
Leasehold (99 years) 99,000.00
Extinction Reserve for Leasehold 24,000.00
Buildings 125,000.00
Depreciation Reserve for Buildings 50,000.00
Machinery 72,520.70
Depreciation Reserve for Machinery 21,490.16
Tools 5,140.17
Accessories Inventory 19,580.65
Direct Labor 35,918.60
Indirect Labor 10,372.40
Light, Heat, and Power 8,917.18
Manufacturing Expense 5,890.10
Rent 3,300.00
Machinery Repairs and Renewals 575.00
Raw Materials Purchases 175,460.18
Raw Materials Purchases Returns
and Allowances 9,840.60
Accessories Purchases 95,640.81
Accessories Purchases Returns
and Allowances 4,890.06
Advertising 4,800.00
Salesmen’s Salaries 13,690.75
Salesmen’s Commissions 4,610.15
Traveling Expense 10,111.25
Out-Freight and Shipping 790.20
Delivery Expense 3,816.25
Insurance on Sales Room Stock 475.00
Insurance on Factory Materials 820.00
Insurance on Buildings and Equipment 1,890.00
Miscellaneous Selling Expense 4,175.30
Office Salaries 15,210.40
Interest and Discount 3,620.55
Bank Expense 125.45
Office Furniture and Fixtures 1,240.00
Depreciation Reserve Office Furniture
and Fixtures 620.00
Office Supplies 720.20
Miscellaneous Office Expense 1,810.65
Leasehold (99 years) 99,000.00
Extinction Reserve for Leasehold 24,000.00
Buildings 125,000.00
Depreciation Reserve for Buildings 50,000.00
Machinery 72,520.70
Depreciation Reserve for Machinery 21,490.16
Tools 5,140.17
Page 552
Patterns 7,500.00
Depreciation Reserve for Patterns 5,405.14
Factory Furniture and Fixtures 8,100.00
Depreciation Reserve Factory
Furniture and Fixtures 3,190.20
Sales Room Furniture and Fixtures 10,250.00
Depreciation Reserve Sales Room
Furniture and Fixtures 4,330.10
Sales Discount 8,440.05
Purchases Discount 10,375.90
Good-Will 50,000.00
Accounts Receivable 110,472.05
Notes Receivable 5,640.10
Accounts Payable 62,490.35
Notes Payable 10,000.00
Mortgage Payable 15,000.00
Petty Cash 150.00
Surplus 150,154.24
Reserve for Doubtful Accounts 3,519.72
Capital Stock Common 100,000.00
Capital Stock Preferred 6% 50,000.00
Harriman National Bank 10,114.55
Common Dividend No. 37 2,000.00
Preferred Dividend No. 25 1,500.00
$1,042,966.04 $1,042,966.04
The company conducts a factory for the manufacture of metal beds. It deals also in mattresses,
springs, bed furnishings, etc., which it buys ready-made and sells to the retail trade. Its two classes of
sales, beds and accessories are kept distinct.
Draw up a balance sheet and profit and loss statement for the year, taking into account the
following inventories and other adjustments:
Inventories:
Raw Materials $31,216.15
Beds in Process 18,793.80
Finished Beds 31,470.95
Bed Accessories 24,640.10
Accrued Expenses:
Direct Labor 690.20
Depreciation Reserve for Patterns 5,405.14
Factory Furniture and Fixtures 8,100.00
Depreciation Reserve Factory
Furniture and Fixtures 3,190.20
Sales Room Furniture and Fixtures 10,250.00
Depreciation Reserve Sales Room
Furniture and Fixtures 4,330.10
Sales Discount 8,440.05
Purchases Discount 10,375.90
Good-Will 50,000.00
Accounts Receivable 110,472.05
Notes Receivable 5,640.10
Accounts Payable 62,490.35
Notes Payable 10,000.00
Mortgage Payable 15,000.00
Petty Cash 150.00
Surplus 150,154.24
Reserve for Doubtful Accounts 3,519.72
Capital Stock Common 100,000.00
Capital Stock Preferred 6% 50,000.00
Harriman National Bank 10,114.55
Common Dividend No. 37 2,000.00
Preferred Dividend No. 25 1,500.00
$1,042,966.04 $1,042,966.04
The company conducts a factory for the manufacture of metal beds. It deals also in mattresses,
springs, bed furnishings, etc., which it buys ready-made and sells to the retail trade. Its two classes of
sales, beds and accessories are kept distinct.
Draw up a balance sheet and profit and loss statement for the year, taking into account the
following inventories and other adjustments:
Inventories:
Raw Materials $31,216.15
Beds in Process 18,793.80
Finished Beds 31,470.95
Bed Accessories 24,640.10
Accrued Expenses:
Direct Labor 690.20
Page 553
Indirect Labor 325.00
Rent 300.00
Light, Heat, and Power 180.20
Advertising 590.00
Sales Commissions 319.40
Interest 150.00
Prepaid Expenses:
Coal, Waste, Oil, etc. $125.00
Advertising 300.00
Office Supplies 75.00
Bank Discount 125.00
Insurance on Sales Room Stock 50.00
Insurance on Factory Materials 125.00
Insurance on Buildings and Equipment 256.40
Interest earned on Notes Receivable but not yet due 75.20
Depreciation is estimated as follows on a yearly basis:
Office Furniture and Fixtures 8⅓%
Factory Furniture and Fixtures 10%
Sales Room Furniture and Fixtures 10%
Buildings 2%
Machinery 10%
Patterns 20%
The leasehold was originally for 99 years of which 25 years have now expired. Bad debts are
calculated as 2% of the accounts and notes outstanding. Tools now on hand amount to $4,800.25. In-
freight and drayage is to be charged 55% to Factory and 45% to Selling. Light, heat, and power charge
90% to Factory, 9% to Selling, and 1% to Office. Rent, charge 60% to Factory, 35% to Selling, and
5% to Office. Insurance on buildings and equipment distribute according to the values invested,
separating buildings’ values on the same basis as rent. Dividends No. 26 for 3% on preferred and No.
38 for 6% on the common are declared and paid.
Instructions
The leasehold was purchased for a lump sum with provision for the payment of a small annual
rental in addition. The rent item on the books covers this charge. $1,000 a year is the amortization
charge on the leasehold.
Insurance on buildings and equipment covers buildings, machinery, tools, patterns, and office,
salesroom, and factory furniture and fixtures. Be careful to distribute this among the manufacturing,
selling, and office sections of the profit and loss summary. Separate the asset values of these items,
which show investment in the factory, the selling section, and the office section of the plant, and
distribute the insurance on the basis of the investment shown.
Depreciation on buildings will be distributed also on the same basis as rent.
Rent 300.00
Light, Heat, and Power 180.20
Advertising 590.00
Sales Commissions 319.40
Interest 150.00
Prepaid Expenses:
Coal, Waste, Oil, etc. $125.00
Advertising 300.00
Office Supplies 75.00
Bank Discount 125.00
Insurance on Sales Room Stock 50.00
Insurance on Factory Materials 125.00
Insurance on Buildings and Equipment 256.40
Interest earned on Notes Receivable but not yet due 75.20
Depreciation is estimated as follows on a yearly basis:
Office Furniture and Fixtures 8⅓%
Factory Furniture and Fixtures 10%
Sales Room Furniture and Fixtures 10%
Buildings 2%
Machinery 10%
Patterns 20%
The leasehold was originally for 99 years of which 25 years have now expired. Bad debts are
calculated as 2% of the accounts and notes outstanding. Tools now on hand amount to $4,800.25. In-
freight and drayage is to be charged 55% to Factory and 45% to Selling. Light, heat, and power charge
90% to Factory, 9% to Selling, and 1% to Office. Rent, charge 60% to Factory, 35% to Selling, and
5% to Office. Insurance on buildings and equipment distribute according to the values invested,
separating buildings’ values on the same basis as rent. Dividends No. 26 for 3% on preferred and No.
38 for 6% on the common are declared and paid.
Instructions
The leasehold was purchased for a lump sum with provision for the payment of a small annual
rental in addition. The rent item on the books covers this charge. $1,000 a year is the amortization
charge on the leasehold.
Insurance on buildings and equipment covers buildings, machinery, tools, patterns, and office,
salesroom, and factory furniture and fixtures. Be careful to distribute this among the manufacturing,
selling, and office sections of the profit and loss summary. Separate the asset values of these items,
which show investment in the factory, the selling section, and the office section of the plant, and
distribute the insurance on the basis of the investment shown.
Depreciation on buildings will be distributed also on the same basis as rent.
Page 554
Dividends 25 and 37 have evidently been paid but not yet charged against Surplus. This is
sometimes done when it is desired to charge an interim dividend against profits of the current year. In
drawing up the balance sheet take cognizance of the fact that dividends 26 and 38 have also been
declared and paid though not yet booked.
Support the balance sheet and profit and loss statement with the customary schedules. The “Cost
of Goods Sold” schedule must in turn be supported by a schedule showing the “Cost to Manufacture.”
As explained in Chapter III, in the cost of goods sold schedule the cost of goods manufactured—
shown by the cost to manufacture schedule—takes the place of the item “Net Purchases” in a trading
business. A typical form of manufacturing statement is shown below.
Exhibit B—Schedule 1
Cogswell & Sons, Manufacturers
Cost to Manufacture, for the Year Ending December 31, 1917
Fireless Cookers:
Raw Materials:
Inventory, January 1, 1917 $25,000.00
Purchases, Net $125,000.00
In-Freight and Cartage 5,000.00 130,000.00
$155,000.00
Less Inventory, December 31, 1917 28,100.00
Cost of Raw Materials Used in Manufacture $126,900.00
Direct Labor 178,600.00
Prime Cost $305,500.00
Factory Expenses:
Indirect Labor $30,000.00
Light, Heat, and Power 20,000.00
Factory Supplies 5,000.00
Sundry Factory Expense 1,500.00
Machinery Repairs 750.00
Building Maintenance and Repairs 1,225.00
Depreciation 6,210.00
Insurance 850.00
Taxes 2,195.00
Royalties 15,276.00 83,006.00
$388,506.00
Deduct, excess of:
Goods in Process, December 31, 1917 over $40,210.00
Goods in Process, January 1, 1917 32,794.00 7,416.00
Cost of Finished Cookers (carried to Schedule 2) $381,090.00
sometimes done when it is desired to charge an interim dividend against profits of the current year. In
drawing up the balance sheet take cognizance of the fact that dividends 26 and 38 have also been
declared and paid though not yet booked.
Support the balance sheet and profit and loss statement with the customary schedules. The “Cost
of Goods Sold” schedule must in turn be supported by a schedule showing the “Cost to Manufacture.”
As explained in Chapter III, in the cost of goods sold schedule the cost of goods manufactured—
shown by the cost to manufacture schedule—takes the place of the item “Net Purchases” in a trading
business. A typical form of manufacturing statement is shown below.
Exhibit B—Schedule 1
Cogswell & Sons, Manufacturers
Cost to Manufacture, for the Year Ending December 31, 1917
Fireless Cookers:
Raw Materials:
Inventory, January 1, 1917 $25,000.00
Purchases, Net $125,000.00
In-Freight and Cartage 5,000.00 130,000.00
$155,000.00
Less Inventory, December 31, 1917 28,100.00
Cost of Raw Materials Used in Manufacture $126,900.00
Direct Labor 178,600.00
Prime Cost $305,500.00
Factory Expenses:
Indirect Labor $30,000.00
Light, Heat, and Power 20,000.00
Factory Supplies 5,000.00
Sundry Factory Expense 1,500.00
Machinery Repairs 750.00
Building Maintenance and Repairs 1,225.00
Depreciation 6,210.00
Insurance 850.00
Taxes 2,195.00
Royalties 15,276.00 83,006.00
$388,506.00
Deduct, excess of:
Goods in Process, December 31, 1917 over $40,210.00
Goods in Process, January 1, 1917 32,794.00 7,416.00
Cost of Finished Cookers (carried to Schedule 2) $381,090.00
Page 555
As stated above, this “Cost of Finished Cookers” is carried to Schedule 2, “Cost of Goods Sold,”
where it is combined with its initial and final inventories to develop the cost of the cookers sold
during the period. With the exception noted, this schedule, for a departmental business, follows the
forms already shown and will not be repeated here. The same thing is true of the other supporting
schedules.
XXIV
Problem
Using the information of Problem XXIII and the statements drawn up there, prepare adjusting and
closing journal entries covering just the manufacturing activities of the business.
Instructions
It is desired here to give the student practice with the group of entries with which he is not yet
familiar. The adjusting and closing entries covering the other activities of the business follow the
methods already explained. In summarizing the manufacturing group of entries, the process is the
same, in the main, as other summary entries. The exact entries necessary depend, of course, on the
accounts carried and the way in which they are used. This applies particularly to the use of one or
several different inventory accounts and the Goods in Process account.
To bring the goods in process inventory on the books requires a debit to Manufacturing and a
credit to Goods in Process to clear it—i.e., Goods in Process—of the initial inventory, and then a debit
to Goods in Process and a credit to Manufacturing to set up the present inventory. This secures the
proper charge or credit, for the excess of the one inventory over the other, necessary to develop the
correct cost to manufacture.
Where a Finished Goods account is carried, it is sometimes used as an inventory account, in which
case the method of handling it is similar to that of Goods in Process excepting that the Finished Goods
account is used in connection with the Profit and Loss (or Trading) account instead of the
Manufacturing account. When Finished Goods account is used in this way, the balance of the
Manufacturing account, i.e., the cost of goods manufactured, is transferred in toto to the Profit and
Loss account in which the cost of the manufactured goods sold is developed. Where other
commodities are dealt in, in addition to the manufactured product, this may result in an awkward and
inconsistent method of developing the costs of the different commodities sold. This has sometimes led
to the use of the Finished Goods account somewhat on the lines of a purchases account. To it the
balance of the Manufacturing account is transferred, and the cost of finished goods sold is developed
in it by bringing the two inventories into this account. This necessitates the use of a Finished Goods
Inventory account in addition to Finished Goods account—or finished goods inventory may be set up
in Merchandise Inventory account, where only one inventory account is carried. The cost of
manufactured goods sold is then transferred from Finished Goods account to Profit and Loss account,
where, together with the costs of the other commodities sold, it helps to effect the closing of the
books.
In this problem use the Finished Beds account as an inventory account.
XXV-XXVI
Practice Data
Prepare a condensed balance sheet and profit and loss statement as of
December 31, 1917, taking account of the following adjustments and inventories.
where it is combined with its initial and final inventories to develop the cost of the cookers sold
during the period. With the exception noted, this schedule, for a departmental business, follows the
forms already shown and will not be repeated here. The same thing is true of the other supporting
schedules.
XXIV
Problem
Using the information of Problem XXIII and the statements drawn up there, prepare adjusting and
closing journal entries covering just the manufacturing activities of the business.
Instructions
It is desired here to give the student practice with the group of entries with which he is not yet
familiar. The adjusting and closing entries covering the other activities of the business follow the
methods already explained. In summarizing the manufacturing group of entries, the process is the
same, in the main, as other summary entries. The exact entries necessary depend, of course, on the
accounts carried and the way in which they are used. This applies particularly to the use of one or
several different inventory accounts and the Goods in Process account.
To bring the goods in process inventory on the books requires a debit to Manufacturing and a
credit to Goods in Process to clear it—i.e., Goods in Process—of the initial inventory, and then a debit
to Goods in Process and a credit to Manufacturing to set up the present inventory. This secures the
proper charge or credit, for the excess of the one inventory over the other, necessary to develop the
correct cost to manufacture.
Where a Finished Goods account is carried, it is sometimes used as an inventory account, in which
case the method of handling it is similar to that of Goods in Process excepting that the Finished Goods
account is used in connection with the Profit and Loss (or Trading) account instead of the
Manufacturing account. When Finished Goods account is used in this way, the balance of the
Manufacturing account, i.e., the cost of goods manufactured, is transferred in toto to the Profit and
Loss account in which the cost of the manufactured goods sold is developed. Where other
commodities are dealt in, in addition to the manufactured product, this may result in an awkward and
inconsistent method of developing the costs of the different commodities sold. This has sometimes led
to the use of the Finished Goods account somewhat on the lines of a purchases account. To it the
balance of the Manufacturing account is transferred, and the cost of finished goods sold is developed
in it by bringing the two inventories into this account. This necessitates the use of a Finished Goods
Inventory account in addition to Finished Goods account—or finished goods inventory may be set up
in Merchandise Inventory account, where only one inventory account is carried. The cost of
manufactured goods sold is then transferred from Finished Goods account to Profit and Loss account,
where, together with the costs of the other commodities sold, it helps to effect the closing of the
books.
In this problem use the Finished Beds account as an inventory account.
XXV-XXVI
Practice Data
Prepare a condensed balance sheet and profit and loss statement as of
December 31, 1917, taking account of the following adjustments and inventories.
Page 556
Also draw up a statement of surplus for the 16 months of the current fiscal period.
Coal and Power Supplies on Hand $ 1,240.19
Packing Materials on Hand 340.20
Gasoline on Hand 125.00
Factory Supplies 100.00
Insurance Unexpired 540.23
Warehouse Rent Prepaid 150.00
Stationery on Hand 150.00
Experimental Laboratory Materials on Hand 425.00
Advertising Prepaid 500.00
Purchases Discount Not Yet Taken on Unpaid Vouchers 840.22
Advertising Unpaid 1,000.00
Direct Labor Accrued 1,793.75
Indirect Labor Accrued 225.33
Engineers and Firemen’s Wages Accrued 125.67
Receiving and Shipping Clerk’s Wages Accrued 75.50
Assembling and Setting Up Wages Accrued 15.00
Salesmen’s Salaries Accrued 2,524.50
Salesmen’s Commissions Accrued 1,360.18
Deliverymen’s Wages Accrued 67.50
Royalties Accrued 150.00
Rent Accrued 400.00
Interest Payable 17.25
Taxes on Factory Accrued 819.37
Taxes on Stock Accrued 395.62
Bond Interest Accrued 150.00
Inventories of stock-in-trade and raw materials were:
Desks and Tables $20,855.10
Bookcases and Filing Cabinets 17,671.40
Knoxfrauds, Finished 2,511.20
Raw Materials 15,241.92
Goods in Process 9,255.65
Calculate depreciation at the yearly rates given below. The balance in the
account is to be used as the basis, reckoning for 16 months.
Power Equipment 12½%
Machinery 8⅓%
Factory Buildings 1½%
Coal and Power Supplies on Hand $ 1,240.19
Packing Materials on Hand 340.20
Gasoline on Hand 125.00
Factory Supplies 100.00
Insurance Unexpired 540.23
Warehouse Rent Prepaid 150.00
Stationery on Hand 150.00
Experimental Laboratory Materials on Hand 425.00
Advertising Prepaid 500.00
Purchases Discount Not Yet Taken on Unpaid Vouchers 840.22
Advertising Unpaid 1,000.00
Direct Labor Accrued 1,793.75
Indirect Labor Accrued 225.33
Engineers and Firemen’s Wages Accrued 125.67
Receiving and Shipping Clerk’s Wages Accrued 75.50
Assembling and Setting Up Wages Accrued 15.00
Salesmen’s Salaries Accrued 2,524.50
Salesmen’s Commissions Accrued 1,360.18
Deliverymen’s Wages Accrued 67.50
Royalties Accrued 150.00
Rent Accrued 400.00
Interest Payable 17.25
Taxes on Factory Accrued 819.37
Taxes on Stock Accrued 395.62
Bond Interest Accrued 150.00
Inventories of stock-in-trade and raw materials were:
Desks and Tables $20,855.10
Bookcases and Filing Cabinets 17,671.40
Knoxfrauds, Finished 2,511.20
Raw Materials 15,241.92
Goods in Process 9,255.65
Calculate depreciation at the yearly rates given below. The balance in the
account is to be used as the basis, reckoning for 16 months.
Power Equipment 12½%
Machinery 8⅓%
Factory Buildings 1½%
Page 557
Patterns 20%
Patents ¹/₁₇
Delivery Equipment 15%
Furniture and Fixtures, Factory 12½%
Furniture and Fixtures, Store and Office 10%
Organization Expense 5% of the original cost
Tools Inventory $825.50
Allocate the following charges as indicated:
Insurance: $2,196.43 to Factory and $519.24 to Selling.
Taxes: $1,012.24 to Factory and $411.23 to Selling.
Receiving and shipping: ¾ to Shipping and ¼ to Receiving, of which 40% to Desks and Tables,
35% to Bookcases and Filing Cabinets, 25% to Raw Materials.
In-freight and delivery: $4,400 to Desks and Tables, $3,500 to Bookcases and Filing Cabinets,
$750 to Raw Materials.
Rent: $6,400 to Selling, $1,500 to Office.
Light, heat, and power: 92% to Factory, 6% to Selling, 2% to Office.
Create a reserve for doubtful accounts of ½% of all gross sales for the period. It is decided to take
into account as an additional expense chargeable to this period 1¼% of outstanding trade debtors for
sales discounts that will probably still be taken advantage of.
Close Loss on Sale of Dynamo against Surplus.
Close Fire Loss and Strike Costs to Surplus.
In closing, bond discount is to be amortized on a straight line basis, i.e., ¹/₄₀ each half-year. Take
account of accrued amortization for the two-month period since November 1.
The experimental laboratory has succeeded in securing a patent for a listing and adding device for
use with the Knoxfraud, of much simpler operation and cheaper to manufacture, than the one on
which royalty is being paid. Hence, when the royalty contract expires it will not be renewed.
Capitalize the laboratory expense to date.
A very careful analysis of the advertising costs shows an expenditure of $78,445.25 above normal.
It is decided to transfer this to Good-Will.
Claims for damage have been filed against the railways amounting to $1,025.10. (Bring this on to
the books with an offsetting reserve of the same amount.)
A dividend of 12½% on the common is declared payable January 20, 1918.
Take into consideration the sinking fund requirements of the bond mortgage.
Instructions
On the condensed balance sheet, show all receivables (other than the claims against customers on
note and open account) under the title “Other Accounts Receivable,” immediately following but
separate from the current asset group. Carry all inventories under one title “Inventories.” All fixed
assets, except the intangibles, show under the title “Plant and Equipment,” from which show deducted
the total of the various depreciation reserves. List the intangible assets individually. Set up supporting
Patents ¹/₁₇
Delivery Equipment 15%
Furniture and Fixtures, Factory 12½%
Furniture and Fixtures, Store and Office 10%
Organization Expense 5% of the original cost
Tools Inventory $825.50
Allocate the following charges as indicated:
Insurance: $2,196.43 to Factory and $519.24 to Selling.
Taxes: $1,012.24 to Factory and $411.23 to Selling.
Receiving and shipping: ¾ to Shipping and ¼ to Receiving, of which 40% to Desks and Tables,
35% to Bookcases and Filing Cabinets, 25% to Raw Materials.
In-freight and delivery: $4,400 to Desks and Tables, $3,500 to Bookcases and Filing Cabinets,
$750 to Raw Materials.
Rent: $6,400 to Selling, $1,500 to Office.
Light, heat, and power: 92% to Factory, 6% to Selling, 2% to Office.
Create a reserve for doubtful accounts of ½% of all gross sales for the period. It is decided to take
into account as an additional expense chargeable to this period 1¼% of outstanding trade debtors for
sales discounts that will probably still be taken advantage of.
Close Loss on Sale of Dynamo against Surplus.
Close Fire Loss and Strike Costs to Surplus.
In closing, bond discount is to be amortized on a straight line basis, i.e., ¹/₄₀ each half-year. Take
account of accrued amortization for the two-month period since November 1.
The experimental laboratory has succeeded in securing a patent for a listing and adding device for
use with the Knoxfraud, of much simpler operation and cheaper to manufacture, than the one on
which royalty is being paid. Hence, when the royalty contract expires it will not be renewed.
Capitalize the laboratory expense to date.
A very careful analysis of the advertising costs shows an expenditure of $78,445.25 above normal.
It is decided to transfer this to Good-Will.
Claims for damage have been filed against the railways amounting to $1,025.10. (Bring this on to
the books with an offsetting reserve of the same amount.)
A dividend of 12½% on the common is declared payable January 20, 1918.
Take into consideration the sinking fund requirements of the bond mortgage.
Instructions
On the condensed balance sheet, show all receivables (other than the claims against customers on
note and open account) under the title “Other Accounts Receivable,” immediately following but
separate from the current asset group. Carry all inventories under one title “Inventories.” All fixed
assets, except the intangibles, show under the title “Plant and Equipment,” from which show deducted
the total of the various depreciation reserves. List the intangible assets individually. Set up supporting
Page 558
schedules for all condensations effected. The profit and loss statement must have supporting
schedules, also.
Although some inaccuracies result from using the bases indicated for the calculation of
depreciation, they are insignificant. Note that the basis for writing down patents has been changed
since the last period. This indicates a policy of intention to secure patented improvements on the
various devices owned. (See Chapter XVIII for discussion of this point.)
Declaration of a dividend on common stock means, of course, that the required dividends on both
issues of preferred have also been authorized. The student is required to calculate the rates on these.
XXVII-XXVIII
Practice Data
Adjust and close the books in accordance with the data given in assignments XXV-XXVI.
Treat the account “Knoxfrauds Manufactured” as a purchase account as explained in assignment
XXIV.
Handle the estimate of 1¼% of trade debtors for expected sales discounts, as an accrued item in
Sales Discount account.
There is no accrual on sinking fund provisions, inasmuch as the trust deed requires that payment
out of profits be made at the close of the fiscal period and not at the time bond interest falls due.
The Knox-Davis blanks, with all statements, are due at the time of the last class period and must
be turned in whether completed or not, if credit is desired for the course.
schedules, also.
Although some inaccuracies result from using the bases indicated for the calculation of
depreciation, they are insignificant. Note that the basis for writing down patents has been changed
since the last period. This indicates a policy of intention to secure patented improvements on the
various devices owned. (See Chapter XVIII for discussion of this point.)
Declaration of a dividend on common stock means, of course, that the required dividends on both
issues of preferred have also been authorized. The student is required to calculate the rates on these.
XXVII-XXVIII
Practice Data
Adjust and close the books in accordance with the data given in assignments XXV-XXVI.
Treat the account “Knoxfrauds Manufactured” as a purchase account as explained in assignment
XXIV.
Handle the estimate of 1¼% of trade debtors for expected sales discounts, as an accrued item in
Sales Discount account.
There is no accrual on sinking fund provisions, inasmuch as the trust deed requires that payment
out of profits be made at the close of the fiscal period and not at the time bond interest falls due.
The Knox-Davis blanks, with all statements, are due at the time of the last class period and must
be turned in whether completed or not, if credit is desired for the course.
Page 559
APPENDIX B
PRACTICE WORK FOR STUDENT—
SECOND HALF-YEAR
In this appendix enough material is furnished for approximately 30 hours of classroom work. If more time
is devoted to the work, this material may well be supplemented by drawing on Appendix C.
The student will find it convenient to have a supply of standard-ruled journal paper and of analysis paper
—10-or 12-column—to be used for working sheets.
For all formal statement work prepared for presentation to the instructor, it is suggested that plain, unruled
paper of uniform size (8½ × 11 inches, letter size) be used. The chief purpose of this second semester’s work
is to give training in analysis—the ability to grasp the essentials of a given set of conditions and to see the
significance and interrelations of the various parts. Next in importance to this is the ability to draw up a
statement or statements which shall present clearly and in proper order the results of your analysis. The
student should develop the habit of thinking clearly and setting forth conclusions in intelligent, clean-cut
form. In ninety-nine cases out of every hundred, slovenly, sloppy work evidences a like characteristic of
reasoning ability. If the course develops clear thinking and clean-cut presentation, it will have accomplished
its two main purposes.
The problems have a more or less direct relation to Chapters XXVIII to XXXV of this volume, but of
course they are not limited to the principles developed there. Many of the problems are somewhat closely
connected and relate to each other while some are entirely disconnected. They are graded, proceeding from
the simpler to the more difficult by easy stages. Where necessary, instructions are given, although the student
is thrown more on his own resources than previously. In the solution of problems involving trial balance,
adjustments, and financial statements, the method of the accountant’s working sheet will be found to offer the
best procedure. See Volume I, Chapter XLIII, pages 386-391, for explanation and illustration.
As to the method of attacking problems, the student is perhaps already aware that before attempting
solution it is best to read and study the problem carefully to determine exactly what is called for and then to
decide as to the treatment of all doubtful points and items—what they mean and how they must be handled to
arrive at what is called for. With these preliminary points cleared up, the solution itself is mostly a matter of
accuracy and form. In all problems calling for financial statements, the trial balance should first be tested as to
the equality of debits and credits. As stated above, the method of the work sheet is usually the best method for
summarizing results, although sometimes skeleton ledger accounts will be found helpful in order to visualize
the effect of entries and to trace their course through the accounts. Only painstaking work and the solution of
many problems will produce facility and confidence in work of this kind.
The instructor should direct the student to take Problem XXVIII under consideration throughout the whole
semester, in order adequately to get his material together and into shape. It may well be treated as a thesis for
the semester.
I
At the close of the fiscal year ended June 30, 1913, Thomas J. Howe called you in to determine his
financial condition. From the books, which were kept on the single-entry plan, and from other sources, you
gathered the following information:
The ledger contained the following accounts: Thomas J. Howe, Capital, $4,000; Thomas J. Howe,
Drawing (debit) $472; Expense (debit) $184; Sales $18,945; Purchases $17,450; customers’ accounts
considered good: H. E. Brewer $110; D. Cohen $85; Will Benton $190; Linn Bros. $77; customers’ accounts
which have proved uncollectible and are considered bad: Peter Metz $43; L. C. Fish $101; creditors’ accounts:
PRACTICE WORK FOR STUDENT—
SECOND HALF-YEAR
In this appendix enough material is furnished for approximately 30 hours of classroom work. If more time
is devoted to the work, this material may well be supplemented by drawing on Appendix C.
The student will find it convenient to have a supply of standard-ruled journal paper and of analysis paper
—10-or 12-column—to be used for working sheets.
For all formal statement work prepared for presentation to the instructor, it is suggested that plain, unruled
paper of uniform size (8½ × 11 inches, letter size) be used. The chief purpose of this second semester’s work
is to give training in analysis—the ability to grasp the essentials of a given set of conditions and to see the
significance and interrelations of the various parts. Next in importance to this is the ability to draw up a
statement or statements which shall present clearly and in proper order the results of your analysis. The
student should develop the habit of thinking clearly and setting forth conclusions in intelligent, clean-cut
form. In ninety-nine cases out of every hundred, slovenly, sloppy work evidences a like characteristic of
reasoning ability. If the course develops clear thinking and clean-cut presentation, it will have accomplished
its two main purposes.
The problems have a more or less direct relation to Chapters XXVIII to XXXV of this volume, but of
course they are not limited to the principles developed there. Many of the problems are somewhat closely
connected and relate to each other while some are entirely disconnected. They are graded, proceeding from
the simpler to the more difficult by easy stages. Where necessary, instructions are given, although the student
is thrown more on his own resources than previously. In the solution of problems involving trial balance,
adjustments, and financial statements, the method of the accountant’s working sheet will be found to offer the
best procedure. See Volume I, Chapter XLIII, pages 386-391, for explanation and illustration.
As to the method of attacking problems, the student is perhaps already aware that before attempting
solution it is best to read and study the problem carefully to determine exactly what is called for and then to
decide as to the treatment of all doubtful points and items—what they mean and how they must be handled to
arrive at what is called for. With these preliminary points cleared up, the solution itself is mostly a matter of
accuracy and form. In all problems calling for financial statements, the trial balance should first be tested as to
the equality of debits and credits. As stated above, the method of the work sheet is usually the best method for
summarizing results, although sometimes skeleton ledger accounts will be found helpful in order to visualize
the effect of entries and to trace their course through the accounts. Only painstaking work and the solution of
many problems will produce facility and confidence in work of this kind.
The instructor should direct the student to take Problem XXVIII under consideration throughout the whole
semester, in order adequately to get his material together and into shape. It may well be treated as a thesis for
the semester.
I
At the close of the fiscal year ended June 30, 1913, Thomas J. Howe called you in to determine his
financial condition. From the books, which were kept on the single-entry plan, and from other sources, you
gathered the following information:
The ledger contained the following accounts: Thomas J. Howe, Capital, $4,000; Thomas J. Howe,
Drawing (debit) $472; Expense (debit) $184; Sales $18,945; Purchases $17,450; customers’ accounts
considered good: H. E. Brewer $110; D. Cohen $85; Will Benton $190; Linn Bros. $77; customers’ accounts
which have proved uncollectible and are considered bad: Peter Metz $43; L. C. Fish $101; creditors’ accounts:
Page 560
Stone Bros. $942; Little & Co. $1,082; H. Hudson $1,220; also accounts with Salaries $375; Advertising
$112.
Other sources yielded this information: stock of goods on hand inventoried at $5,641; horses and wagons
estimated as worth $730; store fixtures $1,114; rent of store building unpaid $300; clerks’ salaries unpaid $84;
notes receivable $2,300; notes payable outstanding (non-interest bearing) $2,400. Bill of goods received from
Stone Bros., which has been included in the inventory but which has not been entered in Stone Bros.’ account,
$193; interest accrued on notes receivable $16; cash in the bank and safe $1,724.
It was found that the following information was available for determining his financial condition as at the
close of the preceding fiscal year, June 30, 1912: cash $1,478; notes receivable $500; notes payable $800;
Howe’s capital $4,000; store fixtures $900; inventory of goods in stock $2,800; horses and wagons at an
estimated value of $800; customers’ accounts total $2,314; creditors’ accounts total $3,609.
From the foregoing prepare:
(a) Statement of financial condition of Thomas J. Howe as of June 30, 1913.
(b) Statement showing the amount of profit made or loss sustained for the
fiscal year ended June 30, 1913.
(c) Statement setting forth in numerical order the advantages of double-entry
over single-entry accounting systems.
(d) As a result of your convincing argument Mr. Howe has decided to change
his system of accounting from single- to double-entry. Prepare the
necessary entries to change the accounting system to double-entry,
continuing the use of the old ledger and providing for controlling accounts
for customers and creditors.
Instructions
See Volume I, Chapters LV and LVI.
II
The following trial balance was taken from the books of Thomas J. Howe at the close of the next fiscal
year.
Thomas J. Howe
Trial Balance, June 30, 1914
Cash $ 894.00
Notes Receivable 5,000.00
Accounts Receivable 18,000.00
Thomas J. Howe, Capital 6,000.00
Thomas J. Howe, Drawing 560.00
Notes Payable 3,000.00
Accounts Payable 15,640.00
Purchases 77,100.00
Sales 93,620.00
Merchandise Inventory, June 30, 1913 5,641.00
Purchase Discounts 743.00
Sales Discounts 1,420.00
Freight Inward 2,884.00
Insurance 300.00
$112.
Other sources yielded this information: stock of goods on hand inventoried at $5,641; horses and wagons
estimated as worth $730; store fixtures $1,114; rent of store building unpaid $300; clerks’ salaries unpaid $84;
notes receivable $2,300; notes payable outstanding (non-interest bearing) $2,400. Bill of goods received from
Stone Bros., which has been included in the inventory but which has not been entered in Stone Bros.’ account,
$193; interest accrued on notes receivable $16; cash in the bank and safe $1,724.
It was found that the following information was available for determining his financial condition as at the
close of the preceding fiscal year, June 30, 1912: cash $1,478; notes receivable $500; notes payable $800;
Howe’s capital $4,000; store fixtures $900; inventory of goods in stock $2,800; horses and wagons at an
estimated value of $800; customers’ accounts total $2,314; creditors’ accounts total $3,609.
From the foregoing prepare:
(a) Statement of financial condition of Thomas J. Howe as of June 30, 1913.
(b) Statement showing the amount of profit made or loss sustained for the
fiscal year ended June 30, 1913.
(c) Statement setting forth in numerical order the advantages of double-entry
over single-entry accounting systems.
(d) As a result of your convincing argument Mr. Howe has decided to change
his system of accounting from single- to double-entry. Prepare the
necessary entries to change the accounting system to double-entry,
continuing the use of the old ledger and providing for controlling accounts
for customers and creditors.
Instructions
See Volume I, Chapters LV and LVI.
II
The following trial balance was taken from the books of Thomas J. Howe at the close of the next fiscal
year.
Thomas J. Howe
Trial Balance, June 30, 1914
Cash $ 894.00
Notes Receivable 5,000.00
Accounts Receivable 18,000.00
Thomas J. Howe, Capital 6,000.00
Thomas J. Howe, Drawing 560.00
Notes Payable 3,000.00
Accounts Payable 15,640.00
Purchases 77,100.00
Sales 93,620.00
Merchandise Inventory, June 30, 1913 5,641.00
Purchase Discounts 743.00
Sales Discounts 1,420.00
Freight Inward 2,884.00
Insurance 300.00
Page 561
Interest Earned 146.00
Returned Sales 930.00
Returned Purchases 760.00
Furniture and Fixtures 2,000.00
Horses, Wagons, and Harness 1,200.00
Rent 1,500.00
Advertising 300.00
Expense 180.00
Salaries 1,600.00
Commissions Paid on Sales 400.00
$119,909.00 $119,909.00
At this date, you will find that the following items must be considered to determine the financial condition
of Mr. Howe: Merchandise inventory $2,470; insurance unexpired $100; interest accrued on notes receivable
$66; interest accrued on notes payable $30; he owes for two months’ rent $300.
1% of net sales is to be set aside as a reserve for uncollectible accounts. Furniture and fixtures are to be
written off in the amount of 10%. Provide for a reserve of 10% for depreciation of horses, wagons, and
harness.
Advertising carried forward to the next period $75; unused stationery and other expense items $42;
commissions on sales due but unpaid $90.
(a) Prepare the working sheet.
(b) Construct the balance sheet as of June 30, 1914.
(c) Prepare profit and loss statement—percentages based on net sales.
(d) Write the adjusting and closing journal entries.
III
Joseph Mason was Howe’s greatest competitor. After getting better acquainted with each other, Howe
conceived the plan of uniting their capital and services in the form of a partnership. After some discussion it
was decided to operate as Howe & Mason, the capital to consist of $12,000, of which Howe is to contribute
$8,000 in the form of his existing business. The excess of Howe’s net worth, as shown by the balance sheet of
June 30, 1914, over $8,000, his investment in the partnership, is to be considered as a loan to the firm. Mason
is to transfer his entire business—assets and liabilities—and sufficient cash to make his net investment
$4,000, or one-third of the total capitalization.
As of July 1, 1914, the date of the formation of the partnership, Mason’s assets and liabilities were as
follows: cash $1,340; accounts receivable $2,460; notes receivable $1,120; stock of goods inventoried at
$4,590; furniture and fixtures appraised at $1,316; accounts payable $5,280; notes payable $1,770; rent
unpaid $320.
Prepare journal entries to give effect to the foregoing on Howe’s books, which are to be continued for the
partnership.
During the year Charles Palmer purchased one-third interest in the capital and profits of the firm by
contributing $9,000 in cash. The total capital of the new firm is set at $18,000. Business is to be conducted
under the old firm name, the old partners retaining their respective capital investments. Howe’s loan account
is to be continued at its original amount.
Write the necessary journal entries to record on the books of the firm the admission of the new partner and
the adjustments between Howe and Mason.
Returned Sales 930.00
Returned Purchases 760.00
Furniture and Fixtures 2,000.00
Horses, Wagons, and Harness 1,200.00
Rent 1,500.00
Advertising 300.00
Expense 180.00
Salaries 1,600.00
Commissions Paid on Sales 400.00
$119,909.00 $119,909.00
At this date, you will find that the following items must be considered to determine the financial condition
of Mr. Howe: Merchandise inventory $2,470; insurance unexpired $100; interest accrued on notes receivable
$66; interest accrued on notes payable $30; he owes for two months’ rent $300.
1% of net sales is to be set aside as a reserve for uncollectible accounts. Furniture and fixtures are to be
written off in the amount of 10%. Provide for a reserve of 10% for depreciation of horses, wagons, and
harness.
Advertising carried forward to the next period $75; unused stationery and other expense items $42;
commissions on sales due but unpaid $90.
(a) Prepare the working sheet.
(b) Construct the balance sheet as of June 30, 1914.
(c) Prepare profit and loss statement—percentages based on net sales.
(d) Write the adjusting and closing journal entries.
III
Joseph Mason was Howe’s greatest competitor. After getting better acquainted with each other, Howe
conceived the plan of uniting their capital and services in the form of a partnership. After some discussion it
was decided to operate as Howe & Mason, the capital to consist of $12,000, of which Howe is to contribute
$8,000 in the form of his existing business. The excess of Howe’s net worth, as shown by the balance sheet of
June 30, 1914, over $8,000, his investment in the partnership, is to be considered as a loan to the firm. Mason
is to transfer his entire business—assets and liabilities—and sufficient cash to make his net investment
$4,000, or one-third of the total capitalization.
As of July 1, 1914, the date of the formation of the partnership, Mason’s assets and liabilities were as
follows: cash $1,340; accounts receivable $2,460; notes receivable $1,120; stock of goods inventoried at
$4,590; furniture and fixtures appraised at $1,316; accounts payable $5,280; notes payable $1,770; rent
unpaid $320.
Prepare journal entries to give effect to the foregoing on Howe’s books, which are to be continued for the
partnership.
During the year Charles Palmer purchased one-third interest in the capital and profits of the firm by
contributing $9,000 in cash. The total capital of the new firm is set at $18,000. Business is to be conducted
under the old firm name, the old partners retaining their respective capital investments. Howe’s loan account
is to be continued at its original amount.
Write the necessary journal entries to record on the books of the firm the admission of the new partner and
the adjustments between Howe and Mason.
Page 562
Before determining the profits for the year Palmer assigns his interest in the capital and profits of the firm
to John H. Bartlett, who settles directly with Palmer for $10,000. Howe and Mason agree to admit Bartlett as
a partner in place of Palmer and new articles of partnership are signed by the members.
Give journal entries to show the effect on the partnership books.
Instructions
Note carefully the terms under which Palmer is admitted. His capital will appear on the books as $6,000.
Make the adjustment through a good-will account. Howe and Mason withdraw cash to effect their respective
adjustments.
IV
The business has been in operation as a partnership one year. At the conclusion of this period the trial
balance given below shows the condition of the accounts on the books of the firm.
Howe & Mason
Trial Balance, June 30, 1915
Cash $ 1,872.00
Accounts Receivable 22,945.00
Reserve for Bad Debts $ 384.00
Horses, Wagons, and Harness 3,100.00
Reserve for Depreciation,
Horses, Wagons, and Harness 120.00
Furniture and Fixtures 5,390.00
Merchandise Inventory June 30, 1914 7,060.00
Notes Receivable 12,456.00
Notes Receivable Discounted 4,780.00
Accounts Payable 24,220.00
Notes Payable 8,500.00
Thomas J. Howe, Loan 1,540.10
Thomas J. Howe, Capital 8,000.00
Thomas J. Howe, Drawing 2,440.00
Joseph Mason, Capital 4,000.00
Joseph Mason, Drawing 1,710.00
John H. Bartlett, Capital 6,000.00
Sales 158,335.00
Returned Sales and Allowances 3,890.00
Purchases 144,244.60
Freight Inward 3,518.50
Warehouse Labor and Supplies 1,002.00
Returned Purchases and Allowances 2,714.00
Salesmen’s Salaries 2,215.00
Advertising 872.00
Freight and Cartage Outward 316.00
Office Salaries 2,619.00
to John H. Bartlett, who settles directly with Palmer for $10,000. Howe and Mason agree to admit Bartlett as
a partner in place of Palmer and new articles of partnership are signed by the members.
Give journal entries to show the effect on the partnership books.
Instructions
Note carefully the terms under which Palmer is admitted. His capital will appear on the books as $6,000.
Make the adjustment through a good-will account. Howe and Mason withdraw cash to effect their respective
adjustments.
IV
The business has been in operation as a partnership one year. At the conclusion of this period the trial
balance given below shows the condition of the accounts on the books of the firm.
Howe & Mason
Trial Balance, June 30, 1915
Cash $ 1,872.00
Accounts Receivable 22,945.00
Reserve for Bad Debts $ 384.00
Horses, Wagons, and Harness 3,100.00
Reserve for Depreciation,
Horses, Wagons, and Harness 120.00
Furniture and Fixtures 5,390.00
Merchandise Inventory June 30, 1914 7,060.00
Notes Receivable 12,456.00
Notes Receivable Discounted 4,780.00
Accounts Payable 24,220.00
Notes Payable 8,500.00
Thomas J. Howe, Loan 1,540.10
Thomas J. Howe, Capital 8,000.00
Thomas J. Howe, Drawing 2,440.00
Joseph Mason, Capital 4,000.00
Joseph Mason, Drawing 1,710.00
John H. Bartlett, Capital 6,000.00
Sales 158,335.00
Returned Sales and Allowances 3,890.00
Purchases 144,244.60
Freight Inward 3,518.50
Warehouse Labor and Supplies 1,002.00
Returned Purchases and Allowances 2,714.00
Salesmen’s Salaries 2,215.00
Advertising 872.00
Freight and Cartage Outward 316.00
Office Salaries 2,619.00
Page 563
Postage 82.00
Stationery and Printing 116.00
Legal Expenses 85.00
Office Heat and Light 212.00
Interest Earned 117.00
Interest on Bank Balances 14.00
Cash Discount on Sales 2,306.00
Cash Discount on Purchases 3,041.00
Interest Paid 143.00
Telephone and Telegrams 17.00
Insurance 500.00
Rent 2,200.00
Miscellaneous Expense 74.00
Commissions on Sales 380.00
$221,765.10 $221,765.10
Additional information is as follows:
Merchandise inventory, June 30, 1915, $13,260; stationery and printed matter on hand $35; unused
postage stamps $17.00. One-fourth of advertising is to be applied to the next year. Warehouse labor of $130,
due but unpaid, has not been recorded on the books. Interest accrued but not recorded: on notes receivable
$71, on notes payable $47, on bank balances $8. Rent prepaid $200.
You find that no record has been made on the books for $750 worth of merchandise received from Marsh
& Co., but that these goods have been included in the current inventory. Four-fifths of the insurance has
expired. Interest is to be accrued on Howe’s Loan account at 6%. Through error $100 of commissions on sales
has been charged to Salesmen’s Salaries account.
It has been decided to provide for depreciation and reserves as follows: 10% reserve on reducing balances
for horses, wagons, and harness; a reserve of ½% on sales for uncollectible accounts; by writing off 10% of
the book value of furniture and fixtures.
Profits and losses are to be shared according to the original investments of the partners.
Give due consideration to the foregoing and construct:
(a) The working sheet as of June 30, 1915.
(b) Balance sheet.
(c) Profit and loss statement containing percentages on sales.
(d) Adjusting and closing journal entries.
Instructions
Note the bases for the various depreciation reserves and that depreciation on furniture and fixtures is to be
written off the books, i.e., no reserve is to be set up.
V
July 1, 1915, the capital of the firm of Howe & Mason is increased to $30,000 and Wm. R. Gray is
admitted as a partner.
Among other things, the articles of copartnership provide that:
Business is to be conducted under the firm name of Howe, Mason & Co.
Stationery and Printing 116.00
Legal Expenses 85.00
Office Heat and Light 212.00
Interest Earned 117.00
Interest on Bank Balances 14.00
Cash Discount on Sales 2,306.00
Cash Discount on Purchases 3,041.00
Interest Paid 143.00
Telephone and Telegrams 17.00
Insurance 500.00
Rent 2,200.00
Miscellaneous Expense 74.00
Commissions on Sales 380.00
$221,765.10 $221,765.10
Additional information is as follows:
Merchandise inventory, June 30, 1915, $13,260; stationery and printed matter on hand $35; unused
postage stamps $17.00. One-fourth of advertising is to be applied to the next year. Warehouse labor of $130,
due but unpaid, has not been recorded on the books. Interest accrued but not recorded: on notes receivable
$71, on notes payable $47, on bank balances $8. Rent prepaid $200.
You find that no record has been made on the books for $750 worth of merchandise received from Marsh
& Co., but that these goods have been included in the current inventory. Four-fifths of the insurance has
expired. Interest is to be accrued on Howe’s Loan account at 6%. Through error $100 of commissions on sales
has been charged to Salesmen’s Salaries account.
It has been decided to provide for depreciation and reserves as follows: 10% reserve on reducing balances
for horses, wagons, and harness; a reserve of ½% on sales for uncollectible accounts; by writing off 10% of
the book value of furniture and fixtures.
Profits and losses are to be shared according to the original investments of the partners.
Give due consideration to the foregoing and construct:
(a) The working sheet as of June 30, 1915.
(b) Balance sheet.
(c) Profit and loss statement containing percentages on sales.
(d) Adjusting and closing journal entries.
Instructions
Note the bases for the various depreciation reserves and that depreciation on furniture and fixtures is to be
written off the books, i.e., no reserve is to be set up.
V
July 1, 1915, the capital of the firm of Howe & Mason is increased to $30,000 and Wm. R. Gray is
admitted as a partner.
Among other things, the articles of copartnership provide that:
Business is to be conducted under the firm name of Howe, Mason & Co.
Page 564
The representation of the partners in the capital of the firm shall be Howe, 8/20; Mason, 5/20; Bartlett,
3/20; Gray, 4/20.
Profits and losses shall be shared according to the capital representation of the partners as at the time of
formation of this partnership. In the event of the death of a partner an accounting shall be made at the close of
the fiscal year in which the death occurs and the value of the deceased partner’s estate determined as of the
date of his death by prorating profits on a monthly basis.
Gray is to pay for one-fifth interest in the capital of the firm by giving the firm his note for $2,000 and
$4,000 in cash. The difference in capital is to be supplied by good-will, which is to be distributed among the
three partners constituting the firm of Howe & Mason on the basis of their original capital representations in
that firm, i.e., in the ratio of $8,000, $4,000, $6,000 respectively.
After adjustments have been made, the respective partners’ drawing accounts shall be settled in cash.
(a) Write the necessary journal entries to admit Gray as a partner and to adjust
the several partners’ capital and drawing accounts.
(b) Set up the capital and drawing accounts of all the partners.
Instructions
The partnership agreement is to be interpreted to mean that, after distribution of the good-will, Howe,
Mason, and Bartlett are to contribute or withdraw cash necessary to give them the respective capital shares
agreed upon for the new firm.
VI
Wm. R. Gray died November 30, 1917, two years and five months after he became a partner in the firm of
Howe, Mason & Co. As provided in the articles of partnership, the business continued until the end of the
fiscal year, June 30, 1918, at which date an accounting was made on the basis of the following trial balance
and subjoined data.
Howe, Mason & Co.
Trial Balance, June 30, 1918
Land $ 10,000.00
Buildings 40,000.00
Reserve for Depreciation, Buildings $ 2,000.00
Delivery Equipment 6,000.00
Reserve for Depreciation, Equipment 1,200.00
Furniture and Fixtures 5,990.00
Good-Will 6,000.00
Cash 2,010.00
Accounts Receivable 36,000.00
Reserve for Bad Debts 1,460.00
Notes Receivable 7,500.00
Notes Receivable Discounted 4,500.00
Merchandise Inventory—Bags, June 30, 1917 6,770.00
Merchandise Inventory—Trunks, June 30, 1917 12,410.00
Mortgage Payable 25,000.00
Accounts Payable 26,000.00
3/20; Gray, 4/20.
Profits and losses shall be shared according to the capital representation of the partners as at the time of
formation of this partnership. In the event of the death of a partner an accounting shall be made at the close of
the fiscal year in which the death occurs and the value of the deceased partner’s estate determined as of the
date of his death by prorating profits on a monthly basis.
Gray is to pay for one-fifth interest in the capital of the firm by giving the firm his note for $2,000 and
$4,000 in cash. The difference in capital is to be supplied by good-will, which is to be distributed among the
three partners constituting the firm of Howe & Mason on the basis of their original capital representations in
that firm, i.e., in the ratio of $8,000, $4,000, $6,000 respectively.
After adjustments have been made, the respective partners’ drawing accounts shall be settled in cash.
(a) Write the necessary journal entries to admit Gray as a partner and to adjust
the several partners’ capital and drawing accounts.
(b) Set up the capital and drawing accounts of all the partners.
Instructions
The partnership agreement is to be interpreted to mean that, after distribution of the good-will, Howe,
Mason, and Bartlett are to contribute or withdraw cash necessary to give them the respective capital shares
agreed upon for the new firm.
VI
Wm. R. Gray died November 30, 1917, two years and five months after he became a partner in the firm of
Howe, Mason & Co. As provided in the articles of partnership, the business continued until the end of the
fiscal year, June 30, 1918, at which date an accounting was made on the basis of the following trial balance
and subjoined data.
Howe, Mason & Co.
Trial Balance, June 30, 1918
Land $ 10,000.00
Buildings 40,000.00
Reserve for Depreciation, Buildings $ 2,000.00
Delivery Equipment 6,000.00
Reserve for Depreciation, Equipment 1,200.00
Furniture and Fixtures 5,990.00
Good-Will 6,000.00
Cash 2,010.00
Accounts Receivable 36,000.00
Reserve for Bad Debts 1,460.00
Notes Receivable 7,500.00
Notes Receivable Discounted 4,500.00
Merchandise Inventory—Bags, June 30, 1917 6,770.00
Merchandise Inventory—Trunks, June 30, 1917 12,410.00
Mortgage Payable 25,000.00
Accounts Payable 26,000.00
Page 565
Notes Payable 14,400.00
Thomas J. Howe, Loan 2,000.00
Thomas J. Howe, Capital 12,000.00
Thomas J. Howe, Drawing 1,210.00
Joseph Mason, Capital 7,500.00
John H. Bartlett, Capital 4,500.00
Wm. R. Gray, Capital 6,000.00
Wm. R. Gray, Drawing 1,100.00
Sales—Bags 71,432.00
Returned Sales and Allowances—Bags 3,690.00
Sales—Trunks 222,386.00
Returned Sales and Allowances—Trunks 1,508.00
Purchases—Bags 59,315.00
Returned Purchases and Allowances—Bags 4,230.00
Purchases—Trunks 184,824.00
Returned Purchases and Allowances—Trunks 2,716.00
Freight Inward 7,020.00
Warehouse Labor and Supplies 1,875.00
Salesmen’s Salaries 4,303.00
Salesmen’s Traveling Expenses 2,809.00
Advertising 2,146.00
Freight and Cartage Outward 1,154.00
Commissions on Sales 981.00
Office Salaries 2,274.00
Miscellaneous Office Supplies 170.00
Legal Expense 200.00
Postage 127.00
Telephones and Telegrams 93.00
Interest Earned on Notes Receivable 385.00
Cash Discounts on Purchases 3,547.00
Rent Collected 1,500.00
Taxes 1,312.00
Insurance 680.00
Interest Paid 472.00
Cash Discounts on Sales 2,789.00
Collection and Exchange 24.00
$412,756.00 $412,756.00
The books have been closed at the end of each fiscal year.
Merchandise inventories, June 30, 1918, bags $2,431, trunks $4,380. A reserve of ½% of the sales is to be
provided for bad debts. The furniture and fixtures are to be written down 10% of their book value.
Thomas J. Howe, Loan 2,000.00
Thomas J. Howe, Capital 12,000.00
Thomas J. Howe, Drawing 1,210.00
Joseph Mason, Capital 7,500.00
John H. Bartlett, Capital 4,500.00
Wm. R. Gray, Capital 6,000.00
Wm. R. Gray, Drawing 1,100.00
Sales—Bags 71,432.00
Returned Sales and Allowances—Bags 3,690.00
Sales—Trunks 222,386.00
Returned Sales and Allowances—Trunks 1,508.00
Purchases—Bags 59,315.00
Returned Purchases and Allowances—Bags 4,230.00
Purchases—Trunks 184,824.00
Returned Purchases and Allowances—Trunks 2,716.00
Freight Inward 7,020.00
Warehouse Labor and Supplies 1,875.00
Salesmen’s Salaries 4,303.00
Salesmen’s Traveling Expenses 2,809.00
Advertising 2,146.00
Freight and Cartage Outward 1,154.00
Commissions on Sales 981.00
Office Salaries 2,274.00
Miscellaneous Office Supplies 170.00
Legal Expense 200.00
Postage 127.00
Telephones and Telegrams 93.00
Interest Earned on Notes Receivable 385.00
Cash Discounts on Purchases 3,547.00
Rent Collected 1,500.00
Taxes 1,312.00
Insurance 680.00
Interest Paid 472.00
Cash Discounts on Sales 2,789.00
Collection and Exchange 24.00
$412,756.00 $412,756.00
The books have been closed at the end of each fiscal year.
Merchandise inventories, June 30, 1918, bags $2,431, trunks $4,380. A reserve of ½% of the sales is to be
provided for bad debts. The furniture and fixtures are to be written down 10% of their book value.
Page 566
The old account of Horses, Wagons, and Harness was closed and Delivery Equipment opened when the
horses were sold and an automobile service installed. It is deemed advisable to increase the reserve by 10% of
the declining value.
An additional 5% of the original cost of the buildings will be set aside as a reserve for depreciation.
Accruals are as follows: taxes $370; interest on mortgage 9 months at 5%; interest on notes receivable
$80; interest on notes payable $520; interest on bank balances $61.20; office salaries $150; interest on Howe
loan 6% for one year.
Advances made to salesmen on salaries $400; tenants paid $300 in advance rent; unused postage $32;
miscellaneous office supplies on hand $30; one-fourth of the insurance remains in force; advertising deferred
$600. Distribute in-freight and warehouse labor on the basis of gross purchases.
Profits and losses are to be shared according to the original investments, as stated in the articles of
partnership.
One clause in the partnership agreement entered into July 1, 1915, read as follows:
“In the event of dissolution, good-will is to be increased at the rate of 24% per year of the original value.”
Take this into account now as effective for 2 years and 5 months.
As of June 30, 1918:
(a) Prepare working sheet.
(b) Construct balance sheet.
(c) Construct income statement.
(d) Write the closing journal entries.
(e) The three remaining partners, as a firm, take over the interest of Gray’s
estate, paying therefore cash $1,000 and three equal notes with interest at
6%, maturing in one, two, and three years, for the balance.
(f) Write entries which will adjust the partnership interest represented by
Gray’s estate and show settlement of that interest.
VII
The Ironclad Trunk Corporation was organized and incorporated November 1, 1912, for the purpose of
manufacturing trunks, bags, and brushes of all kinds and dealing in traveling requisites of every description.
The authorized capital of $100,000 consists of 750 shares of common stock having a par value of $100 per
share, and 250 shares of preferred stock of the same par value.
The incorporators subscribed for at par and paid for the common stock as indicated below:
Arthur Butler, 250 shares in cash.
A. J. Lindsey, 150 shares by transferring the following assets and liabilities: cash $3,000; accounts
receivable $7,000; notes payable $3,000; notes receivable $2,000; stock of raw material $9,000; accounts
payable $5,000; furniture and fixtures $2,000.
Edward Harrison, 100 shares by giving bill of sale of machinery appraised at $6,000; the balance to be
paid in one year.
Charles E. Wells, 50 shares by his personal note for $5,000 with interest at 6%, due in one year.
In connection with the organization of the corporation the following items were paid in cash: corporation
tax $50; filing fees $20; recording fees $12; legal expenses $500.
(a) Write journal entries to record this information on the books of the
corporation.
horses were sold and an automobile service installed. It is deemed advisable to increase the reserve by 10% of
the declining value.
An additional 5% of the original cost of the buildings will be set aside as a reserve for depreciation.
Accruals are as follows: taxes $370; interest on mortgage 9 months at 5%; interest on notes receivable
$80; interest on notes payable $520; interest on bank balances $61.20; office salaries $150; interest on Howe
loan 6% for one year.
Advances made to salesmen on salaries $400; tenants paid $300 in advance rent; unused postage $32;
miscellaneous office supplies on hand $30; one-fourth of the insurance remains in force; advertising deferred
$600. Distribute in-freight and warehouse labor on the basis of gross purchases.
Profits and losses are to be shared according to the original investments, as stated in the articles of
partnership.
One clause in the partnership agreement entered into July 1, 1915, read as follows:
“In the event of dissolution, good-will is to be increased at the rate of 24% per year of the original value.”
Take this into account now as effective for 2 years and 5 months.
As of June 30, 1918:
(a) Prepare working sheet.
(b) Construct balance sheet.
(c) Construct income statement.
(d) Write the closing journal entries.
(e) The three remaining partners, as a firm, take over the interest of Gray’s
estate, paying therefore cash $1,000 and three equal notes with interest at
6%, maturing in one, two, and three years, for the balance.
(f) Write entries which will adjust the partnership interest represented by
Gray’s estate and show settlement of that interest.
VII
The Ironclad Trunk Corporation was organized and incorporated November 1, 1912, for the purpose of
manufacturing trunks, bags, and brushes of all kinds and dealing in traveling requisites of every description.
The authorized capital of $100,000 consists of 750 shares of common stock having a par value of $100 per
share, and 250 shares of preferred stock of the same par value.
The incorporators subscribed for at par and paid for the common stock as indicated below:
Arthur Butler, 250 shares in cash.
A. J. Lindsey, 150 shares by transferring the following assets and liabilities: cash $3,000; accounts
receivable $7,000; notes payable $3,000; notes receivable $2,000; stock of raw material $9,000; accounts
payable $5,000; furniture and fixtures $2,000.
Edward Harrison, 100 shares by giving bill of sale of machinery appraised at $6,000; the balance to be
paid in one year.
Charles E. Wells, 50 shares by his personal note for $5,000 with interest at 6%, due in one year.
In connection with the organization of the corporation the following items were paid in cash: corporation
tax $50; filing fees $20; recording fees $12; legal expenses $500.
(a) Write journal entries to record this information on the books of the
corporation.
Page 567
(b) Prepare a balance sheet showing the condition of the corporation at this
date.
Instructions
Refer to trial balance of VIII to see the method pursued in making the opening entries for the corporation.
VIII
The following trial balance was taken from the books of the Ironclad Trunk Corporation at the close of its
first year. From it and the additional notations appended thereto you are asked to furnish:
(a) Working sheet.
(b) Balance sheet.
(c) Income statement.
(d) Closing journal entries.
Ironclad Trunk Corporation
Trial Balance, October 31, 1913
Fifth National Bank $ 7,940.00
Imprest Cash 200.00
Land 10,000.00
Buildings 30,000.00
Machinery and Tools 25,000.00
Materials and Supplies, October 31, 1912 9,000.00
Accounts Receivable 12,000.00
Notes Receivable 10,000.00
Notes Receivable Discounted $ 4,000.00
Advertising Unexpired 1,000.00
Insurance Prepaid 200.00
Purchases—Material 108,000.00
Notes Payable 18,000.00
Taxes Accrued 200.00
Wages Accrued 3,400.00
Returned Sales 2,200.00
Returned Purchases 2,800.00
Factory Supplies 2,600.00
Labor—Direct 70,000.00
Superintendence 4,000.00
Heat, Light, and Power 12,000.00
Miscellaneous Wages—Factory 3,620.00
Factory Expense 400.00
Accounts Payable 26,000.00
Reserve for Depreciation, Buildings 3,000.00
Interest Accrued on Notes Payable 700.00
Sales 214,706.00
date.
Instructions
Refer to trial balance of VIII to see the method pursued in making the opening entries for the corporation.
VIII
The following trial balance was taken from the books of the Ironclad Trunk Corporation at the close of its
first year. From it and the additional notations appended thereto you are asked to furnish:
(a) Working sheet.
(b) Balance sheet.
(c) Income statement.
(d) Closing journal entries.
Ironclad Trunk Corporation
Trial Balance, October 31, 1913
Fifth National Bank $ 7,940.00
Imprest Cash 200.00
Land 10,000.00
Buildings 30,000.00
Machinery and Tools 25,000.00
Materials and Supplies, October 31, 1912 9,000.00
Accounts Receivable 12,000.00
Notes Receivable 10,000.00
Notes Receivable Discounted $ 4,000.00
Advertising Unexpired 1,000.00
Insurance Prepaid 200.00
Purchases—Material 108,000.00
Notes Payable 18,000.00
Taxes Accrued 200.00
Wages Accrued 3,400.00
Returned Sales 2,200.00
Returned Purchases 2,800.00
Factory Supplies 2,600.00
Labor—Direct 70,000.00
Superintendence 4,000.00
Heat, Light, and Power 12,000.00
Miscellaneous Wages—Factory 3,620.00
Factory Expense 400.00
Accounts Payable 26,000.00
Reserve for Depreciation, Buildings 3,000.00
Interest Accrued on Notes Payable 700.00
Sales 214,706.00
Page 568
Interest on Bank Balances 46.00
Freight Inward 2,770.00
General Expense 1,920.00
Taxes 350.00
Rent of Building 1,000.00
Reserve for Depreciation, Machinery 2,500.00
Salesmen’s Salaries 4,200.00
Repairs to Machinery 630.00
Reserve for Bad Debts 1,000.00
Cash Discount on Purchases 3,110.00
Interest Earned 418.00
Commissions—Salesmen 3,600.00
Office Salaries 2,800.00
Insurance 150.00
Freight Outward 1,100.00
Bad Debts 1,000.00
Furniture and Fixtures 3,700.00
Authorized Capital Stock—Preferred 25,000.00
Authorized Capital Stock—Common 75,000.00
Unissued Stock—Preferred 12,000.00
Unissued Stock—Common 20,000.00
Subscriptions 4,000.00
Notes Received—Stock Subscription 6,000.00
Bonding Employees—Office 100.00
Cash Discount on Sales 2,300.00
Depreciation 5,500.00
Advertising 600.00
$380,880.00 $380,880.00
You are presented with properly certified statements showing the present inventory of materials and
supplies to be $16,300; goods in process $1,400; finished goods $9,800, and factory supplies in storeroom
$700. It has been estimated that $200 of the freight inward is applicable to the present inventory of materials
and supplies. Salesmen have been overpaid $600 on their salary accounts. Items aggregating $400 which have
been charged to Expense are found to be on hand. In the customers ledger you find accounts having credit
balances amounting to $1,500, and uncollectible accounts to the amount of $710. You decide to write down
furniture and fixtures 10%.
Instructions
It will be noted that the trial balance presented indicates that the books have been partially adjusted. The
uncollectible accounts of $710 were taken into consideration when the estimate for reserve for doubtful
accounts was made. Charge them against the reserve.
IX
After Edward S. White, the inventor of a process for constructing a superior fiber for trunk-making,
demonstrated the practicability of his process, the Ironclad Trunk Corporation purchased all his rights in
Freight Inward 2,770.00
General Expense 1,920.00
Taxes 350.00
Rent of Building 1,000.00
Reserve for Depreciation, Machinery 2,500.00
Salesmen’s Salaries 4,200.00
Repairs to Machinery 630.00
Reserve for Bad Debts 1,000.00
Cash Discount on Purchases 3,110.00
Interest Earned 418.00
Commissions—Salesmen 3,600.00
Office Salaries 2,800.00
Insurance 150.00
Freight Outward 1,100.00
Bad Debts 1,000.00
Furniture and Fixtures 3,700.00
Authorized Capital Stock—Preferred 25,000.00
Authorized Capital Stock—Common 75,000.00
Unissued Stock—Preferred 12,000.00
Unissued Stock—Common 20,000.00
Subscriptions 4,000.00
Notes Received—Stock Subscription 6,000.00
Bonding Employees—Office 100.00
Cash Discount on Sales 2,300.00
Depreciation 5,500.00
Advertising 600.00
$380,880.00 $380,880.00
You are presented with properly certified statements showing the present inventory of materials and
supplies to be $16,300; goods in process $1,400; finished goods $9,800, and factory supplies in storeroom
$700. It has been estimated that $200 of the freight inward is applicable to the present inventory of materials
and supplies. Salesmen have been overpaid $600 on their salary accounts. Items aggregating $400 which have
been charged to Expense are found to be on hand. In the customers ledger you find accounts having credit
balances amounting to $1,500, and uncollectible accounts to the amount of $710. You decide to write down
furniture and fixtures 10%.
Instructions
It will be noted that the trial balance presented indicates that the books have been partially adjusted. The
uncollectible accounts of $710 were taken into consideration when the estimate for reserve for doubtful
accounts was made. Charge them against the reserve.
IX
After Edward S. White, the inventor of a process for constructing a superior fiber for trunk-making,
demonstrated the practicability of his process, the Ironclad Trunk Corporation purchased all his rights in
Page 569
patents granted by United States, Canada, Mexico, and Great Britain. The sale went into effect January 1,
1914. The consideration of $100,000 was made payable $60,000 in cash, $20,000 in bonds at par, and $20,000
in two-year interest bearing notes of the company.
To provide for payment of the patent, the corporation, after duly complying with all legal requirements,
issued $100,000 in 20-year 6% sinking fund bonds, under date of December 1, 1913, interest payable June 1
and December 1. During the month $70,000 of the bonds were sold for cash on a 7% basis, and the remainder
at the same price during the following month.
The trust agreement provided that a sinking fund should be established by a charge against profits every
interest period, of an amount sufficient on a 4% compound interest basis—interest compounded semiannually
—to retire the bonds at maturity. The fund was placed in a trust company for accumulation.
(a) Give journal entries to effect the foregoing on the corporation’s books.
(b) Prepare a statement setting forth the condition of the sinking fund at each
interest date during the last five years previous to maturity of the bonds.
Instructions
It will be noted that the problem requires the calculation of the selling price of the bonds, i.e., their
valuation on the given basis. This may be found from bond tables but preferably by the formula of Chapter
XV. The sinking fund may also be found from tables or the formula of Chapter XXV.
(1.035⁴⁰ = 3.95925972; 1.02³¹ = 1.84758882; and 1.02⁴⁰ =2.20803966)
X
(a) Prepare an amortization schedule covering the first five years life of the
bonds.
(b) Write the journal entries for:
1. The first sinking fund instalment.
2. The first bond interest payment.
3. The liberation of the sinking fund at maturity.
4. The retirement of the bonds at maturity.
Instructions
Averaging the bonds sold at par with those sold on a 7% basis places the whole issue approximately on a
6.787% basis. Use that as the effective rate for the amortization schedule.
XI
Several customers of the Ironclad Trunk Corporation protested vigorously against paying their accounts
when we sent them statements requesting payment. They denied that they owed the amounts shown on our
books and produced receipts and canceled checks to prove their contentions. In many cases we found that the
receipts and checks were dated several weeks before the credits appeared on the books and in some cases no
credits had been entered.
The manager immediately requested Leroy Swift, a certified public accountant, to make a thorough audit.
Among other things, the accountant’s report disclosed the following:
The petty cash sales had been entered in the cash book at smaller amounts than the records showed. The
discrepancy between cash book and sales records was: trunks $1,040, bags $360.
Freight bills had been raised $300. The Railroad Company had been overpaid this amount but refunded it
on the request of our bookkeeper, S. O. Bright, who cashed the checks and retained the money.
1914. The consideration of $100,000 was made payable $60,000 in cash, $20,000 in bonds at par, and $20,000
in two-year interest bearing notes of the company.
To provide for payment of the patent, the corporation, after duly complying with all legal requirements,
issued $100,000 in 20-year 6% sinking fund bonds, under date of December 1, 1913, interest payable June 1
and December 1. During the month $70,000 of the bonds were sold for cash on a 7% basis, and the remainder
at the same price during the following month.
The trust agreement provided that a sinking fund should be established by a charge against profits every
interest period, of an amount sufficient on a 4% compound interest basis—interest compounded semiannually
—to retire the bonds at maturity. The fund was placed in a trust company for accumulation.
(a) Give journal entries to effect the foregoing on the corporation’s books.
(b) Prepare a statement setting forth the condition of the sinking fund at each
interest date during the last five years previous to maturity of the bonds.
Instructions
It will be noted that the problem requires the calculation of the selling price of the bonds, i.e., their
valuation on the given basis. This may be found from bond tables but preferably by the formula of Chapter
XV. The sinking fund may also be found from tables or the formula of Chapter XXV.
(1.035⁴⁰ = 3.95925972; 1.02³¹ = 1.84758882; and 1.02⁴⁰ =2.20803966)
X
(a) Prepare an amortization schedule covering the first five years life of the
bonds.
(b) Write the journal entries for:
1. The first sinking fund instalment.
2. The first bond interest payment.
3. The liberation of the sinking fund at maturity.
4. The retirement of the bonds at maturity.
Instructions
Averaging the bonds sold at par with those sold on a 7% basis places the whole issue approximately on a
6.787% basis. Use that as the effective rate for the amortization schedule.
XI
Several customers of the Ironclad Trunk Corporation protested vigorously against paying their accounts
when we sent them statements requesting payment. They denied that they owed the amounts shown on our
books and produced receipts and canceled checks to prove their contentions. In many cases we found that the
receipts and checks were dated several weeks before the credits appeared on the books and in some cases no
credits had been entered.
The manager immediately requested Leroy Swift, a certified public accountant, to make a thorough audit.
Among other things, the accountant’s report disclosed the following:
The petty cash sales had been entered in the cash book at smaller amounts than the records showed. The
discrepancy between cash book and sales records was: trunks $1,040, bags $360.
Freight bills had been raised $300. The Railroad Company had been overpaid this amount but refunded it
on the request of our bookkeeper, S. O. Bright, who cashed the checks and retained the money.
Page 570
The Customers column and Net Cash column in the cash book were short-footed $8,430. To make the
balance in the Customers’ controlling account agree with the total of the individual accounts, the sales book
was short-footed the same amount—bags $2,790, and trunks $5,640.
Credits to customers’ accounts in the amount of $4,740 were missing. Not a trace of a record for this
amount or any part thereof could be found in any book.
Leather novelties amounting to $1,560 had been sold from the National Novelty Co.’s consignment but no
remittance had been made. The only record of the transactions were duplicate bills of the sales made. The
money received for these sales had not been deposited and was appropriated by the embezzler.
Nine productive labor pay-rolls had been over-footed $100 each.
A $1,000 note receivable had been transferred by forged indorsement as $950 part payment on a $1,300
automobile bought by the embezzler for his personal use. The Self-Starter Auto Co. were the holders of the
note.
Checks for $1,800 were drawn to the order of fictitious creditors. The indorsements were forged by Bright
and the checks duly passed through the bank.
The relatives and friends of Bright agreed to repay the company the greater part or all of the losses due to
his embezzlement. In order to provide funds for immediate needs the present stockholders donate 20% of their
present holdings of stock, both common and preferred.
Prepare journal entries to give effect to the foregoing as of December 13, 1913.
XII
The City of Oswego donated to the Ironclad Trunk Corporation a building site having a market value of
$40,000, on condition that the company build a factory worth at least $100,000 and operate at least five years,
employing not less than 100 factory operators.
To take advantage of this offer the corporation obtained permission to issue $100,000 of 7% cumulative
preferred stock having a par value of $100 per share, dividends payable semiannually. A condition of the issue
made the stock redeemable by lot at the call of the company, the shareholder having the option of receiving
110 in cash or 120 in common stock. A redemption fund is to be created out of profits at the yearly rate of
10% of the issue.
The entire issue was sold for cash May 1, 1914 at 100½. On the same day 101 Blue Valley R. R. 4%
bonds, par $1,000, were purchased at 98 with accumulated interest. The bonds are payable July 1, 1924;
interest payable January 1 and July 1. The entire bond investment was set aside as a building fund.
Record as of July 31, 1914, the transactions that took place in connection with the erection of the building
and the removal from the old to the new plant.
The corporation paid taxes of $400 on the building site and partially completed building. Of this amount
$100 applied to the uncompleted building. During the period the manager devoted two-thirds of his time to
superintending building operations and one-third to supervising installation of machinery and equipment. His
salary amounted to $3,000.
The old land and building and part of the machinery were sold to the American Harness Company for
$49,000, payable $11,000 in cash and the balance covered by mortgage for five years at 6%. The amount of
the sale was distributed—land $12,000, building $29,000, machinery and tools $8,000. At the date of the sale
the accounts appeared on the books as follows: land $10,000; buildings $31,000, with a reserve of $3,000 and
nine months’ depreciation on a 5% basis still to be provided for; machinery and tools $25,000 with a reserve
for depreciation of $2,500. The machinery and tools sold cost $12,000, on which depreciation has been
booked for one year at 10% on original cost. Take into consideration an additional period of nine months.
The remaining machinery, having been designed especially for our use, could not be sold for more than
one-half its cost; accordingly, the directors had the machines moved to the new plant. The old machines
appear on the books at a cost of $13,000, with reserve recorded for one year at 10% and nine months’
balance in the Customers’ controlling account agree with the total of the individual accounts, the sales book
was short-footed the same amount—bags $2,790, and trunks $5,640.
Credits to customers’ accounts in the amount of $4,740 were missing. Not a trace of a record for this
amount or any part thereof could be found in any book.
Leather novelties amounting to $1,560 had been sold from the National Novelty Co.’s consignment but no
remittance had been made. The only record of the transactions were duplicate bills of the sales made. The
money received for these sales had not been deposited and was appropriated by the embezzler.
Nine productive labor pay-rolls had been over-footed $100 each.
A $1,000 note receivable had been transferred by forged indorsement as $950 part payment on a $1,300
automobile bought by the embezzler for his personal use. The Self-Starter Auto Co. were the holders of the
note.
Checks for $1,800 were drawn to the order of fictitious creditors. The indorsements were forged by Bright
and the checks duly passed through the bank.
The relatives and friends of Bright agreed to repay the company the greater part or all of the losses due to
his embezzlement. In order to provide funds for immediate needs the present stockholders donate 20% of their
present holdings of stock, both common and preferred.
Prepare journal entries to give effect to the foregoing as of December 13, 1913.
XII
The City of Oswego donated to the Ironclad Trunk Corporation a building site having a market value of
$40,000, on condition that the company build a factory worth at least $100,000 and operate at least five years,
employing not less than 100 factory operators.
To take advantage of this offer the corporation obtained permission to issue $100,000 of 7% cumulative
preferred stock having a par value of $100 per share, dividends payable semiannually. A condition of the issue
made the stock redeemable by lot at the call of the company, the shareholder having the option of receiving
110 in cash or 120 in common stock. A redemption fund is to be created out of profits at the yearly rate of
10% of the issue.
The entire issue was sold for cash May 1, 1914 at 100½. On the same day 101 Blue Valley R. R. 4%
bonds, par $1,000, were purchased at 98 with accumulated interest. The bonds are payable July 1, 1924;
interest payable January 1 and July 1. The entire bond investment was set aside as a building fund.
Record as of July 31, 1914, the transactions that took place in connection with the erection of the building
and the removal from the old to the new plant.
The corporation paid taxes of $400 on the building site and partially completed building. Of this amount
$100 applied to the uncompleted building. During the period the manager devoted two-thirds of his time to
superintending building operations and one-third to supervising installation of machinery and equipment. His
salary amounted to $3,000.
The old land and building and part of the machinery were sold to the American Harness Company for
$49,000, payable $11,000 in cash and the balance covered by mortgage for five years at 6%. The amount of
the sale was distributed—land $12,000, building $29,000, machinery and tools $8,000. At the date of the sale
the accounts appeared on the books as follows: land $10,000; buildings $31,000, with a reserve of $3,000 and
nine months’ depreciation on a 5% basis still to be provided for; machinery and tools $25,000 with a reserve
for depreciation of $2,500. The machinery and tools sold cost $12,000, on which depreciation has been
booked for one year at 10% on original cost. Take into consideration an additional period of nine months.
The remaining machinery, having been designed especially for our use, could not be sold for more than
one-half its cost; accordingly, the directors had the machines moved to the new plant. The old machines
appear on the books at a cost of $13,000, with reserve recorded for one year at 10% and nine months’
Page 571
depreciation still to be booked. Additional expenses of removing were as follows: dismantling $40; crating,
drayage and freight $170; labor for setting up machines $60; superintendent’s time for moving and installation
$150.
The manager, not being sure as to the amount at which to book the machinery, obtained an estimate to
duplicate this particular machinery and put it in running order for $9,000.
(a) Write the journal entries to place the above data on the company’s books.
(b) Explain briefly the theory underlying your treatment of the old machinery
transferred to the new plant.
Instructions
See Chapters V, XI, XVI, and XVII, where most of these matters are discussed.
XIII-XIV
The directors of the Ironclad Trunk Corporation, after receiving full authority from the stockholders, set
December 31 as the close of the fiscal year, thereby making the present fiscal period fourteen months instead
of one year.
From the following trial balance and supplementary data prepare:
(a) Condensed balance sheet, supported by schedules.
(b) Condensed income statement, supported by schedules.
Trial Balance, December 31, 1918
Land Donated $ 40,000.00
Buildings 129,000.00
Machinery 47,000.00
Tools 4,680.00
Delivery Equipment 5,900.00
Furniture and Fixtures 2,300.00
Patents 108,000.00
Loans to Employees 6,320.00
Dividend No. 6, Cumulative Preferred Stock
(Payable January 10, 1919) $ 1,400.00
Dividend No. 7, Preferred Stock
(Payable January 10, 1919) 1,500.00
Dividend No. 8, Common Stock
(Payable January 10, 1919) 3,000.00
Interest Accrued on Bonds Receivable 3,200.00
Freight Inward 4,334.82
Freight and Express Outward 2,613.07
Royal Leather Preferred Stock (100 shares) 7,480.00
Fire Loss 6,000.00
Strike Loss 4,200.00
Credit Department Expenses 2,950.40
Pamphlets, Price Lists, and Posters 973.00
drayage and freight $170; labor for setting up machines $60; superintendent’s time for moving and installation
$150.
The manager, not being sure as to the amount at which to book the machinery, obtained an estimate to
duplicate this particular machinery and put it in running order for $9,000.
(a) Write the journal entries to place the above data on the company’s books.
(b) Explain briefly the theory underlying your treatment of the old machinery
transferred to the new plant.
Instructions
See Chapters V, XI, XVI, and XVII, where most of these matters are discussed.
XIII-XIV
The directors of the Ironclad Trunk Corporation, after receiving full authority from the stockholders, set
December 31 as the close of the fiscal year, thereby making the present fiscal period fourteen months instead
of one year.
From the following trial balance and supplementary data prepare:
(a) Condensed balance sheet, supported by schedules.
(b) Condensed income statement, supported by schedules.
Trial Balance, December 31, 1918
Land Donated $ 40,000.00
Buildings 129,000.00
Machinery 47,000.00
Tools 4,680.00
Delivery Equipment 5,900.00
Furniture and Fixtures 2,300.00
Patents 108,000.00
Loans to Employees 6,320.00
Dividend No. 6, Cumulative Preferred Stock
(Payable January 10, 1919) $ 1,400.00
Dividend No. 7, Preferred Stock
(Payable January 10, 1919) 1,500.00
Dividend No. 8, Common Stock
(Payable January 10, 1919) 3,000.00
Interest Accrued on Bonds Receivable 3,200.00
Freight Inward 4,334.82
Freight and Express Outward 2,613.07
Royal Leather Preferred Stock (100 shares) 7,480.00
Fire Loss 6,000.00
Strike Loss 4,200.00
Credit Department Expenses 2,950.40
Pamphlets, Price Lists, and Posters 973.00
Page 572
Advertising Space Prepaid 260.00
Advertising 731.40
Directors’ Fees 200.00
Entertainment of Customers’ Agents 174.50
Charity 60.00
Workmen’s Compensation Insurance Premiums 640.00
Rent from Houses for Employees 2,390.00
Maintenance of Houses for Employees 318.30
Watchmen’s Wages 700.00
Bonuses Paid to Employees (Direct Labor) 1,980.10
Experimental Expense 2,300.00
Contingent Royalties Fund 2,140.00
Mercantile Agency Reports 80.00
Accounting Expense 500.00
Legal Expenses 300.00
Claims Against Transportation Companies 3,792.00
Bright—Special 14,500.00
Suspense 370.00
Delivery Expense 1,194.50
Due to Consignors 4,387.20
Imprest Cash 200.00
Raw Materials Inventory, October 31, 1917 21,304.00
Trade Customers 108,946.63
Finished Goods Inventory, October 31, 1917 22,100.00
Notes Receivable 18,000.00
Notes Receivable Discounted 3,460.00
Insurance Prepaid 200.00
Insurance 480.00
Raw Materials Purchases 240,000.00
Accrued Office Salaries 760.40
Accrued Taxes 1,220.00
Accrued Advertising 190.00
Sales, Trunks 416,775.00
Sales, Bags 93,518.80
Returned Sales, Trunks 1,750.00
Returned Sales, Bags 619.00
Returned Purchases, Raw Material 2,320.00
Returned Purchases, Bags 974.00
Factory Supplies 2,436.00
Labor, Direct 78,751.20
Labor, Indirect 3,497.00
Factory Superintendence 3,200.00
Advertising 731.40
Directors’ Fees 200.00
Entertainment of Customers’ Agents 174.50
Charity 60.00
Workmen’s Compensation Insurance Premiums 640.00
Rent from Houses for Employees 2,390.00
Maintenance of Houses for Employees 318.30
Watchmen’s Wages 700.00
Bonuses Paid to Employees (Direct Labor) 1,980.10
Experimental Expense 2,300.00
Contingent Royalties Fund 2,140.00
Mercantile Agency Reports 80.00
Accounting Expense 500.00
Legal Expenses 300.00
Claims Against Transportation Companies 3,792.00
Bright—Special 14,500.00
Suspense 370.00
Delivery Expense 1,194.50
Due to Consignors 4,387.20
Imprest Cash 200.00
Raw Materials Inventory, October 31, 1917 21,304.00
Trade Customers 108,946.63
Finished Goods Inventory, October 31, 1917 22,100.00
Notes Receivable 18,000.00
Notes Receivable Discounted 3,460.00
Insurance Prepaid 200.00
Insurance 480.00
Raw Materials Purchases 240,000.00
Accrued Office Salaries 760.40
Accrued Taxes 1,220.00
Accrued Advertising 190.00
Sales, Trunks 416,775.00
Sales, Bags 93,518.80
Returned Sales, Trunks 1,750.00
Returned Sales, Bags 619.00
Returned Purchases, Raw Material 2,320.00
Returned Purchases, Bags 974.00
Factory Supplies 2,436.00
Labor, Direct 78,751.20
Labor, Indirect 3,497.00
Factory Superintendence 3,200.00
Page 573
Heat, Light, and Power Service 7,147.10
Miscellaneous Factory Expense 283.14
Trade Creditors 40,309.00
Reserve for Depreciation, Buildings 13,810.00
Reserve for Depreciation, Machinery 18,411.00
Reserve for Depreciation, Delivery Equipment 2,300.00
Reserve for Depreciation, Furniture and Fixtures 750.00
Reserve for Expiration of Patents 21,000.00
Reserve for Sinking Fund—Bonds of 1933 18,128.08
Reserve for Contingent Royalties 2,140.00
Reserve for Supersession of Patents 20,000.00
Interest Earned 7,810.00
Interest Paid 11,200.00
Office Expense 1,873.38
Warehouse Labor on Raw Materials 1,143.26
Salesmen’s Salaries 4,500.00
Salesmen’s Commissions 12,305.40
Repairs to Machinery 1,748.80
Repairs to Buildings 3,755.50
Reserve for Doubtful Accounts 3,330.70
Discount on Purchases 3,751.30
Discount on Sales 6,400.00
Office Salaries 7,974.00
Provision for Doubtful Accounts 2,379.12
Capital Stock, Cumulative Preferred 100,000.00
Capital Stock, Preferred 50,000.00
Capital Stock, Common 200,000.00
Unissued Stock, Common 10,000.00
Treasury Stock, Common 40,000.00
Assessment for Street Improvements
(Donated Land) 2,000.00
Bonding Employees—Office 200.00
Surplus 41,394.49
Drawings and Patterns 4,606.00
Mortgage Receivable (due 1923) 38,000.00
Accrued Pay-Roll 957.75
Reserve for Land Donated 40,000.00
Bonds Payable 100,000.00
Employees’ Pension Fund 47,500.00
Reserve for Employees’ Pension Fund 47,500.00
Discount on Bonds Payable 7,332.33
Wrapping and Crating Supplies 1,418.90
Miscellaneous Factory Expense 283.14
Trade Creditors 40,309.00
Reserve for Depreciation, Buildings 13,810.00
Reserve for Depreciation, Machinery 18,411.00
Reserve for Depreciation, Delivery Equipment 2,300.00
Reserve for Depreciation, Furniture and Fixtures 750.00
Reserve for Expiration of Patents 21,000.00
Reserve for Sinking Fund—Bonds of 1933 18,128.08
Reserve for Contingent Royalties 2,140.00
Reserve for Supersession of Patents 20,000.00
Interest Earned 7,810.00
Interest Paid 11,200.00
Office Expense 1,873.38
Warehouse Labor on Raw Materials 1,143.26
Salesmen’s Salaries 4,500.00
Salesmen’s Commissions 12,305.40
Repairs to Machinery 1,748.80
Repairs to Buildings 3,755.50
Reserve for Doubtful Accounts 3,330.70
Discount on Purchases 3,751.30
Discount on Sales 6,400.00
Office Salaries 7,974.00
Provision for Doubtful Accounts 2,379.12
Capital Stock, Cumulative Preferred 100,000.00
Capital Stock, Preferred 50,000.00
Capital Stock, Common 200,000.00
Unissued Stock, Common 10,000.00
Treasury Stock, Common 40,000.00
Assessment for Street Improvements
(Donated Land) 2,000.00
Bonding Employees—Office 200.00
Surplus 41,394.49
Drawings and Patterns 4,606.00
Mortgage Receivable (due 1923) 38,000.00
Accrued Pay-Roll 957.75
Reserve for Land Donated 40,000.00
Bonds Payable 100,000.00
Employees’ Pension Fund 47,500.00
Reserve for Employees’ Pension Fund 47,500.00
Discount on Bonds Payable 7,332.33
Wrapping and Crating Supplies 1,418.90
Page 574
Ralston National Bank 17,841.53
Bond Sinking Fund 18,128.08
Redemption Fund—Cumulative Preferred Stock 40,000.00
Reserve for Redemption of Cumulative
Preferred Stock 40,000.00
Houses and Land for Employees 24,600.00
Purchases—Bags 91,360.00
Trunks in Process, October 31, 1917 4,984.20
Commissions Earned 564.80
Notes Payable 7,108.00
Taxes 1,520.00
Accrued Interest Receivable 250.00
$1,314,143.59 $1,314,143.59
A careful investigation disclosed the following:
Interim dividends had been paid May 15, 1918: No. 5, cumulative preferred stock, $1,400; No. 6,
preferred stock, $1,500; No. 7, common stock, $3,000.
The Royal Leather Co. stock now has a market value of $90 per share.
Items to be distributed:
Account Distribution
Buildings Expenses Selling ¼; Office ⅛; Factory ⅝.
Furniture & Fixtures Expense Selling ¼; Office ⅛; Factory ⅝.
Light, Heat, and Power. Selling $842.90; Office $392; Factory $5,912.20.
Freight Inward Materials ¾; Bags ¼.
Taxes Building and Equipment $1,300;
Employees’ Houses $220.
The Suspense account was credited for $370 received from a former customer in payment of an old
account which had been charged off as uncollectible some years ago.
In many cases notes payable have been issued with interest included in the face of the notes. Of this
interest $290 is applicable to the succeeding period.
Provision for contingent royalties was begun two years ago in anticipation of an unfavorable decision in
an action brought against us for infringement of patents. Recently the action was decided in our favor.
Legal expenses of $1,500 for prosecution of infringements of patents had been charged against profits at
the close of the previous year. Of the present legal expenses, $100 was paid for services in protecting patents.
Inventories as at December 31, 1918:
Wrapping and Crating Supplies Unused $ 387.50
Factory Supplies on Hand 718.50
Pamphlets, Price Lists, and Posters on Hand 450.00
Workmen’s Compensation Insurance Prepaid 160.00
Bags in Stock 12,542.00
Trunks in Stock 28,050.00
Raw Materials 8,000.00
Bond Sinking Fund 18,128.08
Redemption Fund—Cumulative Preferred Stock 40,000.00
Reserve for Redemption of Cumulative
Preferred Stock 40,000.00
Houses and Land for Employees 24,600.00
Purchases—Bags 91,360.00
Trunks in Process, October 31, 1917 4,984.20
Commissions Earned 564.80
Notes Payable 7,108.00
Taxes 1,520.00
Accrued Interest Receivable 250.00
$1,314,143.59 $1,314,143.59
A careful investigation disclosed the following:
Interim dividends had been paid May 15, 1918: No. 5, cumulative preferred stock, $1,400; No. 6,
preferred stock, $1,500; No. 7, common stock, $3,000.
The Royal Leather Co. stock now has a market value of $90 per share.
Items to be distributed:
Account Distribution
Buildings Expenses Selling ¼; Office ⅛; Factory ⅝.
Furniture & Fixtures Expense Selling ¼; Office ⅛; Factory ⅝.
Light, Heat, and Power. Selling $842.90; Office $392; Factory $5,912.20.
Freight Inward Materials ¾; Bags ¼.
Taxes Building and Equipment $1,300;
Employees’ Houses $220.
The Suspense account was credited for $370 received from a former customer in payment of an old
account which had been charged off as uncollectible some years ago.
In many cases notes payable have been issued with interest included in the face of the notes. Of this
interest $290 is applicable to the succeeding period.
Provision for contingent royalties was begun two years ago in anticipation of an unfavorable decision in
an action brought against us for infringement of patents. Recently the action was decided in our favor.
Legal expenses of $1,500 for prosecution of infringements of patents had been charged against profits at
the close of the previous year. Of the present legal expenses, $100 was paid for services in protecting patents.
Inventories as at December 31, 1918:
Wrapping and Crating Supplies Unused $ 387.50
Factory Supplies on Hand 718.50
Pamphlets, Price Lists, and Posters on Hand 450.00
Workmen’s Compensation Insurance Prepaid 160.00
Bags in Stock 12,542.00
Trunks in Stock 28,050.00
Raw Materials 8,000.00
Page 575
Trunks in Process as under:
materials $6,497.10
direct labor $2,680.40
manufacturing expense $976.50
Fire Loss was debited for $6,000 which represents damage to buildings of $4,000 and loss of machinery
of $2,000 after making due allowance for depreciation. Just after the trial balance was made a check for
$5,400 was received from the insurance company in full settlement of our claims for fire damage.
The Repairs to Buildings account contains $3,500 of charges for replacing the parts destroyed by fire.
Provision for reserve for depreciation is to be made on a straight line basis, at the following yearly rate:
buildings 5%; machinery 10%; delivery equipment 12%; furniture and fixtures 12%.
It was deemed advisable to write off 20% of the accounts of Tools, and Drawings and Patterns. Also, to
reserve from profits $2,000 for supersession of patents in addition to providing for the reduction in the life of
the patent.
Interest has accrued on bonds payable for one month, and there is accrued amortization.
Bright—Special account shows the balance due on Bright’s embezzlement. The company holds good
collateral in the form of stock for the full amount.
Trunks in Process, October 31, 1917, comprised raw materials $3,115, direct labor $1,120, and factory
burden $749.20.
The account, Freight and Express Outward, represented items charged to customers on account of outward
freight charges assumed by us and still owing to the transportation companies.
It was ascertained that on Oct. 31, 1917, the patents had 164 months yet to run, and that the policy is to
depreciate the value remaining at the end of each fiscal period over the remaining life of the patents.
Royal leather stock was being held because of trade advantages secured thereby.
Claims against transportation companies represented claims for damage acknowledged as good by the
companies.
Instructions
In a footnote to the balance sheet call attention to the contingent value of donated land. Extreme
conservatism might require the setting aside of a reserve of surplus covering any expenditures on the land,
such as assessments for street improvements, inasmuch as the same contingency attaches to them as to the
land. So long as a good balance of general surplus is maintained, a special reserve is not usually considered
necessary.
Note that both the Contingent Royalty Fund and its reserve are free. Transfer the fund to general cash, and
the reserve to surplus.
Note that the reserve for supersession of patents is a reserve created out of surplus and therefore to be
treated as a part of net worth. This is, of course, contrary to best practice.
Fire Loss account, as it appears in the trial balance, has been properly charged with the values of the assets
destroyed but has not yet been credited with the insurance. Consider carefully the proper booking of the
repairs to buildings on account of the fire.
See Problem XXVI, Appendix A, for instructions as to content of condensed balance sheet. See also
Problem XV, this Appendix.
XV
From the information furnished in the preceding problem.
materials $6,497.10
direct labor $2,680.40
manufacturing expense $976.50
Fire Loss was debited for $6,000 which represents damage to buildings of $4,000 and loss of machinery
of $2,000 after making due allowance for depreciation. Just after the trial balance was made a check for
$5,400 was received from the insurance company in full settlement of our claims for fire damage.
The Repairs to Buildings account contains $3,500 of charges for replacing the parts destroyed by fire.
Provision for reserve for depreciation is to be made on a straight line basis, at the following yearly rate:
buildings 5%; machinery 10%; delivery equipment 12%; furniture and fixtures 12%.
It was deemed advisable to write off 20% of the accounts of Tools, and Drawings and Patterns. Also, to
reserve from profits $2,000 for supersession of patents in addition to providing for the reduction in the life of
the patent.
Interest has accrued on bonds payable for one month, and there is accrued amortization.
Bright—Special account shows the balance due on Bright’s embezzlement. The company holds good
collateral in the form of stock for the full amount.
Trunks in Process, October 31, 1917, comprised raw materials $3,115, direct labor $1,120, and factory
burden $749.20.
The account, Freight and Express Outward, represented items charged to customers on account of outward
freight charges assumed by us and still owing to the transportation companies.
It was ascertained that on Oct. 31, 1917, the patents had 164 months yet to run, and that the policy is to
depreciate the value remaining at the end of each fiscal period over the remaining life of the patents.
Royal leather stock was being held because of trade advantages secured thereby.
Claims against transportation companies represented claims for damage acknowledged as good by the
companies.
Instructions
In a footnote to the balance sheet call attention to the contingent value of donated land. Extreme
conservatism might require the setting aside of a reserve of surplus covering any expenditures on the land,
such as assessments for street improvements, inasmuch as the same contingency attaches to them as to the
land. So long as a good balance of general surplus is maintained, a special reserve is not usually considered
necessary.
Note that both the Contingent Royalty Fund and its reserve are free. Transfer the fund to general cash, and
the reserve to surplus.
Note that the reserve for supersession of patents is a reserve created out of surplus and therefore to be
treated as a part of net worth. This is, of course, contrary to best practice.
Fire Loss account, as it appears in the trial balance, has been properly charged with the values of the assets
destroyed but has not yet been credited with the insurance. Consider carefully the proper booking of the
repairs to buildings on account of the fire.
See Problem XXVI, Appendix A, for instructions as to content of condensed balance sheet. See also
Problem XV, this Appendix.
XV
From the information furnished in the preceding problem.
Page 576
(a) Construct a surplus statement.
(b) Write the adjusting and closing journal entries.
Treat the surplus statement as a schedule supporting the balance sheet.
XVI
Some time ago the stockholders of the A. M. Strong Fiber Co. and the Randall Manufacturing Co.
appointed committees on merger. At a joint meeting of the two committees a plan for merger of the two
companies was adopted. The stockholders of the respective companies accepted the plan for the joint
committee and instructed and authorized their boards of directors to carry out the terms of the merger. The
agreement provided that a new corporation be formed to acquire the assets and assume the liabilities of the
two companies as shown on their balance sheets of December 31, 1916, except as noted.
The subjoined balance sheets show the conditions of the two companies. The balance sheet of the Randall
Co. has already been adjusted to meet the conditions of the merger. The agreement provided, however, that the
machinery and tools of the Strong Co. should be taken over at a 10% reduction of their present book
valuation; that the book value of the Special War Plant assets be written up $20,000 on account of their
adaptability to the regular needs of the merger; and that the reserve for bad debts be increased to $5,000. The
surplus, after these adjustments, was reduced to even multiples of $10,000.
A. M. Strong Fiber Co.
Balance Sheet, December 31, 1916
Assets Liabilities and Capital
Machinery $ 60,000.00 Notes Payable $ 10,000.00
Tools 4,000.00 Accounts Payable 75,000.00
Furniture and Fixtures 7,500.00 Reserve for Bad Debts 3,000.00
Good-Will 150,000.00 Depreciation Reserve
Raw Materials 75,000.00 for Machinery 7,000.00
Cash 25,000.00 Depreciation Reserve
Notes Receivable 47,500.00 for Furn. and Fixt. 1,500.00
Accounts Receivable 112,500.00 Depreciation Reserve
Special War Plant 130,000.00 for War Plant 50,000.00
Bonds Payable (6%) 100,000.00
War Munition Bonds (7%) 60,000.00
Reserve for Sinking Fund 30,000.00
Capital Stock, Common 150,000.00
Capital Stock, Preferred (6%) 100,000.00
Surplus 25,000.00
$611,500.00 $611,500.00
Randall Manufacturing Co.
Balance Sheet, December 31, 1916
(b) Write the adjusting and closing journal entries.
Treat the surplus statement as a schedule supporting the balance sheet.
XVI
Some time ago the stockholders of the A. M. Strong Fiber Co. and the Randall Manufacturing Co.
appointed committees on merger. At a joint meeting of the two committees a plan for merger of the two
companies was adopted. The stockholders of the respective companies accepted the plan for the joint
committee and instructed and authorized their boards of directors to carry out the terms of the merger. The
agreement provided that a new corporation be formed to acquire the assets and assume the liabilities of the
two companies as shown on their balance sheets of December 31, 1916, except as noted.
The subjoined balance sheets show the conditions of the two companies. The balance sheet of the Randall
Co. has already been adjusted to meet the conditions of the merger. The agreement provided, however, that the
machinery and tools of the Strong Co. should be taken over at a 10% reduction of their present book
valuation; that the book value of the Special War Plant assets be written up $20,000 on account of their
adaptability to the regular needs of the merger; and that the reserve for bad debts be increased to $5,000. The
surplus, after these adjustments, was reduced to even multiples of $10,000.
A. M. Strong Fiber Co.
Balance Sheet, December 31, 1916
Assets Liabilities and Capital
Machinery $ 60,000.00 Notes Payable $ 10,000.00
Tools 4,000.00 Accounts Payable 75,000.00
Furniture and Fixtures 7,500.00 Reserve for Bad Debts 3,000.00
Good-Will 150,000.00 Depreciation Reserve
Raw Materials 75,000.00 for Machinery 7,000.00
Cash 25,000.00 Depreciation Reserve
Notes Receivable 47,500.00 for Furn. and Fixt. 1,500.00
Accounts Receivable 112,500.00 Depreciation Reserve
Special War Plant 130,000.00 for War Plant 50,000.00
Bonds Payable (6%) 100,000.00
War Munition Bonds (7%) 60,000.00
Reserve for Sinking Fund 30,000.00
Capital Stock, Common 150,000.00
Capital Stock, Preferred (6%) 100,000.00
Surplus 25,000.00
$611,500.00 $611,500.00
Randall Manufacturing Co.
Balance Sheet, December 31, 1916
Page 577
Assets Liabilities and Capital
Land $ 90,000.00 Accounts Payable $ 35,800.00
Machinery 70,000.00 Notes Payable 20,000.00
Tools 10,000.00 Wages Payable 2,000.00
Motor Trucks 12,000.00 Interest Accrued 1,000.00
Furniture and Fixtures 3,000.00 Reserve for Bad Debts 1,200.00
Patents 60,000.00 Bonds Payable (5%) 100,000.00
Raw Material 14,000.00 Capital Stock, Preferred 50,000.00
Goods in Process 8,000.00 Capital Stock, Common 100,000.00
Finished Goods 19,000.00 Surplus 40,000.00
Cash 8,000.00
Notes Receivable 16,000.00
Accounts Receivable 40,000.00
$350,000.00 $350,000.00
To effect the reduction of the surplus of the Strong Co. to even multiples of $10,000, by consent of all the
stockholders, a special dividend was declared to be shared by both common and preferred stockholders
equally on the basis of their respective holdings; and it was further agreed that because the preferred stock
carried a participation privilege and preference as to assets, in the distribution of the stock of the merger in
payment of the respective interests of the present stockholders, the preferred holders should be considered as
being entitled to a pro rata share of the adjusted surplus and good-will.
The net profits for the last period, after deduction therefrom of 8% interest on the respective capitals as
adjusted by taking effect of the foregoing items, were capitalized in even thousands of dollars on a 20% basis,
to determine the value of the good-will of the two companies; the good-will of the Strong Co. so determined
to be in addition to its present good-will. It was ascertained that the net profits for the last period were: Strong
Co. $41,750, Randall Co., $30,000.
To carry out the plan of the merger, the Sterling Trunk Corporation was organized with sufficient capital in
7% cumulative preferred stock and common stock to acquire the two other companies, and additional
common—to remain unissued for the present—to bring the total capitalization to $750,000.
(a) Submit a statement showing the capitalization of the Sterling Trunk
Corporation and the distribution of the capital stock to the other companies.
(b) Prepare the balance sheet of the Sterling Trunk Corporation as of December
31, 1916.
(c) Write the journal entries necessary to adjust the books of the A. M. Strong
Fiber Co. and to show its sale and the transfer of its properties to the
Sterling Trunk Corporation.
XVII
1. A fire partially destroyed the power plant and equipment of the Zehner Manufacturing Co. on the night
of June 30, 1918, entailing a loss of $25,000 on the building, and a ⅔ loss on the equipment. Insurance for one
year, with the 80% coinsurance clause, had been purchased January 1, 1918, for $1,775, covering the above
property. The policies carried $40,000 on the power house and $100,000 on the power house equipment. On
that date—January 1, 1918—the values of the power house and equipment as shown on the balance sheet
were:
Land $ 90,000.00 Accounts Payable $ 35,800.00
Machinery 70,000.00 Notes Payable 20,000.00
Tools 10,000.00 Wages Payable 2,000.00
Motor Trucks 12,000.00 Interest Accrued 1,000.00
Furniture and Fixtures 3,000.00 Reserve for Bad Debts 1,200.00
Patents 60,000.00 Bonds Payable (5%) 100,000.00
Raw Material 14,000.00 Capital Stock, Preferred 50,000.00
Goods in Process 8,000.00 Capital Stock, Common 100,000.00
Finished Goods 19,000.00 Surplus 40,000.00
Cash 8,000.00
Notes Receivable 16,000.00
Accounts Receivable 40,000.00
$350,000.00 $350,000.00
To effect the reduction of the surplus of the Strong Co. to even multiples of $10,000, by consent of all the
stockholders, a special dividend was declared to be shared by both common and preferred stockholders
equally on the basis of their respective holdings; and it was further agreed that because the preferred stock
carried a participation privilege and preference as to assets, in the distribution of the stock of the merger in
payment of the respective interests of the present stockholders, the preferred holders should be considered as
being entitled to a pro rata share of the adjusted surplus and good-will.
The net profits for the last period, after deduction therefrom of 8% interest on the respective capitals as
adjusted by taking effect of the foregoing items, were capitalized in even thousands of dollars on a 20% basis,
to determine the value of the good-will of the two companies; the good-will of the Strong Co. so determined
to be in addition to its present good-will. It was ascertained that the net profits for the last period were: Strong
Co. $41,750, Randall Co., $30,000.
To carry out the plan of the merger, the Sterling Trunk Corporation was organized with sufficient capital in
7% cumulative preferred stock and common stock to acquire the two other companies, and additional
common—to remain unissued for the present—to bring the total capitalization to $750,000.
(a) Submit a statement showing the capitalization of the Sterling Trunk
Corporation and the distribution of the capital stock to the other companies.
(b) Prepare the balance sheet of the Sterling Trunk Corporation as of December
31, 1916.
(c) Write the journal entries necessary to adjust the books of the A. M. Strong
Fiber Co. and to show its sale and the transfer of its properties to the
Sterling Trunk Corporation.
XVII
1. A fire partially destroyed the power plant and equipment of the Zehner Manufacturing Co. on the night
of June 30, 1918, entailing a loss of $25,000 on the building, and a ⅔ loss on the equipment. Insurance for one
year, with the 80% coinsurance clause, had been purchased January 1, 1918, for $1,775, covering the above
property. The policies carried $40,000 on the power house and $100,000 on the power house equipment. On
that date—January 1, 1918—the values of the power house and equipment as shown on the balance sheet
were:
Page 578
Power House $75,000.00
Less Depreciation Reserve 12,000.00 $ 63,000.00
Power House Equipment $200,000.00
Less Depreciation Reserve 80,000.00 120,000.00
Depreciation was estimated at the rate of 4% per annum on the power house, and 10% on the equipment.
The insurance company settled on the above basis.
Show the journal entries necessary to make all the adjustments in the accounts.
For the purpose of the problem assume that the rate on the power house was the same as on the
equipment.
2. The Colorado Rock Drill Co. authorized the issue of $100,000 of 6% cumulative preferred stock
callable by lot in amounts as follows:
$10,000 at the end of 5 years at 107 in cash.
$10,000 at the end of 7 years at 106 in cash.
$15,000 at the end of 10 years at 105 in cash.
$15,000 at the end of 12 years at 104 in cash.
$50,000 at the end of 20 years at par in cash
or convertible into the company’s common
stock at the option of the company.
The entire issue was sold for cash at 103.
Set up the accounts showing the handling of all redemption transactions at the five periods above referred
to, with these additional facts: It is the expectation of the company to provide for a permanent increase in
capital of $100,000, the amount of the preferred stock issue, during the life of the issue; and at the end of the
20 years, the company exercises its option by converting $30,000 of the preferred into common stock out of
unissued common to that amount held in the treasury.
Instructions
Problem 1. Refer to Chapter XXXII.
Problem 2. Refer to Chapters I and XXI.
XVIII
The Sterling Trunk Corporation, hoping to recoup excessive trade losses, engaged more extensively in the
manufacture of war supplies. Instead of realizing the enormous anticipated profits, they sustained a severe
loss through an explosion followed by a disastrous fire on August 1, 1918. The assets destroyed were only
partially protected by insurance because of difficulty in getting a reasonable rate. Also some policies which
had expired had not been renewed.
The following information was accepted by the insurance companies as a basis for settlement. Date of
policies January 1, 1918.
LEGEND:
(A) = Name of Property Insured
(B) = Original Value of the Property
(C) = Reserve for Depreciation, Jan 1, 1918
Less Depreciation Reserve 12,000.00 $ 63,000.00
Power House Equipment $200,000.00
Less Depreciation Reserve 80,000.00 120,000.00
Depreciation was estimated at the rate of 4% per annum on the power house, and 10% on the equipment.
The insurance company settled on the above basis.
Show the journal entries necessary to make all the adjustments in the accounts.
For the purpose of the problem assume that the rate on the power house was the same as on the
equipment.
2. The Colorado Rock Drill Co. authorized the issue of $100,000 of 6% cumulative preferred stock
callable by lot in amounts as follows:
$10,000 at the end of 5 years at 107 in cash.
$10,000 at the end of 7 years at 106 in cash.
$15,000 at the end of 10 years at 105 in cash.
$15,000 at the end of 12 years at 104 in cash.
$50,000 at the end of 20 years at par in cash
or convertible into the company’s common
stock at the option of the company.
The entire issue was sold for cash at 103.
Set up the accounts showing the handling of all redemption transactions at the five periods above referred
to, with these additional facts: It is the expectation of the company to provide for a permanent increase in
capital of $100,000, the amount of the preferred stock issue, during the life of the issue; and at the end of the
20 years, the company exercises its option by converting $30,000 of the preferred into common stock out of
unissued common to that amount held in the treasury.
Instructions
Problem 1. Refer to Chapter XXXII.
Problem 2. Refer to Chapters I and XXI.
XVIII
The Sterling Trunk Corporation, hoping to recoup excessive trade losses, engaged more extensively in the
manufacture of war supplies. Instead of realizing the enormous anticipated profits, they sustained a severe
loss through an explosion followed by a disastrous fire on August 1, 1918. The assets destroyed were only
partially protected by insurance because of difficulty in getting a reasonable rate. Also some policies which
had expired had not been renewed.
The following information was accepted by the insurance companies as a basis for settlement. Date of
policies January 1, 1918.
LEGEND:
(A) = Name of Property Insured
(B) = Original Value of the Property
(C) = Reserve for Depreciation, Jan 1, 1918
Page 579
(D) = Yearly Rate of Depreciation
(E) = Face of Ppolicy
(F) = Amount of Property Destroyed on Aug 1, 1918
(G) = Unexpired Premium on Policy Aug 1, 1918
(H) = Coinsurance Clause in the Policy
(A) (B) (C) (D) (E) (F) (G) (H)
Buildings $110,000 $10,500 5% $30,000 $80,000 $200 80%
Machinery 76,000 14,000 10% 20,000 ¾ 150 100%
Furniture & Fixtures 4,700 1,200 12% 4,000 70% 10 80%
Patterns & Drawings 3,500 20% 1,500 All None 60%
Finished Goods[83] 16,400 80% of 90% of
selling selling 120 80%
price price
(a) What is the effect of the coinsurance clause?
(b) Determine the amount of insurance received for each asset.
(c) Indicate, by means of journal entries, the effect on the various accounts
involved in the settlement of the losses.
XIX
The European War caused a reduction in the income of the Trunk Company by an abrupt falling off of
sales; also as a result of the rapid increase in materials several contracts were completed at a loss. These losses
together with the unexpected loss by fire placed the company in an embarrassing financial condition. There
was great pressure from bondholders because the interest for the last year had not been paid, and
dissatisfaction among stockholders because dividends had been passed. Current debts could not be met and it
was clearly evident that the business could not continue long in its present condition. To remedy this a
meeting of the stockholders was called and a committee on reorganization appointed. The recommendations
of the committee, which are given below, were put into effect on December 31, 1918.
The holders of the 6% bonds were given one share of new cumulative 7% preferred stock in payment of
defaulted interest on each bond. The holders of the $100,000 of 5% bonds assumed for Randall
Manufacturing Co. contributed in cash 5% of the amount of their bonds and received for each $1,000 bond a
new $500 bond bearing 5% interest and $700 in non-cumulative 6% preferred stock. The holders of $60,000
7% war munitions bonds received for each $1,000 bond $600 in 6% preferred stock and $500 in common
stock. The old cumulative preferred stockholders were given new non-cumulative preferred stock, share for
share. The old common stockholders were given new common stock and were assessed $20 per share for
which they were given new cumulative preferred stock.
(a) Determine the amount of cash, bonds and various classes of stock to carry
into effect the reorganization.
(b) Present the journal entries necessary to record these data.
See Problem XVI for other necessary data. Assume all common stock outstanding. Par value of old issue
bonds, $1,000; stock, $100.
XX
(E) = Face of Ppolicy
(F) = Amount of Property Destroyed on Aug 1, 1918
(G) = Unexpired Premium on Policy Aug 1, 1918
(H) = Coinsurance Clause in the Policy
(A) (B) (C) (D) (E) (F) (G) (H)
Buildings $110,000 $10,500 5% $30,000 $80,000 $200 80%
Machinery 76,000 14,000 10% 20,000 ¾ 150 100%
Furniture & Fixtures 4,700 1,200 12% 4,000 70% 10 80%
Patterns & Drawings 3,500 20% 1,500 All None 60%
Finished Goods[83] 16,400 80% of 90% of
selling selling 120 80%
price price
(a) What is the effect of the coinsurance clause?
(b) Determine the amount of insurance received for each asset.
(c) Indicate, by means of journal entries, the effect on the various accounts
involved in the settlement of the losses.
XIX
The European War caused a reduction in the income of the Trunk Company by an abrupt falling off of
sales; also as a result of the rapid increase in materials several contracts were completed at a loss. These losses
together with the unexpected loss by fire placed the company in an embarrassing financial condition. There
was great pressure from bondholders because the interest for the last year had not been paid, and
dissatisfaction among stockholders because dividends had been passed. Current debts could not be met and it
was clearly evident that the business could not continue long in its present condition. To remedy this a
meeting of the stockholders was called and a committee on reorganization appointed. The recommendations
of the committee, which are given below, were put into effect on December 31, 1918.
The holders of the 6% bonds were given one share of new cumulative 7% preferred stock in payment of
defaulted interest on each bond. The holders of the $100,000 of 5% bonds assumed for Randall
Manufacturing Co. contributed in cash 5% of the amount of their bonds and received for each $1,000 bond a
new $500 bond bearing 5% interest and $700 in non-cumulative 6% preferred stock. The holders of $60,000
7% war munitions bonds received for each $1,000 bond $600 in 6% preferred stock and $500 in common
stock. The old cumulative preferred stockholders were given new non-cumulative preferred stock, share for
share. The old common stockholders were given new common stock and were assessed $20 per share for
which they were given new cumulative preferred stock.
(a) Determine the amount of cash, bonds and various classes of stock to carry
into effect the reorganization.
(b) Present the journal entries necessary to record these data.
See Problem XVI for other necessary data. Assume all common stock outstanding. Par value of old issue
bonds, $1,000; stock, $100.
XX
Page 580
The Hillsdale Co. operates a factory and general sales organization from its main plant and conducts two
branches, A and B, as distribution centers at conveniently located points. The branches maintain independent
records which are subject to periodic audit by the head office. At the close of the fiscal period the branch trial
balances are sent to, and incorporated with, the head office trial balance to determine the results of combined
operation. Below are given the trial balances of the head office and branches with the data necessary to close
the books and determine results. You are asked to present closing journal entries for Branch A and the entries
necessary to incorporate the branch results with the head office and to close the head office books. Also
present a consolidated balance sheet after closing.
Trial Balances, June 30, 1918
Branch A Branch B
Cash $3,000.00 $ 1,000.00
Notes and Accounts Receivable 70,000.00 50,000.00
Salaries 15,000.00 5,000.00
Rent 2,700.00 1,500.00
Other Expenses 10,000.00 7,000.00
Sales $ 75,000.00 $ 48,500.00
Sundry Accounts Payable 5,000.00 7,200.00
Purchases from Head Office 70,000.00 50,000.00
Head Office Merchandise 70,000.00 50,000.00
Head Office General 20,700.00 8,800.00
$170,700.00 $170,700.00 $114,500.00 $114,500.00
Inventories, at billed price: Branch A $10,000, Branch B $5,000.
Create on the branch books reserves for doubtful accounts of 1% of the sales at each branch.
Head Office
Plant and Equipment $250,000.00
Depreciation Reserve Plant and Equipment $50,000.00
Cash 25,000.00
Notes and Accounts Receivable 100,000.00
Reserve for Doubtful Accounts 5,000.00
Merchandise Inventory, June 30, 1917 27,500.00
Notes and Accounts Payable 45,000.00
Purchases 170,000.00
Sundry Expenses 35,250.00
Depreciation 12,500.00
Bad Debts 1,125.00
Sales 225,000.00
Sales to Branches 120,000.00
Branch A, Merchandise 70,000.00
Branch B, Merchandise 50,000.00
branches, A and B, as distribution centers at conveniently located points. The branches maintain independent
records which are subject to periodic audit by the head office. At the close of the fiscal period the branch trial
balances are sent to, and incorporated with, the head office trial balance to determine the results of combined
operation. Below are given the trial balances of the head office and branches with the data necessary to close
the books and determine results. You are asked to present closing journal entries for Branch A and the entries
necessary to incorporate the branch results with the head office and to close the head office books. Also
present a consolidated balance sheet after closing.
Trial Balances, June 30, 1918
Branch A Branch B
Cash $3,000.00 $ 1,000.00
Notes and Accounts Receivable 70,000.00 50,000.00
Salaries 15,000.00 5,000.00
Rent 2,700.00 1,500.00
Other Expenses 10,000.00 7,000.00
Sales $ 75,000.00 $ 48,500.00
Sundry Accounts Payable 5,000.00 7,200.00
Purchases from Head Office 70,000.00 50,000.00
Head Office Merchandise 70,000.00 50,000.00
Head Office General 20,700.00 8,800.00
$170,700.00 $170,700.00 $114,500.00 $114,500.00
Inventories, at billed price: Branch A $10,000, Branch B $5,000.
Create on the branch books reserves for doubtful accounts of 1% of the sales at each branch.
Head Office
Plant and Equipment $250,000.00
Depreciation Reserve Plant and Equipment $50,000.00
Cash 25,000.00
Notes and Accounts Receivable 100,000.00
Reserve for Doubtful Accounts 5,000.00
Merchandise Inventory, June 30, 1917 27,500.00
Notes and Accounts Payable 45,000.00
Purchases 170,000.00
Sundry Expenses 35,250.00
Depreciation 12,500.00
Bad Debts 1,125.00
Sales 225,000.00
Sales to Branches 120,000.00
Branch A, Merchandise 70,000.00
Branch B, Merchandise 50,000.00
Page 581
Branch A, General 20,700.00
Branch B, General 8,800.00
Capital Stock 250,000.00
Surplus 75,875.00
$770,875.00 $770,875.00
Head office inventory, $30,000.
Goods were billed to the branches at 150% of cost.
XXI
A New York company doing business in London, received the following trial balance from its London
office at the end of a fiscal year:
Trial Balance—London Office
Plant £100,000
Accounts Receivable 75,000
Accounts Payable £35,000
Expenses 10,000
Income 100,000
Merchandise 20,000
New York Office Account 135,000
Remittance Account 60,000
Cash 5,000
£270,000 £270,000
The New York books showed as follows:
Trial Balance—New York Books
Capital Stock $1,000,000.00
Patents $600,000.00
London Office Account 656,100.00
Remittance Account 291,712.50
Expenses 10,000.00
Cash 25,612.50
$1,291,712.50 $1,291,712.50
The remittance account consisted of four 60-day drafts on London for £15,000 each, which were sold in
New York at 4.85½, 4.86, 4.86½, and 4.86¾ respectively.
Make such journal entries as are necessary to incorporate with the New York accounts the results of the
year’s business in London (conversion to be made at the average rate of exchange of the four remittances),
and establish the new balance of the London office account so that it will agree with the London books when
converted into sterling at 4.87¼, the rate of exchange ruling on the last day of the year. Show also trial
balance of the New York books after closing.
Branch B, General 8,800.00
Capital Stock 250,000.00
Surplus 75,875.00
$770,875.00 $770,875.00
Head office inventory, $30,000.
Goods were billed to the branches at 150% of cost.
XXI
A New York company doing business in London, received the following trial balance from its London
office at the end of a fiscal year:
Trial Balance—London Office
Plant £100,000
Accounts Receivable 75,000
Accounts Payable £35,000
Expenses 10,000
Income 100,000
Merchandise 20,000
New York Office Account 135,000
Remittance Account 60,000
Cash 5,000
£270,000 £270,000
The New York books showed as follows:
Trial Balance—New York Books
Capital Stock $1,000,000.00
Patents $600,000.00
London Office Account 656,100.00
Remittance Account 291,712.50
Expenses 10,000.00
Cash 25,612.50
$1,291,712.50 $1,291,712.50
The remittance account consisted of four 60-day drafts on London for £15,000 each, which were sold in
New York at 4.85½, 4.86, 4.86½, and 4.86¾ respectively.
Make such journal entries as are necessary to incorporate with the New York accounts the results of the
year’s business in London (conversion to be made at the average rate of exchange of the four remittances),
and establish the new balance of the London office account so that it will agree with the London books when
converted into sterling at 4.87¼, the rate of exchange ruling on the last day of the year. Show also trial
balance of the New York books after closing.
Page 582
XXII
Company A owns the entire capital stock of Companies B and C. The assets and liabilities of the
respective companies are as follows:
Company A: cash $10,000; deferred charges $150; inventories $1,000; due from allied companies
$25,000; notes receivable $15,000; petty cash $100; trade creditors $1,000; capital stock $100,000; surplus
$5,250; notes payable $50,000; other investments $55,000; investments in allied companies $50,000.
Company B: trade debtors $10,000; cash $4,000; deferred charges $200; notes receivable $1,000; petty
cash $500; inventories $8,000; land $10,000; buildings $25,000; equipment $20,000; surplus $1,000;
dividends payable $500; due allied companies $30,000; notes payable $10,000; accrued liabilities $200;
capital stock $25,000; trade creditors $12,000.
Company C: capital stock $30,000; notes payable $15,000; cash $2,000; trade creditors $4,000; notes
receivable $1,000; petty cash $200; accrued expenses $100; trade debtors $3,500; allied companies $5,100;
surplus $2,300; inventories $5,000; land $7,500; deferred charges $100; equipment $15,000; buildings
$12,000.
Prepare consolidated balance sheet. Submit with your solution your working papers.
Criticize briefly (not to exceed 500 words) the condition of each company and state whether, in your
opinion, the investments in allied companies are valued correctly.
XXIII
Jones & Robinson, merchants, are unable to meet their obligations. From their books and the testimony of
the insolvent debtors, the following statement of their condition is ascertained:
Cash on Hand $ 5,500.00
Debtors ($1,000 good; $600 doubtful but
estimated to produce $200, $1,000 bad) 2,600.00
Property (estimated to produce $9,000) 14,000.00
Notes Receivable, Good 4,250.00
Other Securities ($3,000 pledged with
partially secured creditors; the
remainder held by the fully
secured creditors) 28,000.00
Jones, Drawings 9,000.00
Jones, Capital 10,000.00
Robinson, Drawings 8,400.00
Robinson, Capital 16,050.00
Sundry Losses 13,500.00
Preferential Claims—Wages, Salaries, and Taxes 700.00
Trade Expenses 7,400.00
Creditors Unsecured 25,000.00
Creditors Partially Secured 23,900.00
Creditors Fully Secured 17,000.00
Prepare a statement of affairs and deficiency account.
XXIV
Company A owns the entire capital stock of Companies B and C. The assets and liabilities of the
respective companies are as follows:
Company A: cash $10,000; deferred charges $150; inventories $1,000; due from allied companies
$25,000; notes receivable $15,000; petty cash $100; trade creditors $1,000; capital stock $100,000; surplus
$5,250; notes payable $50,000; other investments $55,000; investments in allied companies $50,000.
Company B: trade debtors $10,000; cash $4,000; deferred charges $200; notes receivable $1,000; petty
cash $500; inventories $8,000; land $10,000; buildings $25,000; equipment $20,000; surplus $1,000;
dividends payable $500; due allied companies $30,000; notes payable $10,000; accrued liabilities $200;
capital stock $25,000; trade creditors $12,000.
Company C: capital stock $30,000; notes payable $15,000; cash $2,000; trade creditors $4,000; notes
receivable $1,000; petty cash $200; accrued expenses $100; trade debtors $3,500; allied companies $5,100;
surplus $2,300; inventories $5,000; land $7,500; deferred charges $100; equipment $15,000; buildings
$12,000.
Prepare consolidated balance sheet. Submit with your solution your working papers.
Criticize briefly (not to exceed 500 words) the condition of each company and state whether, in your
opinion, the investments in allied companies are valued correctly.
XXIII
Jones & Robinson, merchants, are unable to meet their obligations. From their books and the testimony of
the insolvent debtors, the following statement of their condition is ascertained:
Cash on Hand $ 5,500.00
Debtors ($1,000 good; $600 doubtful but
estimated to produce $200, $1,000 bad) 2,600.00
Property (estimated to produce $9,000) 14,000.00
Notes Receivable, Good 4,250.00
Other Securities ($3,000 pledged with
partially secured creditors; the
remainder held by the fully
secured creditors) 28,000.00
Jones, Drawings 9,000.00
Jones, Capital 10,000.00
Robinson, Drawings 8,400.00
Robinson, Capital 16,050.00
Sundry Losses 13,500.00
Preferential Claims—Wages, Salaries, and Taxes 700.00
Trade Expenses 7,400.00
Creditors Unsecured 25,000.00
Creditors Partially Secured 23,900.00
Creditors Fully Secured 17,000.00
Prepare a statement of affairs and deficiency account.
XXIV
Page 583
Parker & Riley, being unable to meet their obligations, have made an assignment. You are asked to prepare
a statement of affairs for presentation at a meeting of their creditors. Some of the creditors are entirely or
partially secured, the security being a part of the assets. The following is a trial balance of their ledger at the
date of the assignment:
Cash $ 1,200.00
Stock and Material (old inventory) 12,000.00
Reliance Trust Co. Stock (20 shares at cost) 2,200.00
Accounts Receivable 10,550.00
Notes Receivable 2,000.00
Mortgage Receivable (second mortgage) 1,000.00
Real Estate (store building and lot) 14,000.00
Fixtures 1,700.00
Horses, Trucks, and Harness (asset account) 1,400.00
Accounts Payable $ 28,000.00
Loans Payable 7,000.00
Mortgage on Real Estate 5,000.00
Purchases 30,000.00
Sales 36,000.00
Rents 1,200.00
Salaries 3,500.00
Interest and Discount 960.00
Taxes Accrued 740.00
Insurance Unexpired 500.00
General Expenses 4,130.00
Parker, Capital 8,000.00
Riley, Capital 4,000.00
Parker, Drawings 3,000.00
Riley, Drawings 1,800.00
$89,940.00 $89,940.00
The accounts receivable are classed as: good $8,000; doubtful $1,500 (estimated to produce $1,000);
worthless, $1,050. Notes receivable will realize $1,800; the second mortgage is estimated to produce $800;
the trust company shares $1,800; delivery equipment $900; fixtures $1,000; and real estate $12,500.
Of the accounts payable $20,000 is unsecured and $8,000 is secured by the second mortgage and trust
company stock. The loans payable are secured by the equity in the real estate. The inventory of merchandise
on hand which foots $5,000 is expected to realize $3,000. Other liabilities not booked are employees’ wages
$550, and interest on mortgage $125. The unexpired insurance is expected to yield $150 upon redemption.
Draw up a statement of affairs and deficiency account.
XXV
The Metropolitan Book Co., a corporation, goes into voluntary liquidation and a trustee is appointed. The
following is the trial balance of the company on July 1, 1918, the date when its affairs are turned over to the
trustee.
Capital Stock $ 20,000.00
Cash $ 553.69
a statement of affairs for presentation at a meeting of their creditors. Some of the creditors are entirely or
partially secured, the security being a part of the assets. The following is a trial balance of their ledger at the
date of the assignment:
Cash $ 1,200.00
Stock and Material (old inventory) 12,000.00
Reliance Trust Co. Stock (20 shares at cost) 2,200.00
Accounts Receivable 10,550.00
Notes Receivable 2,000.00
Mortgage Receivable (second mortgage) 1,000.00
Real Estate (store building and lot) 14,000.00
Fixtures 1,700.00
Horses, Trucks, and Harness (asset account) 1,400.00
Accounts Payable $ 28,000.00
Loans Payable 7,000.00
Mortgage on Real Estate 5,000.00
Purchases 30,000.00
Sales 36,000.00
Rents 1,200.00
Salaries 3,500.00
Interest and Discount 960.00
Taxes Accrued 740.00
Insurance Unexpired 500.00
General Expenses 4,130.00
Parker, Capital 8,000.00
Riley, Capital 4,000.00
Parker, Drawings 3,000.00
Riley, Drawings 1,800.00
$89,940.00 $89,940.00
The accounts receivable are classed as: good $8,000; doubtful $1,500 (estimated to produce $1,000);
worthless, $1,050. Notes receivable will realize $1,800; the second mortgage is estimated to produce $800;
the trust company shares $1,800; delivery equipment $900; fixtures $1,000; and real estate $12,500.
Of the accounts payable $20,000 is unsecured and $8,000 is secured by the second mortgage and trust
company stock. The loans payable are secured by the equity in the real estate. The inventory of merchandise
on hand which foots $5,000 is expected to realize $3,000. Other liabilities not booked are employees’ wages
$550, and interest on mortgage $125. The unexpired insurance is expected to yield $150 upon redemption.
Draw up a statement of affairs and deficiency account.
XXV
The Metropolitan Book Co., a corporation, goes into voluntary liquidation and a trustee is appointed. The
following is the trial balance of the company on July 1, 1918, the date when its affairs are turned over to the
trustee.
Capital Stock $ 20,000.00
Cash $ 553.69
Page 584
Office Furniture 1,666.92
Meter Deposit 60.00
Accounts Receivable 26,153.95
Rogers & Co.
(moneys collected for their account) 14,738.00
Notes Payable 27,573.50
Accounts Payable 4,197.22
Purchases 27,404.74
Sales 8,045.35
Expense 10,751.97
Surplus 7,962.80
$74,554.07 $74,554.07
Value of merchandise on hand is $20,183.86, and the other assets are appraised at book value. The
trustee’s cash receipts and disbursements are:
Dr. Cash Cr.
Balance taken over $ 553.69 Notes Paid $ 27,573.50
Meter Deposit 60.00 Accounts Paid 4,197.22
Office Furniture 487.90 Merchandise Bought 562.55
Accounts Receivable 22,872.75 Expenses 5,697.01
Additional Collections for Rogers & Co. (in full) 16,703.24
Rogers & Co. (in full) 1,965.24
Sales of Merchandise 22,090.70
Commission from Rogers & Co. 6,703.24
$54,733.52 $54,733.52
Accounts receivable not collected are worthless.
Prepare a realization and liquidation account in technical form.
XXVI
Messrs. Sharp and Green having given the firm’s notes to a friendly company as an accommodation,
became embarrassed through failure of the payee and appointed a trustee to realize and liquidate. The
following is a statement of their condition January 1, 1916:
Assets Liabilities and Capital
Cash $ 500.00 Mortgage on Real Estate $ 5,000.00
Merchandise 20,000.00 Mortgage Interest Accrued 250.00
Real Estate 25,000.00 Taxes Accrued 375.00
Notes Receivable 5,000.00 Accounts Payable (including
Accounts Receivable accommodation paper as contra) 61,550.00
(including accommodated Notes Payable 1,000.00
Meter Deposit 60.00
Accounts Receivable 26,153.95
Rogers & Co.
(moneys collected for their account) 14,738.00
Notes Payable 27,573.50
Accounts Payable 4,197.22
Purchases 27,404.74
Sales 8,045.35
Expense 10,751.97
Surplus 7,962.80
$74,554.07 $74,554.07
Value of merchandise on hand is $20,183.86, and the other assets are appraised at book value. The
trustee’s cash receipts and disbursements are:
Dr. Cash Cr.
Balance taken over $ 553.69 Notes Paid $ 27,573.50
Meter Deposit 60.00 Accounts Paid 4,197.22
Office Furniture 487.90 Merchandise Bought 562.55
Accounts Receivable 22,872.75 Expenses 5,697.01
Additional Collections for Rogers & Co. (in full) 16,703.24
Rogers & Co. (in full) 1,965.24
Sales of Merchandise 22,090.70
Commission from Rogers & Co. 6,703.24
$54,733.52 $54,733.52
Accounts receivable not collected are worthless.
Prepare a realization and liquidation account in technical form.
XXVI
Messrs. Sharp and Green having given the firm’s notes to a friendly company as an accommodation,
became embarrassed through failure of the payee and appointed a trustee to realize and liquidate. The
following is a statement of their condition January 1, 1916:
Assets Liabilities and Capital
Cash $ 500.00 Mortgage on Real Estate $ 5,000.00
Merchandise 20,000.00 Mortgage Interest Accrued 250.00
Real Estate 25,000.00 Taxes Accrued 375.00
Notes Receivable 5,000.00 Accounts Payable (including
Accounts Receivable accommodation paper as contra) 61,550.00
(including accommodated Notes Payable 1,000.00
Page 585
party $58,000) 62,000.00 Henry Maxwell, Special Partner 10,000.00
Samuel Green, Capital 20,325.00
James Sharp, Capital 14,000.00
$112,500.00 $112,500.00
The following is a memorandum of the trustee’s transactions for the year: purchases to complete contract
orders $70,000; sales for the year for cash $108,000; uncollected accounts $2,000; stock of goods on hand
December 31, 1916, $10,000; notes receivable collected at a loss of $600; accounts receivable collected
$3,600, balance lost; received 75% in full settlement of accommodation notes and paid cash on account of
same $48,000 giving renewal notes for $10,000. The legal fees and petty expenses paid on account of
accommodation paper amounted to $2,400. The following payments were also made: mortgage, with interest,
and one year’s accrued interest to December 31, 1916; all taxes, notes payable, and accounts payable; and
clerk hire, wages, and other expense, including an allowance of $100 per month to each of the active partners,
one year’s interest at 6% to Maxwell, interest on Green’s excess capital ($6,325) for one year at 6%, and
trustee’s fee of $5,000—in all $10,000.
The special partner had a ¹/₁₀ interest and the general partners shared alike in the residue of the net profits.
On January 1, 1917, the estate was returned to the owners.
Prepare the trustee’s realization and liquidation account in technical form, supported by trustee’s cash
account. Show a balance sheet of the estate as turned back to the partners, and set up the partners’ accounts.
XXVII
Three partners contribute capital as follows: X $90,000, Y $45,000, Z $15,000. They share profits in the
proportion of X 50%, Y 30%, Z 20%. X’s salary is $5,000, Y’s salary is $3,000, Z’s salary is $2,000. At the
end of their fiscal period X dies. The books are closed and the net assets ascertained to be $152,500. Z and Y
liquidate the firm’s affairs and distribute the surplus assets quarterly as follows:
First quarter $42,410.20
Second quarter 74,622.30
Third quarter 31,967.50 $149,000.00
Prepare a statement of the partners’ accounts, showing how the distribution of assets should be made,
together with the apportionment of the loss. Give your authorities.
XXVIII
Use the following instructions as a guide in preparing a special report on a business with which you are
familiar, either by experience or through investigation.
(a) Write a short history of the business, giving:
1. Title.
2. Character of business in which engaged.
3. Date of beginning and amount of capital invested.
4. Successive changes affecting:
The ownership (individual, partnership, or corporate).
The amount of capital.
The character of the business in which engaged.
(b) Submit:
1. A trial balance at the close of a fiscal period.
Samuel Green, Capital 20,325.00
James Sharp, Capital 14,000.00
$112,500.00 $112,500.00
The following is a memorandum of the trustee’s transactions for the year: purchases to complete contract
orders $70,000; sales for the year for cash $108,000; uncollected accounts $2,000; stock of goods on hand
December 31, 1916, $10,000; notes receivable collected at a loss of $600; accounts receivable collected
$3,600, balance lost; received 75% in full settlement of accommodation notes and paid cash on account of
same $48,000 giving renewal notes for $10,000. The legal fees and petty expenses paid on account of
accommodation paper amounted to $2,400. The following payments were also made: mortgage, with interest,
and one year’s accrued interest to December 31, 1916; all taxes, notes payable, and accounts payable; and
clerk hire, wages, and other expense, including an allowance of $100 per month to each of the active partners,
one year’s interest at 6% to Maxwell, interest on Green’s excess capital ($6,325) for one year at 6%, and
trustee’s fee of $5,000—in all $10,000.
The special partner had a ¹/₁₀ interest and the general partners shared alike in the residue of the net profits.
On January 1, 1917, the estate was returned to the owners.
Prepare the trustee’s realization and liquidation account in technical form, supported by trustee’s cash
account. Show a balance sheet of the estate as turned back to the partners, and set up the partners’ accounts.
XXVII
Three partners contribute capital as follows: X $90,000, Y $45,000, Z $15,000. They share profits in the
proportion of X 50%, Y 30%, Z 20%. X’s salary is $5,000, Y’s salary is $3,000, Z’s salary is $2,000. At the
end of their fiscal period X dies. The books are closed and the net assets ascertained to be $152,500. Z and Y
liquidate the firm’s affairs and distribute the surplus assets quarterly as follows:
First quarter $42,410.20
Second quarter 74,622.30
Third quarter 31,967.50 $149,000.00
Prepare a statement of the partners’ accounts, showing how the distribution of assets should be made,
together with the apportionment of the loss. Give your authorities.
XXVIII
Use the following instructions as a guide in preparing a special report on a business with which you are
familiar, either by experience or through investigation.
(a) Write a short history of the business, giving:
1. Title.
2. Character of business in which engaged.
3. Date of beginning and amount of capital invested.
4. Successive changes affecting:
The ownership (individual, partnership, or corporate).
The amount of capital.
The character of the business in which engaged.
(b) Submit:
1. A trial balance at the close of a fiscal period.
Page 586
2. A balance sheet for the same period.
3. A profit and loss statement for the same period.
4. Adjusting and closing journal entries for the same period.
Note: If possible, give 1, 2, 3, for two successive periods
and prepare a comparative balance sheet and profit and loss
statement.
(c) Prepare:
1. A list of the different books and blanks used to record the financial
transactions.
2. A sample page or blank or a copy of each item listed under 1.
Note: If the copy should require a great deal of space, simply give the form of
ruling, headings, and size of page.
(d) Write one or two typical entries in each book and show the form of closing in actual use.
(e) As a separate problem:
1. Outline the course of an article from the time the order is placed until the
goods reach you. This would be a purchase department record.
2. Outline the course of an article from the time you receive the order until the
goods reach your customer. This would be a sales department record.
Note: For both 1 and 2 attach actual forms used or copy of same, if possible.
(f) Information in regard to:
1. Terms of sale.
2. Treatment of C. O. D. or approval sales on the books.
3. Treatment of freight inward on the books.
4. Treatment of freight outward on the books.
5. Treatment of accounts for containers or boxes to be returned by
your firm; by your customers.
6. Treatment of petty cash. If this has not been furnished under
(c) 2, give sample page of petty cash.
7. Treatment of consigned goods on the books.
8. Closing journal entries. If this has been furnished under
(b) 4, omit.
9. Treatment of instalment sales.
10. Pay-roll system.
11. Your method of entering payment from customers.
12. Provision for bad debts.
13. Method of providing for depreciation. Give an example.
14. Provision for redemption of bonds payable.
15. Interest on daily or other balances.
16. Proportional discount.
17. Assignment of accounts receivable.
18. Use of check figures.
19. Number of customers.
20. Amount of gross sales.
21. Amount of gross purchases.
22. Methods of obtaining inventories and basis for valuation.
23. Usual gross profit.
24. Usual gross expense.
25. Figuring profits. On selling price or cost price.
3. A profit and loss statement for the same period.
4. Adjusting and closing journal entries for the same period.
Note: If possible, give 1, 2, 3, for two successive periods
and prepare a comparative balance sheet and profit and loss
statement.
(c) Prepare:
1. A list of the different books and blanks used to record the financial
transactions.
2. A sample page or blank or a copy of each item listed under 1.
Note: If the copy should require a great deal of space, simply give the form of
ruling, headings, and size of page.
(d) Write one or two typical entries in each book and show the form of closing in actual use.
(e) As a separate problem:
1. Outline the course of an article from the time the order is placed until the
goods reach you. This would be a purchase department record.
2. Outline the course of an article from the time you receive the order until the
goods reach your customer. This would be a sales department record.
Note: For both 1 and 2 attach actual forms used or copy of same, if possible.
(f) Information in regard to:
1. Terms of sale.
2. Treatment of C. O. D. or approval sales on the books.
3. Treatment of freight inward on the books.
4. Treatment of freight outward on the books.
5. Treatment of accounts for containers or boxes to be returned by
your firm; by your customers.
6. Treatment of petty cash. If this has not been furnished under
(c) 2, give sample page of petty cash.
7. Treatment of consigned goods on the books.
8. Closing journal entries. If this has been furnished under
(b) 4, omit.
9. Treatment of instalment sales.
10. Pay-roll system.
11. Your method of entering payment from customers.
12. Provision for bad debts.
13. Method of providing for depreciation. Give an example.
14. Provision for redemption of bonds payable.
15. Interest on daily or other balances.
16. Proportional discount.
17. Assignment of accounts receivable.
18. Use of check figures.
19. Number of customers.
20. Amount of gross sales.
21. Amount of gross purchases.
22. Methods of obtaining inventories and basis for valuation.
23. Usual gross profit.
24. Usual gross expense.
25. Figuring profits. On selling price or cost price.
Page 587
26. Figuring expenses. On selling price or cost price.
27. Use of selling or expense charts or charts of any other kind.
28. Insurance carried and manner in which it is written off.
29. System of branch or agency accounts.
30. Nature of items found in allowances.
31. Use of mechanical appliances in offices.
32. Filing systems, other than for correspondence.
33. Frequency of audits by firm’s staff. By outside parties.
34. Cost system in use.
35. Date of installation of present system.
36. Rate of turnover.
37. Treatment of cash sales.
(g) Give:
1. Adverse criticism of any department or part of same which you know from actual experience
does not work out as it should.
2. Your opinion as to the cause.
(h) Constructive criticism of any department or part of same which you think would make it more
effective or less expensive if conducted according to your plan.
(i) Anything peculiar to your business which has not been included in any of the previous
divisions.
27. Use of selling or expense charts or charts of any other kind.
28. Insurance carried and manner in which it is written off.
29. System of branch or agency accounts.
30. Nature of items found in allowances.
31. Use of mechanical appliances in offices.
32. Filing systems, other than for correspondence.
33. Frequency of audits by firm’s staff. By outside parties.
34. Cost system in use.
35. Date of installation of present system.
36. Rate of turnover.
37. Treatment of cash sales.
(g) Give:
1. Adverse criticism of any department or part of same which you know from actual experience
does not work out as it should.
2. Your opinion as to the cause.
(h) Constructive criticism of any department or part of same which you think would make it more
effective or less expensive if conducted according to your plan.
(i) Anything peculiar to your business which has not been included in any of the previous
divisions.
Page 588
APPENDIX C
MISCELLANEOUS PROBLEMS
FOR SUPPLEMENTARY WORK[84]
Partnership
1. A partnership on equal terms between A and B is dissolved July 1, 1917, the books on that date showing the
following:
A’s capital paid in was $16,000, and his drawings were $3,500. B’s capital paid in was $2,000, and his
drawings were $1,500. Goods purchased $50,000; sales $40,000; business expenses $1,800. A loss of $1,600 was
made on a $5,000 consignment of goods to Liverpool. In the settlement A agrees to pay B an old debt of $3,500.
Prepare requisite accounts, and show final balance payable by one partner to the other.
2. A and B are partners carrying on a business in Winnipeg. On January 1, 1918, after adding profits for the
past half-year, A’s capital amounted to $150,000, and B’s to $100,000. On that date they take into partnership C,
upon the following terms: viz.: he is to bring in capital amounting to $25,000, and each partner is to be credited
with interest on his capital at 6% per annum. All profits (after debiting interest) up to $25,000 are to be shared by
A and B exclusively in proportion to the amounts of their capital at January 1, 1918. All profits in excess of
$25,000 are to be shared equally by the three partners. Accounts are to be prepared and profits and interest credited
half-yearly. C is to be credited with a salary of $5,000 per annum. On June 30, 1918, the profits divisible after
debiting C’s salary, which he has drawn, but before charging interest on partners’ capital, amounted to $75,000.
The partners’ withdrawals which are not chargeable with interest were: A $12,500, B $10,000, and C $3,750. Draw
up partners’ separate accounts as they should stand on July 1, 1918.
Assume that instead of a profit, a loss of $75,000 had occurred. How would you have treated it in the accounts
in the absence of any direct provision in the partnership agreement relative to losses?
3. A, B, and C were partners in business for several years. A died December 31, 1917. The articles of
copartnership provided that on any change in the firm the good-will should be taken into account and its value
divided—one-half to A and one-quarter each to B and C. The balance sheet at the date of A’s death was as follows:
Assets
Cash $ 1,500.00
Merchandise on Hand 12,000.00
Sundry Notes and Accounts Receivable 15,000.00 $28,500.00
Liabilities
Sundry Accounts Payable $ 8,500.00
A’s Net Investment 10,000.00
B’s Net Investment 5,000.00
C’s Net Investment 5,000.00 $28,500.00
In January, 1918, B and C arranged with D to come into the firm with $5,000. The good-will is, by agreement,
to be valued at $3,000. The new firm, consisting of B, C, and D, takes over the business and good-will in equal
shares, subject to an allowance of 2½% on the notes and accounts receivable. It pays the estate of A $5,000, with
the understanding that the balance due A’s estate shall remain as a loan at the rate of 5% interest.
Prepare the balance sheet and the capital accounts of B, C, and D as they should appear at the beginning of the
new business, writing off the purchase of good-will in equal proportions to the amount of capital invested.
MISCELLANEOUS PROBLEMS
FOR SUPPLEMENTARY WORK[84]
Partnership
1. A partnership on equal terms between A and B is dissolved July 1, 1917, the books on that date showing the
following:
A’s capital paid in was $16,000, and his drawings were $3,500. B’s capital paid in was $2,000, and his
drawings were $1,500. Goods purchased $50,000; sales $40,000; business expenses $1,800. A loss of $1,600 was
made on a $5,000 consignment of goods to Liverpool. In the settlement A agrees to pay B an old debt of $3,500.
Prepare requisite accounts, and show final balance payable by one partner to the other.
2. A and B are partners carrying on a business in Winnipeg. On January 1, 1918, after adding profits for the
past half-year, A’s capital amounted to $150,000, and B’s to $100,000. On that date they take into partnership C,
upon the following terms: viz.: he is to bring in capital amounting to $25,000, and each partner is to be credited
with interest on his capital at 6% per annum. All profits (after debiting interest) up to $25,000 are to be shared by
A and B exclusively in proportion to the amounts of their capital at January 1, 1918. All profits in excess of
$25,000 are to be shared equally by the three partners. Accounts are to be prepared and profits and interest credited
half-yearly. C is to be credited with a salary of $5,000 per annum. On June 30, 1918, the profits divisible after
debiting C’s salary, which he has drawn, but before charging interest on partners’ capital, amounted to $75,000.
The partners’ withdrawals which are not chargeable with interest were: A $12,500, B $10,000, and C $3,750. Draw
up partners’ separate accounts as they should stand on July 1, 1918.
Assume that instead of a profit, a loss of $75,000 had occurred. How would you have treated it in the accounts
in the absence of any direct provision in the partnership agreement relative to losses?
3. A, B, and C were partners in business for several years. A died December 31, 1917. The articles of
copartnership provided that on any change in the firm the good-will should be taken into account and its value
divided—one-half to A and one-quarter each to B and C. The balance sheet at the date of A’s death was as follows:
Assets
Cash $ 1,500.00
Merchandise on Hand 12,000.00
Sundry Notes and Accounts Receivable 15,000.00 $28,500.00
Liabilities
Sundry Accounts Payable $ 8,500.00
A’s Net Investment 10,000.00
B’s Net Investment 5,000.00
C’s Net Investment 5,000.00 $28,500.00
In January, 1918, B and C arranged with D to come into the firm with $5,000. The good-will is, by agreement,
to be valued at $3,000. The new firm, consisting of B, C, and D, takes over the business and good-will in equal
shares, subject to an allowance of 2½% on the notes and accounts receivable. It pays the estate of A $5,000, with
the understanding that the balance due A’s estate shall remain as a loan at the rate of 5% interest.
Prepare the balance sheet and the capital accounts of B, C, and D as they should appear at the beginning of the
new business, writing off the purchase of good-will in equal proportions to the amount of capital invested.
Page 589
Corporation—Opening the Books
4. C, D, and E are partners sharing profits in accordance with capital investments. At end of the fiscal year,
after all nominal accounts are closed, the books show the following:
Cash $ 20,051.00
Plant 60,422.00
Inventory of Merchandise 41,300.00
Bills Receivable 18,028.00
Book Accounts Receivable 70,402.00
C, Drawings 8,400.00
D, Drawings 6,000.00
E, Drawings 4,800.00
Bills Payable $ 5,211.00
C, Capital 100,000.00
D, Capital 50,000.00
E, Capital 50,000.00
Profit and Loss, Undivided Profits 24,192.00
$229,403.00 $229,403.00
The partners thereupon incorporate a company with an authorized capital of $250,000. The company so formed
purchased the partnership assets and good-will, not including the cash, for $250,000, payable $200,000 in stock
and $50,000 in cash, the last-mentioned cash being the proceeds of sale of stock to F.
It is the intention to divide the purchase-money stock among the vendors in proportion to their former capital
and to adjust their accounts by the division of the cash shown in trial balance, which will then be placed to their
credit as loans to the company at 6% interest and remain as working capital. The bills payable are to be settled by
the partners. As the drawings of the partners are not in proportion to their respective shares in the profits, the
partners are charged with the interest thereon in the following amounts, viz.: C $231, D $165, and E $132.
(a) Frame the necessary entries to close the partnership books and show the amount of cash received by
each partner.
(b) Referring to question (a), frame the necessary entries to open the books of the company and prepare
a balance sheet showing the condition of the company at the beginning of its operations.
5. The Frost Manufacturing Co. was incorporated April 10, 1918, with a capital stock of $200,000, divided into
2,000 shares of a par value of $100 each.
Payments were made on this date as indicated in the following subscription register:
Subscriber No. Shares Amount Form of Payment
C. Dunn 100 $10,000.00 Cash
E. Ferris 200 20,000.00 Cash
G. Hall Cash $10,000,
and Hall's note with
400 40,000.00
interest at 6%, due in
one year, the balance.
April 12. Expenses of $1,200 incidental to the organization of the corporation were paid in cash.
April 15. The corporation purchased J. King’s entire plant valued at $170,000 and assumed his liabilities
amounting to $70,000, giving in full payment 1,200 shares of stock at par.
4. C, D, and E are partners sharing profits in accordance with capital investments. At end of the fiscal year,
after all nominal accounts are closed, the books show the following:
Cash $ 20,051.00
Plant 60,422.00
Inventory of Merchandise 41,300.00
Bills Receivable 18,028.00
Book Accounts Receivable 70,402.00
C, Drawings 8,400.00
D, Drawings 6,000.00
E, Drawings 4,800.00
Bills Payable $ 5,211.00
C, Capital 100,000.00
D, Capital 50,000.00
E, Capital 50,000.00
Profit and Loss, Undivided Profits 24,192.00
$229,403.00 $229,403.00
The partners thereupon incorporate a company with an authorized capital of $250,000. The company so formed
purchased the partnership assets and good-will, not including the cash, for $250,000, payable $200,000 in stock
and $50,000 in cash, the last-mentioned cash being the proceeds of sale of stock to F.
It is the intention to divide the purchase-money stock among the vendors in proportion to their former capital
and to adjust their accounts by the division of the cash shown in trial balance, which will then be placed to their
credit as loans to the company at 6% interest and remain as working capital. The bills payable are to be settled by
the partners. As the drawings of the partners are not in proportion to their respective shares in the profits, the
partners are charged with the interest thereon in the following amounts, viz.: C $231, D $165, and E $132.
(a) Frame the necessary entries to close the partnership books and show the amount of cash received by
each partner.
(b) Referring to question (a), frame the necessary entries to open the books of the company and prepare
a balance sheet showing the condition of the company at the beginning of its operations.
5. The Frost Manufacturing Co. was incorporated April 10, 1918, with a capital stock of $200,000, divided into
2,000 shares of a par value of $100 each.
Payments were made on this date as indicated in the following subscription register:
Subscriber No. Shares Amount Form of Payment
C. Dunn 100 $10,000.00 Cash
E. Ferris 200 20,000.00 Cash
G. Hall Cash $10,000,
and Hall's note with
400 40,000.00
interest at 6%, due in
one year, the balance.
April 12. Expenses of $1,200 incidental to the organization of the corporation were paid in cash.
April 15. The corporation purchased J. King’s entire plant valued at $170,000 and assumed his liabilities
amounting to $70,000, giving in full payment 1,200 shares of stock at par.
Page 590
April 20. S. Samson subscribed for 50 shares of stock and paid an instalment of $30 per share in cash.
April 22. To provide working capital, each of the following stockholders donated 1/10 of his shares of stock:
Dunn, Ferris, Hall, and King.
April 25. Cash was received for 100 shares of donated stock sold at 85.
April 27. Samson gave his note due in six months for the balance due on his stock subscription.
April 28. The directors authorized an issue of $50,000 in bonds, with interest at 5%, to mature in 20 years.
April 30. Bonds having a par value of $30,000 were sold for $28,000 in cash.
(a) Write journal entries to record fully all the above information in the financial books of the
corporation.
(b) Prepare the corporation balance sheet for April 30, 1918.
Manufacturing Statement
6. The Marine Equipment Co., a corporation, manufactures metal boats and deals in marine supplies. A trial
balance of the general ledger, December 31, 1917, is given below:
Land $ 20,000.00
Buildings 50,000.00
Machinery and Tools 40,000.00
Automobile Trucks 5,000.00
Patents 7,000.00
Office Furniture and Fixtures. 700.00
Accounts Receivable 19,000.00
Notes Receivable 10,700.00
Notes Receivable Discounted $ 6,000.00
Raw Materials Inventory, January 1, 1917 20,000.00
Goods in Process Inventory, January 1, 1917 5,000.00
Metal Boats Finished Inventory, January 1, 1917 8,000.00
Marine Supplies Inventory, January 1, 1917 12,000.00
Union National Bank 8,740.00
Capital Stock 100,000.00
Surplus 18,000.00
Treasury Stock 10,000.00
Bonds Payable, 5% First Mortgage 40,000.00
Reserve for Depreciation, Buildings 1,200.00
Reserve for Depreciation, Machinery and Tools 1,000.00
Reserve for Depreciation, Automobile Trucks 200.00
Notes Payable 2,000.00
Accounts Payable 24,000.00
Purchases, Raw Material 40,000.00
Purchases, Marine Supplies 30,000.00
Freight Inward, Raw Materials 2,450.00
Freight Inward, Marine Supplies 1,340.00
Freight and Cartage Outward 824.00
Sales, Metal Boats 131,130.00
April 22. To provide working capital, each of the following stockholders donated 1/10 of his shares of stock:
Dunn, Ferris, Hall, and King.
April 25. Cash was received for 100 shares of donated stock sold at 85.
April 27. Samson gave his note due in six months for the balance due on his stock subscription.
April 28. The directors authorized an issue of $50,000 in bonds, with interest at 5%, to mature in 20 years.
April 30. Bonds having a par value of $30,000 were sold for $28,000 in cash.
(a) Write journal entries to record fully all the above information in the financial books of the
corporation.
(b) Prepare the corporation balance sheet for April 30, 1918.
Manufacturing Statement
6. The Marine Equipment Co., a corporation, manufactures metal boats and deals in marine supplies. A trial
balance of the general ledger, December 31, 1917, is given below:
Land $ 20,000.00
Buildings 50,000.00
Machinery and Tools 40,000.00
Automobile Trucks 5,000.00
Patents 7,000.00
Office Furniture and Fixtures. 700.00
Accounts Receivable 19,000.00
Notes Receivable 10,700.00
Notes Receivable Discounted $ 6,000.00
Raw Materials Inventory, January 1, 1917 20,000.00
Goods in Process Inventory, January 1, 1917 5,000.00
Metal Boats Finished Inventory, January 1, 1917 8,000.00
Marine Supplies Inventory, January 1, 1917 12,000.00
Union National Bank 8,740.00
Capital Stock 100,000.00
Surplus 18,000.00
Treasury Stock 10,000.00
Bonds Payable, 5% First Mortgage 40,000.00
Reserve for Depreciation, Buildings 1,200.00
Reserve for Depreciation, Machinery and Tools 1,000.00
Reserve for Depreciation, Automobile Trucks 200.00
Notes Payable 2,000.00
Accounts Payable 24,000.00
Purchases, Raw Material 40,000.00
Purchases, Marine Supplies 30,000.00
Freight Inward, Raw Materials 2,450.00
Freight Inward, Marine Supplies 1,340.00
Freight and Cartage Outward 824.00
Sales, Metal Boats 131,130.00
Page 591
Sales, Marine Supplies 58,960.00
Productive Labor 32,400.00
Non-Productive Labor 15,230.00
Superintendence 3,420.00
Heat, Light, and Power 8,500.00
Shop Supplies 2,490.00
Miscellaneous Factory Expense 1,300.00
Insurance 300.00
Repairs to Machinery and Tools 2,146.00
Taxes 400.00
Advertising 3,420.00
Returned Sales and Allowances, Metal Boats 1,200.00
Returned Sales and Allowances, Marine Supplies 862.00
Discount on Sales 3,710.00
Discount on Purchases 5,071.00
Salesmen’s Salaries 6,570.00
Salesmen’s Traveling Expenses 2,354.00
Advances to Salesmen 450.00
Office Salaries 8,630.00
Legal Expense 540.00
Stationery and Printing 1,200.00
Postage 190.00
Interest 315.00
Miscellaneous Selling Expense 1,180.00
$387,561.00 $387,561.00
Additional information to be considered:
Inventories, December 31, 1917:
Raw Materials $21,000.00
Goods in Process 7,000.00
Metal Boats Finished 13,000.00
Marine Supplies 8,000.00
Accrued Items:
Interest on Bonds Payable, 1 year at 5% $2,000.00
Interest on Notes Payable 40.00
Interest on Notes Receivable 75.00
Taxes (estimated) 100.00
Unexpired insurance $100.
Provide for Reserve for depreciation on: buildings, 5% on original value; machinery and tools, 10% on
diminishing value; automobile trucks, 20% on diminishing value. Also provide a 2% reserve for bad debts. Write
off depreciation of 10% on the original cost of furniture and fixtures. Patents expire 14 years from January 1, 1917.
One-half of advertising is to be carried to the next period.
Distribute as follows:
Item Mfg. Selling P. L.
Insurance ¾ ¼ 0
Productive Labor 32,400.00
Non-Productive Labor 15,230.00
Superintendence 3,420.00
Heat, Light, and Power 8,500.00
Shop Supplies 2,490.00
Miscellaneous Factory Expense 1,300.00
Insurance 300.00
Repairs to Machinery and Tools 2,146.00
Taxes 400.00
Advertising 3,420.00
Returned Sales and Allowances, Metal Boats 1,200.00
Returned Sales and Allowances, Marine Supplies 862.00
Discount on Sales 3,710.00
Discount on Purchases 5,071.00
Salesmen’s Salaries 6,570.00
Salesmen’s Traveling Expenses 2,354.00
Advances to Salesmen 450.00
Office Salaries 8,630.00
Legal Expense 540.00
Stationery and Printing 1,200.00
Postage 190.00
Interest 315.00
Miscellaneous Selling Expense 1,180.00
$387,561.00 $387,561.00
Additional information to be considered:
Inventories, December 31, 1917:
Raw Materials $21,000.00
Goods in Process 7,000.00
Metal Boats Finished 13,000.00
Marine Supplies 8,000.00
Accrued Items:
Interest on Bonds Payable, 1 year at 5% $2,000.00
Interest on Notes Payable 40.00
Interest on Notes Receivable 75.00
Taxes (estimated) 100.00
Unexpired insurance $100.
Provide for Reserve for depreciation on: buildings, 5% on original value; machinery and tools, 10% on
diminishing value; automobile trucks, 20% on diminishing value. Also provide a 2% reserve for bad debts. Write
off depreciation of 10% on the original cost of furniture and fixtures. Patents expire 14 years from January 1, 1917.
One-half of advertising is to be carried to the next period.
Distribute as follows:
Item Mfg. Selling P. L.
Insurance ¾ ¼ 0
Page 592
Depreciation Auto Trucks ½ ½ 0
Taxes ¾ 0 ¼
From the trial balance and the additional information prepare:
(a) Income statement.
(b) Balance sheet.
(c) Journal entries to record the additional information
and close the ledger.
Consignments, Commissions, Joint Venture
7. December 1, 1917, a New York merchant ships goods of the value of $5,000 on consignment to a
commission merchant at Rio de Janeiro, insuring them in the Atlantic Mutual against loss or damage in transit and
prepaying freight and insurance amounting to $250. On arrival the goods are found to be in a partially damaged
condition and the loss is adjusted at $1,000, the certificates for which the consignee transmits to the consignor
together with an account sales for $3,000, dated March 1, 1918, and a final account sales for $2,000, dated April 1,
1918. A draft on New York for $4,300 accompanied this final account, being the balance due after deducting duty
paid and commission earned.
Give expression to these transactions on the books of the consignor.
8. On November 15, 1917, Isaac Cohen & Co., Ltd. sent for sale on their account a consignment of goods
valued at $5,000 to John Stimson & Sons, factors of Boston; sale to be on a 5% basis with 1% additional for
guaranty of collection of accounts. Prepaid freight amounted to $25.40. December 26, an account sales from
Stimson & Sons showed sales of $5,775.20, and expenses in connection therewith, exclusive of commission and
guaranty, of $42.25. The net proceeds were placed to Cohen & Co.’s credit, subject to sight draft.
(a) Show the alternative treatment of all the accounts affected on Cohen & Co.’s books in order either to show
the profit or loss on this consignment, or to include the profit or loss with their regular sales.
(b) Stimson & Sons’ fiscal year ended November 30. On November 25 they had sold one-fourth of the Cohen
& Co. consignment for $1,500 and had incurred the expenses of $42.25 mentioned above but applicable to the
whole consignment. Show Stimson & Son’s accounts affected properly closed.
(c) If Cohen & Co.’s fiscal year ends on November 30, what entries would be needed to make the record in
accord with the additional data of question (b) above?
9. A, B & Co. and C, D & Co. enter a joint adventure to ship machinery to New Zealand. C, D & Co., October
5, 1917, handed A, B & Co. $600 in cash and granted them their acceptance at 6 months for $1,500. A, B & Co.
were to provide balance of cash required, to manage the venture, to receive a commission of 2% on amount of
invoice for machinery. Profits of venture to be divided equally.
On October 6, 1917, A, B & Co. paid J, K & Co. for machinery $2,500, and on the same date discounted
acceptance of C, D & Co. for $1,500, paying $30 for discount thereon. On the following day A, B & Co. paid $210
for freight and $30 for insurance. On March 25, 1918, A, B & Co. received from New Zealand to account of
proceeds of machinery a draft payable in London for $1,600, out of which, April 8, 1918, they paid $1,500 to retire
bills for that amount.
On August 8, 1918, A, B & Co. received from New Zealand a draft for $1,550, being balance of proceeds for
machinery, after deducting agent’s commission charges and duty. They thereupon closed the accounts and sent C,
D & Co. check for balance due to them.
Make up an account showing result of venture, also C, D & Co.’s account with A, B & Co. Do not regard
interest.
10. A B, a commission merchant, doing business on a 5% basis, hands you the following abstract of his ledger,
showing his transactions for the year.
Furnish A B’s capital account, showing his original investment; also a balance sheet and a detailed cash
account.
Taxes ¾ 0 ¼
From the trial balance and the additional information prepare:
(a) Income statement.
(b) Balance sheet.
(c) Journal entries to record the additional information
and close the ledger.
Consignments, Commissions, Joint Venture
7. December 1, 1917, a New York merchant ships goods of the value of $5,000 on consignment to a
commission merchant at Rio de Janeiro, insuring them in the Atlantic Mutual against loss or damage in transit and
prepaying freight and insurance amounting to $250. On arrival the goods are found to be in a partially damaged
condition and the loss is adjusted at $1,000, the certificates for which the consignee transmits to the consignor
together with an account sales for $3,000, dated March 1, 1918, and a final account sales for $2,000, dated April 1,
1918. A draft on New York for $4,300 accompanied this final account, being the balance due after deducting duty
paid and commission earned.
Give expression to these transactions on the books of the consignor.
8. On November 15, 1917, Isaac Cohen & Co., Ltd. sent for sale on their account a consignment of goods
valued at $5,000 to John Stimson & Sons, factors of Boston; sale to be on a 5% basis with 1% additional for
guaranty of collection of accounts. Prepaid freight amounted to $25.40. December 26, an account sales from
Stimson & Sons showed sales of $5,775.20, and expenses in connection therewith, exclusive of commission and
guaranty, of $42.25. The net proceeds were placed to Cohen & Co.’s credit, subject to sight draft.
(a) Show the alternative treatment of all the accounts affected on Cohen & Co.’s books in order either to show
the profit or loss on this consignment, or to include the profit or loss with their regular sales.
(b) Stimson & Sons’ fiscal year ended November 30. On November 25 they had sold one-fourth of the Cohen
& Co. consignment for $1,500 and had incurred the expenses of $42.25 mentioned above but applicable to the
whole consignment. Show Stimson & Son’s accounts affected properly closed.
(c) If Cohen & Co.’s fiscal year ends on November 30, what entries would be needed to make the record in
accord with the additional data of question (b) above?
9. A, B & Co. and C, D & Co. enter a joint adventure to ship machinery to New Zealand. C, D & Co., October
5, 1917, handed A, B & Co. $600 in cash and granted them their acceptance at 6 months for $1,500. A, B & Co.
were to provide balance of cash required, to manage the venture, to receive a commission of 2% on amount of
invoice for machinery. Profits of venture to be divided equally.
On October 6, 1917, A, B & Co. paid J, K & Co. for machinery $2,500, and on the same date discounted
acceptance of C, D & Co. for $1,500, paying $30 for discount thereon. On the following day A, B & Co. paid $210
for freight and $30 for insurance. On March 25, 1918, A, B & Co. received from New Zealand to account of
proceeds of machinery a draft payable in London for $1,600, out of which, April 8, 1918, they paid $1,500 to retire
bills for that amount.
On August 8, 1918, A, B & Co. received from New Zealand a draft for $1,550, being balance of proceeds for
machinery, after deducting agent’s commission charges and duty. They thereupon closed the accounts and sent C,
D & Co. check for balance due to them.
Make up an account showing result of venture, also C, D & Co.’s account with A, B & Co. Do not regard
interest.
10. A B, a commission merchant, doing business on a 5% basis, hands you the following abstract of his ledger,
showing his transactions for the year.
Furnish A B’s capital account, showing his original investment; also a balance sheet and a detailed cash
account.
Page 593
Sales $45,000.00 $60,000.00
Freight 2,100.00 1,400.00
Claims and Allowance on Settled Account only 600.00 1,500.00
Expense 900.00
Customers’ Accounts 60,000.00 45,000.00
Creditors’ Accounts 37,950.00 39,850.00
Cash 59,000.00 40,950.00
Discounts Lost 400.00
$205,950.00 $188,700.00
11. A and B, commission merchants, suspect their cashier of embezzlement. From the following data determine
whether or not their suspicions are well founded, and produce a balance sheet and profit and loss statement to
prove or disprove the suspicion.
Sales $42,000.00
Cash Receipts, Customers $42,000.00
Freight 4,240.00 2,480.00
Duty 2,120.00 1,240.00
Dock Charges 212.00 124.00
Custom House Charges 90.00 45.00
Interest (account sales at 6%) 248.00
Commission (5% on sales) 1,240.00
Office Expense 2,000.00
Documentary Advances 20,000.00 12,000.00
Acceptances against Shipments 12,000.00 20,000.00
Analysis of account sales ledger debits, duty $875, freight $1,560, dock charges $70, custom house charges
$40.
Analysis by Comparison
12. The trading accounts of a company covering two years are herewith submitted.
Analyze the accounts and make a report to the company showing the reasons for the difference in results.
1916
Merchandise Inventory, January 1, 1916 $150,000.00
Merchandise Purchases 633,000.00
Merchandise Sales, Travelers 600,000.00
Merchandise Sales, Domestic 150,000.00
Merchandise Sales, Cash 10,000.00
Commissions Paid Travelers 30,000.00
Salaries Paid Travelers 30,000.00
Salaries, Domestic Sales 15,000.00
Rental 5,000.00
Stationery, etc. 3,000.00
Expense 22,000.00
Interest 4,000.00
Inventory, January 1, 1917 125,000.00
Freight 2,100.00 1,400.00
Claims and Allowance on Settled Account only 600.00 1,500.00
Expense 900.00
Customers’ Accounts 60,000.00 45,000.00
Creditors’ Accounts 37,950.00 39,850.00
Cash 59,000.00 40,950.00
Discounts Lost 400.00
$205,950.00 $188,700.00
11. A and B, commission merchants, suspect their cashier of embezzlement. From the following data determine
whether or not their suspicions are well founded, and produce a balance sheet and profit and loss statement to
prove or disprove the suspicion.
Sales $42,000.00
Cash Receipts, Customers $42,000.00
Freight 4,240.00 2,480.00
Duty 2,120.00 1,240.00
Dock Charges 212.00 124.00
Custom House Charges 90.00 45.00
Interest (account sales at 6%) 248.00
Commission (5% on sales) 1,240.00
Office Expense 2,000.00
Documentary Advances 20,000.00 12,000.00
Acceptances against Shipments 12,000.00 20,000.00
Analysis of account sales ledger debits, duty $875, freight $1,560, dock charges $70, custom house charges
$40.
Analysis by Comparison
12. The trading accounts of a company covering two years are herewith submitted.
Analyze the accounts and make a report to the company showing the reasons for the difference in results.
1916
Merchandise Inventory, January 1, 1916 $150,000.00
Merchandise Purchases 633,000.00
Merchandise Sales, Travelers 600,000.00
Merchandise Sales, Domestic 150,000.00
Merchandise Sales, Cash 10,000.00
Commissions Paid Travelers 30,000.00
Salaries Paid Travelers 30,000.00
Salaries, Domestic Sales 15,000.00
Rental 5,000.00
Stationery, etc. 3,000.00
Expense 22,000.00
Interest 4,000.00
Inventory, January 1, 1917 125,000.00
Page 594
1917
Merchandise Inventory, January 1, 1917 $125,000.00
Merchandise Purchases 600,000.00
Merchandise Sales, Travelers 600,000.00
Merchandise Sales, Domestic 150,000.00
Merchandise Sales, cash 10,000.00
Commissions Paid Travelers 30,000.00
Salaries Paid Travelers 10,000.00
Salaries, Domestic Sales 10,000.00
Rental 5,000.00
Stationery, etc. 3,000.00
Expense 15,000.00
Interest 1,000.00
Merchandise Inventory, January 1, 1918 125,000.00
13. A corporation’s balance sheets for August, 1918, and September, 1918, were respectively as follows:
August, 1918
Assets
Plant and Equipment $4,000,000.00
Furniture 6,000.00
Tools 3,000.00
Stable 3,811.28
Cash 15,250.36
Material Supplies 30,750.28
Accounts Receivable 28,920.13
Unexpired Insurance 510.29
Total $4,088,242.34
Liabilities
Capital Stock $2,500,000.00
Bonds 1,350,000.00
Accounts Payable 31,336.28
Bills Payable 26,240.12
Accrued Taxes 3,500.00
Accrued Interest 5,625.00
Profit and Loss 171,540.94
Total $4,088,242.34
September, 1918
Assets
Plant and Equipment $4,012,310.21
Furniture 6,205.58
Merchandise Inventory, January 1, 1917 $125,000.00
Merchandise Purchases 600,000.00
Merchandise Sales, Travelers 600,000.00
Merchandise Sales, Domestic 150,000.00
Merchandise Sales, cash 10,000.00
Commissions Paid Travelers 30,000.00
Salaries Paid Travelers 10,000.00
Salaries, Domestic Sales 10,000.00
Rental 5,000.00
Stationery, etc. 3,000.00
Expense 15,000.00
Interest 1,000.00
Merchandise Inventory, January 1, 1918 125,000.00
13. A corporation’s balance sheets for August, 1918, and September, 1918, were respectively as follows:
August, 1918
Assets
Plant and Equipment $4,000,000.00
Furniture 6,000.00
Tools 3,000.00
Stable 3,811.28
Cash 15,250.36
Material Supplies 30,750.28
Accounts Receivable 28,920.13
Unexpired Insurance 510.29
Total $4,088,242.34
Liabilities
Capital Stock $2,500,000.00
Bonds 1,350,000.00
Accounts Payable 31,336.28
Bills Payable 26,240.12
Accrued Taxes 3,500.00
Accrued Interest 5,625.00
Profit and Loss 171,540.94
Total $4,088,242.34
September, 1918
Assets
Plant and Equipment $4,012,310.21
Furniture 6,205.58
Page 595
Tools 3,218.86
Stable 4,009.37
Cash 8,328.29
Material Supplies 39,280.17
Accounts Receivable 32,321.83
Unexpired Insurance 832.12
Total $4,106,506.43
Liabilities
Capital Stock $2,500,000.00
Bonds 1 ,362,000.00
Accounts Payable 33,445.59
Bills Payable 18,240.12
Accrued Taxes 4,000.00
Accrued Interest 11,250.00
Profit and Loss 177,570.72
Total $4,106,506.43
Analyze the differences in the corresponding accounts for the period and show disposition of increased
resources.
14. The board of directors of the X, Y, Z Company removed their manager on April 30, 1918, on the general
suspicion that his books misrepresented the true financial condition of the business. Prepare a statement showing
the nature and the probable extent of the misrepresentation, also an approximate statement of income and profit
and loss for the four months ending April 30, 1918, and a balance sheet as of April 30, 1918.
The following is a trial balance taken from the books April 30, 1918:
Capital Stock $ 75,000.00
Fixtures $ 10,000.00
Inventory, January 1, 1918 128,600.00
Cash 15,450.00
Accounts Receivable 24,600.00
Accounts Payable 39,000.00
Loans Payable 10,000.00
Sales 51,000.00
Purchases 40,700.00
Salaries, Salesmen 2,200.00
Advertising 1,650.00
Salaries, Office 1,100.00
Rent 400.00
Interest 200.00
Insurance, January 1 to December 31, 1918 999.00
Stationery and Printing 105.00
Reserve for Depreciation of Fixtures 2,710.00
Surplus, January 1, 1918 48,294.00
$226,004.00 $226,004.00
Stable 4,009.37
Cash 8,328.29
Material Supplies 39,280.17
Accounts Receivable 32,321.83
Unexpired Insurance 832.12
Total $4,106,506.43
Liabilities
Capital Stock $2,500,000.00
Bonds 1 ,362,000.00
Accounts Payable 33,445.59
Bills Payable 18,240.12
Accrued Taxes 4,000.00
Accrued Interest 11,250.00
Profit and Loss 177,570.72
Total $4,106,506.43
Analyze the differences in the corresponding accounts for the period and show disposition of increased
resources.
14. The board of directors of the X, Y, Z Company removed their manager on April 30, 1918, on the general
suspicion that his books misrepresented the true financial condition of the business. Prepare a statement showing
the nature and the probable extent of the misrepresentation, also an approximate statement of income and profit
and loss for the four months ending April 30, 1918, and a balance sheet as of April 30, 1918.
The following is a trial balance taken from the books April 30, 1918:
Capital Stock $ 75,000.00
Fixtures $ 10,000.00
Inventory, January 1, 1918 128,600.00
Cash 15,450.00
Accounts Receivable 24,600.00
Accounts Payable 39,000.00
Loans Payable 10,000.00
Sales 51,000.00
Purchases 40,700.00
Salaries, Salesmen 2,200.00
Advertising 1,650.00
Salaries, Office 1,100.00
Rent 400.00
Interest 200.00
Insurance, January 1 to December 31, 1918 999.00
Stationery and Printing 105.00
Reserve for Depreciation of Fixtures 2,710.00
Surplus, January 1, 1918 48,294.00
$226,004.00 $226,004.00
Page 596
An analysis of the Purchases and Sales accounts revealed the following: purchases, year 1915, $122,000; sales,
year 1915, $153,750; inventory, January 1, 1915, $101,000; purchases, year 1916, $123,000; sales, year 1916,
$153,170; inventory, January 1, 1916, $100,000; purchases, year 1917, $121,000; sales, year 1917, $154,722;
inventory, January 1, 1917, $102,000.
15. Robert Adams and William Stevens are equal partners. On the night of July 3, their stock and fixtures were
destroyed by fire. A trial balance, which Adams had at his home, showed the following condition of the ledger at
the close of business, June 30:
Robert Adams $ 600.00 $ 7,450.00
William Stevens 600.00 7,450.00
Cash 3,309.00
Fixtures 1,500.00
Merchandise Purchases 32,600.00
Merchandise Sales 24,800.00
Notes Receivable 1,000.00
Notes Payable 2,000.00
Interest 120.00 50.00
Expense 780.00
Customers 4,500.00
Creditors 3,259.00
$45,009.00 $45,009.00
The property is fully covered by insurance. The insurance company, for the purpose of estimating the value of
the merchandise destroyed has agreed to allow 35% as the average gross gain on the sales, and to pay 66⅔% on the
value of the fixtures as shown by the ledger.
On the basis of this agreement, state the result of the business and the capital of each partner.
Statement of Affairs
16. C. C. Carter and A. D. Walker were unable to meet their obligations. From the books of the firm and
additional information you ascertained the following:
Real Estate (estimated to produce $18,000;
subject to a mortgage of $12,000) $20,000.00
Notes Receivable 6,000.00
Expense 7,820.00
Furniture and Fixtures (estimated to produce $2,700) 3,500.00
D. L. & W. Stock (estimated to produce $12,000
pledged with fully secured creditors) 14,000.00
Horse and Wagon (estimated to produce $500) 700.00
Other Securities
(pledged with partially secured creditors) 3,000.00
Accounts Receivable (good $3,000; doubtful $1,800,
but estimated to produce $1,440; bad $600) 5,400.00
Notes Payable 2,000.00
Creditors, Unsecured 18,000.00
Creditors, Partially Secured 8,000.00
Creditors, Fully Secured 10,000.00
year 1915, $153,750; inventory, January 1, 1915, $101,000; purchases, year 1916, $123,000; sales, year 1916,
$153,170; inventory, January 1, 1916, $100,000; purchases, year 1917, $121,000; sales, year 1917, $154,722;
inventory, January 1, 1917, $102,000.
15. Robert Adams and William Stevens are equal partners. On the night of July 3, their stock and fixtures were
destroyed by fire. A trial balance, which Adams had at his home, showed the following condition of the ledger at
the close of business, June 30:
Robert Adams $ 600.00 $ 7,450.00
William Stevens 600.00 7,450.00
Cash 3,309.00
Fixtures 1,500.00
Merchandise Purchases 32,600.00
Merchandise Sales 24,800.00
Notes Receivable 1,000.00
Notes Payable 2,000.00
Interest 120.00 50.00
Expense 780.00
Customers 4,500.00
Creditors 3,259.00
$45,009.00 $45,009.00
The property is fully covered by insurance. The insurance company, for the purpose of estimating the value of
the merchandise destroyed has agreed to allow 35% as the average gross gain on the sales, and to pay 66⅔% on the
value of the fixtures as shown by the ledger.
On the basis of this agreement, state the result of the business and the capital of each partner.
Statement of Affairs
16. C. C. Carter and A. D. Walker were unable to meet their obligations. From the books of the firm and
additional information you ascertained the following:
Real Estate (estimated to produce $18,000;
subject to a mortgage of $12,000) $20,000.00
Notes Receivable 6,000.00
Expense 7,820.00
Furniture and Fixtures (estimated to produce $2,700) 3,500.00
D. L. & W. Stock (estimated to produce $12,000
pledged with fully secured creditors) 14,000.00
Horse and Wagon (estimated to produce $500) 700.00
Other Securities
(pledged with partially secured creditors) 3,000.00
Accounts Receivable (good $3,000; doubtful $1,800,
but estimated to produce $1,440; bad $600) 5,400.00
Notes Payable 2,000.00
Creditors, Unsecured 18,000.00
Creditors, Partially Secured 8,000.00
Creditors, Fully Secured 10,000.00
Page 597
Wages, Salaries and Taxes, preferred by law 560.00
Carter, Capital 15,000.00
Walker, Capital 5,000.00
Carter, Drawings (debit) 3,050.00
Walker, Drawings (debit) 1,000.00
Cash 870.00
Sundry Losses 5,220.00
Prepare statement of affairs and deficiency account as of September 30, 1918.
17. On December 1, 1918, the following particulars are furnished of the position of John Mapleton, insolvent:
factory equipment cost $15,000, estimated to realize $10,000; stock of finished goods $10,000, estimated worth
$7,500; material and supplies $2,500, estimated worth $1,000; furniture and fixtures $900, estimated worth $200;
investments valued at $25,275, of which $15,000 is held by bankers as security for loan of $12,000; accounts
receivable $6,250, of which $2,500 are good, $1,250 bad, and $2,500 estimated to realize $1,500; cash $575, of
which $25 represents petty expense items not charged up, and $50 an I O U of a former employee which is
worthless; accounts payable $28,500; bills payable $25,000, of which $12,000 is due bankers; wages due $500;
rent due and past due $1,000; capital on January 1, 1918, as shown by the books, $15,000; loss by sale of
investment May 1, 1918, $5,000; loss in trading account January 1, 1918, to December 1, 1918, $3,500; drawings
charged personal account of John Mapleton $1,000.
Make up a statement of affairs and a deficiency account as on December 1, 1918.
18. John Thompson exhibits the following balance sheet of his business dated June 30, 1918:
Cash $ 750 Sundry creditors $6,000
Book debts 9,500 Bills Payable 7,500
Stock on hand 6,500 Bank (overdraft) 3,000
Fixtures, etc. 1,750 Balance 2,000
Total $18,500 Total $18,500
On questioning Thompson it was found that he had omitted the following from his balance sheet: $250 owing
for rent; $75 owing for taxes; $2,500 borrowed at 5% from his wife three years ago, no payment having been made
on account of either principal or interest; a draft for $500 accepted by a firm without consideration, falling due in
30 days. His private and household debts amounted to $600.
The item entered on his balance sheet as cash included his personal I O U’s for $600.
Of the book debts about $3,500 might be considered bad and the rest good. The stock was good except $1,000,
which would not produce more than $100. The fixtures, if sold, would not realize more than $250. The only other
assets were household furniture worth about $1,250 and residence valued at $7,500, subject to a first mortgage for
$5,000 at 4%, and also a second mortgage held by his bank as security for overdraft.
Prepare a statement of affairs and deficiency account.
19. June 30, 1918, as a result of careless management, the firm of Howard, Mason & Co. finds itself in a
critical financial condition.
The following trial balance shows the accounts as they appear on the books after closing the ledger.
Post-Closing Trial Balance, June 30, 1918
Land $ 10,000.00
Buildings 42,000.00
Reserve for Depreciation, Buildings $ 6,000.00
Delivery Equipment 7,000.00
Reserve for Depreciation, Equipment 1,500.00
Carter, Capital 15,000.00
Walker, Capital 5,000.00
Carter, Drawings (debit) 3,050.00
Walker, Drawings (debit) 1,000.00
Cash 870.00
Sundry Losses 5,220.00
Prepare statement of affairs and deficiency account as of September 30, 1918.
17. On December 1, 1918, the following particulars are furnished of the position of John Mapleton, insolvent:
factory equipment cost $15,000, estimated to realize $10,000; stock of finished goods $10,000, estimated worth
$7,500; material and supplies $2,500, estimated worth $1,000; furniture and fixtures $900, estimated worth $200;
investments valued at $25,275, of which $15,000 is held by bankers as security for loan of $12,000; accounts
receivable $6,250, of which $2,500 are good, $1,250 bad, and $2,500 estimated to realize $1,500; cash $575, of
which $25 represents petty expense items not charged up, and $50 an I O U of a former employee which is
worthless; accounts payable $28,500; bills payable $25,000, of which $12,000 is due bankers; wages due $500;
rent due and past due $1,000; capital on January 1, 1918, as shown by the books, $15,000; loss by sale of
investment May 1, 1918, $5,000; loss in trading account January 1, 1918, to December 1, 1918, $3,500; drawings
charged personal account of John Mapleton $1,000.
Make up a statement of affairs and a deficiency account as on December 1, 1918.
18. John Thompson exhibits the following balance sheet of his business dated June 30, 1918:
Cash $ 750 Sundry creditors $6,000
Book debts 9,500 Bills Payable 7,500
Stock on hand 6,500 Bank (overdraft) 3,000
Fixtures, etc. 1,750 Balance 2,000
Total $18,500 Total $18,500
On questioning Thompson it was found that he had omitted the following from his balance sheet: $250 owing
for rent; $75 owing for taxes; $2,500 borrowed at 5% from his wife three years ago, no payment having been made
on account of either principal or interest; a draft for $500 accepted by a firm without consideration, falling due in
30 days. His private and household debts amounted to $600.
The item entered on his balance sheet as cash included his personal I O U’s for $600.
Of the book debts about $3,500 might be considered bad and the rest good. The stock was good except $1,000,
which would not produce more than $100. The fixtures, if sold, would not realize more than $250. The only other
assets were household furniture worth about $1,250 and residence valued at $7,500, subject to a first mortgage for
$5,000 at 4%, and also a second mortgage held by his bank as security for overdraft.
Prepare a statement of affairs and deficiency account.
19. June 30, 1918, as a result of careless management, the firm of Howard, Mason & Co. finds itself in a
critical financial condition.
The following trial balance shows the accounts as they appear on the books after closing the ledger.
Post-Closing Trial Balance, June 30, 1918
Land $ 10,000.00
Buildings 42,000.00
Reserve for Depreciation, Buildings $ 6,000.00
Delivery Equipment 7,000.00
Reserve for Depreciation, Equipment 1,500.00
Page 598
Furniture and Fixtures 4,200.00
Good-Will 5,000.00
Cash 2,316.00
F. D. Co. Stock 4,000.00
Accounts Receivable 16,000.00
Reserve for Bad Debts 1,996.00
Notes Receivable 9,400.00
Notes Receivable Discounted 3,800.00
Merchandise Inventory, Bags, June 30, 1918. 4,780.00
Merchandise Inventory, Trunks, June 30, 1918 8,910.00
Mortgage Payable 25,000.00
Accounts Payable 21,000.00
Notes Payable 12,000.00
Thomas J. Howard, Loan 6,000.00
Thomas J. Howard, Capital 15,000.00
Thomas J. Howard, Drawing 1,700.00
Joseph Mason, Loan 4,000.00
Joseph Mason, Capital 9,000.00
Joseph Mason, Drawing 1,000.00
John H. Bartlett, Loan 3,000.00
John H. Bartlett, Capital 6,000.00
Accrued Interest, Mortgage 1,500.00
Accrued Interest, Notes Payable 300.00
Accrued Interest, Notes Receivable 150.00
Prepaid Insurance 60.00
Taxes Accrued 300.00
Accrued Labor 200.00
Miscellaneous Office Supplies 80.00
$116,596.00 $116,596.00
There is dissatisfaction among the partners and they finally agree to dissolve partnership. Preparatory to
dissolving they appraise the assets and rank the liabilities on a liquidating basis.
It has been found that the buildings had been damaged by fire to the extent of $3,000 but that no adjustment
had been made in the buildings account. The delivery equipment is estimated to produce $4,800. Furniture and
fixtures have a value of $3,600. The land has increased in value $6,000.
Of the notes payable, $5,000 has been partially secured by all the F. D. Co. Stock, which is expected to yield
80% of its book value. Collateral in the form of good notes receivable of $4,500 has been given to creditors whose
claims amount to $3,700.
Among the cash there are I O U’s in the amount of $180 that cannot be considered as worth more than $50.
The accounts receivable are classified as worthless $3,000; doubtful $2,000, which are expected to produce
$1,400; the balance are good. Both inventories of merchandise were reduced by 10%.
The accrued taxes and labor are claims preferred by law. Prepaid insurance, miscellaneous office supplies, and
good-will were assumed to have no value in case of liquidation.
From the information at hand:
(a) Prepare a statement of affairs showing the financial condition of the
partnership in anticipation of liquidation.
Good-Will 5,000.00
Cash 2,316.00
F. D. Co. Stock 4,000.00
Accounts Receivable 16,000.00
Reserve for Bad Debts 1,996.00
Notes Receivable 9,400.00
Notes Receivable Discounted 3,800.00
Merchandise Inventory, Bags, June 30, 1918. 4,780.00
Merchandise Inventory, Trunks, June 30, 1918 8,910.00
Mortgage Payable 25,000.00
Accounts Payable 21,000.00
Notes Payable 12,000.00
Thomas J. Howard, Loan 6,000.00
Thomas J. Howard, Capital 15,000.00
Thomas J. Howard, Drawing 1,700.00
Joseph Mason, Loan 4,000.00
Joseph Mason, Capital 9,000.00
Joseph Mason, Drawing 1,000.00
John H. Bartlett, Loan 3,000.00
John H. Bartlett, Capital 6,000.00
Accrued Interest, Mortgage 1,500.00
Accrued Interest, Notes Payable 300.00
Accrued Interest, Notes Receivable 150.00
Prepaid Insurance 60.00
Taxes Accrued 300.00
Accrued Labor 200.00
Miscellaneous Office Supplies 80.00
$116,596.00 $116,596.00
There is dissatisfaction among the partners and they finally agree to dissolve partnership. Preparatory to
dissolving they appraise the assets and rank the liabilities on a liquidating basis.
It has been found that the buildings had been damaged by fire to the extent of $3,000 but that no adjustment
had been made in the buildings account. The delivery equipment is estimated to produce $4,800. Furniture and
fixtures have a value of $3,600. The land has increased in value $6,000.
Of the notes payable, $5,000 has been partially secured by all the F. D. Co. Stock, which is expected to yield
80% of its book value. Collateral in the form of good notes receivable of $4,500 has been given to creditors whose
claims amount to $3,700.
Among the cash there are I O U’s in the amount of $180 that cannot be considered as worth more than $50.
The accounts receivable are classified as worthless $3,000; doubtful $2,000, which are expected to produce
$1,400; the balance are good. Both inventories of merchandise were reduced by 10%.
The accrued taxes and labor are claims preferred by law. Prepaid insurance, miscellaneous office supplies, and
good-will were assumed to have no value in case of liquidation.
From the information at hand:
(a) Prepare a statement of affairs showing the financial condition of the
partnership in anticipation of liquidation.
Page 599
(b) Prepare a statement accounting for the impairment of capital.
Realization and Liquidation
20. It has been mutually agreed that Joseph Mason shall act as liquidating partner with full authority to sell all
property, pay all debts and distribute liquidating dividends among the partners. Mason’s fee as liquidator shall be
5% commission on the converted value of all the assets and is to be paid at each dividend date.
Interest is to be allowed on the loan accounts, and profits and losses are to be shared ½ by Howe, and ¼ each
by Mason and Bartlett, during the period of liquidation.
Settlements are to be made on the last day of each month.
Based on the post-closing trial balance in the preceding problem and the information given below:
(a) Prepare a working sheet which will present the information in convenient form
for preparing the statements incidental to liquidation.
(b) Show the partners’ loan accounts properly closed for each period.
(c) Set up the partners’ capital accounts, and balance them after the payment of
each liquidating dividend.
During the month ended July 31, 1918, delivery equipment having a book value of $3,300 was sold for $3,000
in cash; accounts receivable in the amount of $4,000 were collected and $980 in bad debts were charged off. A sale
of the land and buildings granted the use of the premises during the liquidation. The land was sold for $17,000 and
the buildings for $31,500, the mortgage (with accrued interest to July 3) being assumed by the purchaser as part
payment. The partially secured creditors accepted the F. D. Co. Stock held as collateral at 90% of its book value
and the balance of their claim was paid in cash. Incidental expenses of $350 and the liquidating fees were paid in
cash. From the goods in the inventories there were sold bags of a book value of $1,200 for $1,120, and trunks,
book value $2,530, for $2,280. There was paid to holders of unsecured notes payable $2,000 and interest of $100.
The accrued labor was paid and $10,000 in unsecured accounts payable were settled. The balance of the cash was
applied in paying off partners’ loans and capital as a liquidating dividend.
The next month the delivery equipment was sold for $1,850. Furniture and fixtures having a book value of
$2,100 were sold for $1,700. Of the I O U’s $70 was collected; the balance proved worthless. The notes receivable
as collateral in the hands of fully secured creditors were settled in full and our equity was paid to us in cash, also
accrued interest of $120. Bags having a book value of $2,500 were sold for $2,100, and trunks at book $3,700
brought $3,200. Mason accepted $4,200 in settlement of $5,000 in accounts receivable.
Legal fees of $150; sundry expenses of $460; all the existing debts and the liquidating fees were paid in cash.
The cash remaining was distributed as a liquidating dividend.
In the course of the last month the remaining furniture and fixtures were sold for $1,900. The good-will went to
the same purchaser for $1,000 additional.
The prepaid insurance is without value. Office supplies yielded $20. The notes receivable, together with the
balance of accrued interest were collected in full. There was lost in bad debts $740. The bags were sold at a 10%
reduction. The partners divided the trunks among themselves one-third to each, taking them at book value.
Sundry expenses of $340 and the liquidating fees were paid in cash, after which the cash on hand was
distributed.
Note: Converted value means the value at which any asset is disposed of, whether for cash or in the
cancellation of any claim.
21. Show on the books of the firm of Howard, Mason & Co. all the entries necessary to carry into effect the
liquidation of the business under the conditions set forth in the foregoing problem.
22. The firm of Norton & Brown decided to liquidate at a time when their condition, as shown by the balance
sheet given below, was still solvent.
Balance Sheet, March 31, 1918
Realization and Liquidation
20. It has been mutually agreed that Joseph Mason shall act as liquidating partner with full authority to sell all
property, pay all debts and distribute liquidating dividends among the partners. Mason’s fee as liquidator shall be
5% commission on the converted value of all the assets and is to be paid at each dividend date.
Interest is to be allowed on the loan accounts, and profits and losses are to be shared ½ by Howe, and ¼ each
by Mason and Bartlett, during the period of liquidation.
Settlements are to be made on the last day of each month.
Based on the post-closing trial balance in the preceding problem and the information given below:
(a) Prepare a working sheet which will present the information in convenient form
for preparing the statements incidental to liquidation.
(b) Show the partners’ loan accounts properly closed for each period.
(c) Set up the partners’ capital accounts, and balance them after the payment of
each liquidating dividend.
During the month ended July 31, 1918, delivery equipment having a book value of $3,300 was sold for $3,000
in cash; accounts receivable in the amount of $4,000 were collected and $980 in bad debts were charged off. A sale
of the land and buildings granted the use of the premises during the liquidation. The land was sold for $17,000 and
the buildings for $31,500, the mortgage (with accrued interest to July 3) being assumed by the purchaser as part
payment. The partially secured creditors accepted the F. D. Co. Stock held as collateral at 90% of its book value
and the balance of their claim was paid in cash. Incidental expenses of $350 and the liquidating fees were paid in
cash. From the goods in the inventories there were sold bags of a book value of $1,200 for $1,120, and trunks,
book value $2,530, for $2,280. There was paid to holders of unsecured notes payable $2,000 and interest of $100.
The accrued labor was paid and $10,000 in unsecured accounts payable were settled. The balance of the cash was
applied in paying off partners’ loans and capital as a liquidating dividend.
The next month the delivery equipment was sold for $1,850. Furniture and fixtures having a book value of
$2,100 were sold for $1,700. Of the I O U’s $70 was collected; the balance proved worthless. The notes receivable
as collateral in the hands of fully secured creditors were settled in full and our equity was paid to us in cash, also
accrued interest of $120. Bags having a book value of $2,500 were sold for $2,100, and trunks at book $3,700
brought $3,200. Mason accepted $4,200 in settlement of $5,000 in accounts receivable.
Legal fees of $150; sundry expenses of $460; all the existing debts and the liquidating fees were paid in cash.
The cash remaining was distributed as a liquidating dividend.
In the course of the last month the remaining furniture and fixtures were sold for $1,900. The good-will went to
the same purchaser for $1,000 additional.
The prepaid insurance is without value. Office supplies yielded $20. The notes receivable, together with the
balance of accrued interest were collected in full. There was lost in bad debts $740. The bags were sold at a 10%
reduction. The partners divided the trunks among themselves one-third to each, taking them at book value.
Sundry expenses of $340 and the liquidating fees were paid in cash, after which the cash on hand was
distributed.
Note: Converted value means the value at which any asset is disposed of, whether for cash or in the
cancellation of any claim.
21. Show on the books of the firm of Howard, Mason & Co. all the entries necessary to carry into effect the
liquidation of the business under the conditions set forth in the foregoing problem.
22. The firm of Norton & Brown decided to liquidate at a time when their condition, as shown by the balance
sheet given below, was still solvent.
Balance Sheet, March 31, 1918
Page 600
Assets Liabilities
Plant and Equipment $20,000.00 Notes Payable $ 6,000.00
Office Furniture 2,000.00 Accounts Payable 17,000.00
Inventory, Material 12,000.00 Norton, Loans 5,000.00
Notes Receivable 5,000.00 Brown, Loans 3,000.00
Cash 3,000.00 Brown, Capital 15,000.00
$71,000.00 $71,000.00
Profits and losses were shared three-fourths by Norton and one-fourth by Brown. Interest was allowed on the
loan accounts but not on the capital accounts. At the end of the first month, April 30, it was found that material
inventoried at $5,000 had produced $3,600; accounts receivable to the amount of $15,000 had been collected in
cash and $2,800 in bad debts charged off; notes receivable collected in cash $2,000; expenses of $600 had been
paid in cash; equipment valued at $4,000 produced $3,000. Interest on partner’s loan accounts was not entered this
month.
During the month ended May 31, office furniture valued at $1,600 was sold for $1,000. Material costing
$4,000 produced $3,200 and the balance of material was divided equally between the partners at cost. Plant
equipment listed at $6,000 was sold for $6,200. A $200 note proved worthless and was charged off. Accounts
receivable to the amount of $6,065 and notes receivable of $2,000 were collected in cash. Bad debts charged off
$435. Expenses paid in cash $300. Interest was credited on Norton’s loan account $40 and Brown’s loan account
$25.
Arrange your solution to show:
(a) Your method of obtaining the proper cash distribution.
(b) A statement showing each partner’s capital and loan at the end of each month,
or a detailed capital and loan account for each partner with a balance entered in
each account each month.
(c) A balance sheet at the close of the second month.
23. Walter Hopkins, while perfectly solvent and doing a profitable manufacturing business, had so tied up his
capital in plant and materials that he was on the point of suspending for want of funds to pay for labor, and his
creditors were preparing to commence legal proceedings to enforce a settlement. The condition of his affairs at this
time was as follows:
Balance Sheet
Assets Liabilities
Plant $25,198.00 Creditors $20,230.00
Cash 212.00 Capital 50,000.00
Materials, Raw and Surplus 4,900.00
Partly Finished 40,400.00
Finished Goods 6,070.00
Accounts Receivable 3,250.00
$75,130.00 $75,130.00
At a meeting of creditors he said that while his plant was entirely efficient, it was all of special character and
would realize on forced sale only the value of scrap, that the unfinished goods would require the employment of
Plant and Equipment $20,000.00 Notes Payable $ 6,000.00
Office Furniture 2,000.00 Accounts Payable 17,000.00
Inventory, Material 12,000.00 Norton, Loans 5,000.00
Notes Receivable 5,000.00 Brown, Loans 3,000.00
Cash 3,000.00 Brown, Capital 15,000.00
$71,000.00 $71,000.00
Profits and losses were shared three-fourths by Norton and one-fourth by Brown. Interest was allowed on the
loan accounts but not on the capital accounts. At the end of the first month, April 30, it was found that material
inventoried at $5,000 had produced $3,600; accounts receivable to the amount of $15,000 had been collected in
cash and $2,800 in bad debts charged off; notes receivable collected in cash $2,000; expenses of $600 had been
paid in cash; equipment valued at $4,000 produced $3,000. Interest on partner’s loan accounts was not entered this
month.
During the month ended May 31, office furniture valued at $1,600 was sold for $1,000. Material costing
$4,000 produced $3,200 and the balance of material was divided equally between the partners at cost. Plant
equipment listed at $6,000 was sold for $6,200. A $200 note proved worthless and was charged off. Accounts
receivable to the amount of $6,065 and notes receivable of $2,000 were collected in cash. Bad debts charged off
$435. Expenses paid in cash $300. Interest was credited on Norton’s loan account $40 and Brown’s loan account
$25.
Arrange your solution to show:
(a) Your method of obtaining the proper cash distribution.
(b) A statement showing each partner’s capital and loan at the end of each month,
or a detailed capital and loan account for each partner with a balance entered in
each account each month.
(c) A balance sheet at the close of the second month.
23. Walter Hopkins, while perfectly solvent and doing a profitable manufacturing business, had so tied up his
capital in plant and materials that he was on the point of suspending for want of funds to pay for labor, and his
creditors were preparing to commence legal proceedings to enforce a settlement. The condition of his affairs at this
time was as follows:
Balance Sheet
Assets Liabilities
Plant $25,198.00 Creditors $20,230.00
Cash 212.00 Capital 50,000.00
Materials, Raw and Surplus 4,900.00
Partly Finished 40,400.00
Finished Goods 6,070.00
Accounts Receivable 3,250.00
$75,130.00 $75,130.00
At a meeting of creditors he said that while his plant was entirely efficient, it was all of special character and
would realize on forced sale only the value of scrap, that the unfinished goods would require the employment of
Page 601
skill and processes known to him only, and that while forced suspension would yield to his creditors not over 50%,
it would ruin him absolutely.
The creditors decided to advance him a loan of $5,000 to continue operations and allow him additional credit
for materials and expenses. A trustee was appointed to see that the proceeds were used solely for recuperation of
the business.
The subsequent operations under the supervision of the trustee were as follows:
Purchases on book account, charged to materials $5,100, to expense $12,100; sales on book account $57,802;
losses on bad debts $300; cash receipts (loan from creditors) $5,000; settlement from debtors $58,100; cash
payments for labor $12,500, for expense $4,350; for plant $600; creditors $42,030; Walter Hopkins’ personal
drawings $3,000.
There remained raw materials $4,000, finished goods $22,388.
Prepare:
(a) Realization and liquidation account.
(b) Trustee’s cash account.
(c) Balance sheet of the estate as restored to Walter Hopkins.
24. X, Y, and Z, foundrymen, unable to meet their obligations, suspended payment January 1, 1918, and
appointed a trustee to realize and liquidate for the benefit of their creditors. The books showed the following assets
and liabilities:
Assets
Land and Buildings $125,000.00
Machinery and Tools 75,000.00
Furniture and Fixtures 10,000.00
Materials and Supplies 95,000.00
Bills Receivable 15,000.00
Accounts Receivable 115,000.00
Cash 450.00
Total Assets $435,450.00
Liabilities
Mortgage on Foundry Premises $100,000.00
Bills Payable 135,000.00
Accounts Payable 105,000.00
Interest Accrued on Mortgage 1,250.00
Taxes Accrued (estimated) 835.00
Capital 93,365.00
Total Liabilities $435,450.00
The trustee’s cash receipts and payments during the year 1918 were as follows:
Receipts
Bills Receivable (outstanding January 1, 1918) $ 15,000.00
Accounts Receivable (outstanding January 1, 1918) 106,500.00
Cash Sales 5,435.00
Bills Receivable (contracted during year 1918) 13,500.00
Accounts Receivable (contracted during year 1918) 212,000.00
it would ruin him absolutely.
The creditors decided to advance him a loan of $5,000 to continue operations and allow him additional credit
for materials and expenses. A trustee was appointed to see that the proceeds were used solely for recuperation of
the business.
The subsequent operations under the supervision of the trustee were as follows:
Purchases on book account, charged to materials $5,100, to expense $12,100; sales on book account $57,802;
losses on bad debts $300; cash receipts (loan from creditors) $5,000; settlement from debtors $58,100; cash
payments for labor $12,500, for expense $4,350; for plant $600; creditors $42,030; Walter Hopkins’ personal
drawings $3,000.
There remained raw materials $4,000, finished goods $22,388.
Prepare:
(a) Realization and liquidation account.
(b) Trustee’s cash account.
(c) Balance sheet of the estate as restored to Walter Hopkins.
24. X, Y, and Z, foundrymen, unable to meet their obligations, suspended payment January 1, 1918, and
appointed a trustee to realize and liquidate for the benefit of their creditors. The books showed the following assets
and liabilities:
Assets
Land and Buildings $125,000.00
Machinery and Tools 75,000.00
Furniture and Fixtures 10,000.00
Materials and Supplies 95,000.00
Bills Receivable 15,000.00
Accounts Receivable 115,000.00
Cash 450.00
Total Assets $435,450.00
Liabilities
Mortgage on Foundry Premises $100,000.00
Bills Payable 135,000.00
Accounts Payable 105,000.00
Interest Accrued on Mortgage 1,250.00
Taxes Accrued (estimated) 835.00
Capital 93,365.00
Total Liabilities $435,450.00
The trustee’s cash receipts and payments during the year 1918 were as follows:
Receipts
Bills Receivable (outstanding January 1, 1918) $ 15,000.00
Accounts Receivable (outstanding January 1, 1918) 106,500.00
Cash Sales 5,435.00
Bills Receivable (contracted during year 1918) 13,500.00
Accounts Receivable (contracted during year 1918) 212,000.00
Page 602
Total Receipts $352,435.00
Payments
Bills Payable $ 25,000.00
Accounts Payable 35,000.00
Interest on Mortgage (one year at 5%) 5,000.00
Taxes for the year 1917 865.00
Purchases of Materials and Supplies 98,000.00
Labor 135,000.00
General Expenses 45,000.00
Interest on Bills Payable (to September 30, 1918, at 5%) 2,800.00
Total Payments $346,665.00
Other transactions were as follows:
Sales on Credit $335,000.00
Bad Debts Written Off:
Accounts prior to January 1, 1918 $8,000.00
Accounts subsequent to January 1, 1918 2,000.00 10,000.00
Discounts and Allowances to Customers:
Accounts prior to January 1, 1918 $500.00
Accounts subsequent to January 1, 1918 300.00 800.00
Notes Received from Customers 20,000.00
Notes Given to Creditors ($110,000 being renewals) 180,000.00
Inventory of Materials and Supplies,
December 31, 1918, amounted to 92,000.00
The trust terminated at the end of the year and the business was turned back to the owners.
Prepare realization and liquidation account; also a balance sheet showing the financial condition of the
business at the termination of the trust. Accrued taxes for the year in the usual manner, i.e., on the basis of the
charge for previous year.
Branches
25. The trial balance of Jones & Smith, Chicago branch, shows December 31, 1918, the following:
Home Office $2,000.00
Due from Customers $2,500.00
Cash on Hand 1,000.00
Expenses 1,900.00
Merchandise 3,400.00
$5,400.00 $5,400.00
Inventory $1,000.
Draft the necessary journal entries to close the accounts on the branch books, and the entries to be made in the
home office to make the books agree.
26. A branch office business was started at the first of the year, the head office advancing $5,000 cash. During
the first year merchandise was shipped to branch, invoiced at $75,000.
Payments
Bills Payable $ 25,000.00
Accounts Payable 35,000.00
Interest on Mortgage (one year at 5%) 5,000.00
Taxes for the year 1917 865.00
Purchases of Materials and Supplies 98,000.00
Labor 135,000.00
General Expenses 45,000.00
Interest on Bills Payable (to September 30, 1918, at 5%) 2,800.00
Total Payments $346,665.00
Other transactions were as follows:
Sales on Credit $335,000.00
Bad Debts Written Off:
Accounts prior to January 1, 1918 $8,000.00
Accounts subsequent to January 1, 1918 2,000.00 10,000.00
Discounts and Allowances to Customers:
Accounts prior to January 1, 1918 $500.00
Accounts subsequent to January 1, 1918 300.00 800.00
Notes Received from Customers 20,000.00
Notes Given to Creditors ($110,000 being renewals) 180,000.00
Inventory of Materials and Supplies,
December 31, 1918, amounted to 92,000.00
The trust terminated at the end of the year and the business was turned back to the owners.
Prepare realization and liquidation account; also a balance sheet showing the financial condition of the
business at the termination of the trust. Accrued taxes for the year in the usual manner, i.e., on the basis of the
charge for previous year.
Branches
25. The trial balance of Jones & Smith, Chicago branch, shows December 31, 1918, the following:
Home Office $2,000.00
Due from Customers $2,500.00
Cash on Hand 1,000.00
Expenses 1,900.00
Merchandise 3,400.00
$5,400.00 $5,400.00
Inventory $1,000.
Draft the necessary journal entries to close the accounts on the branch books, and the entries to be made in the
home office to make the books agree.
26. A branch office business was started at the first of the year, the head office advancing $5,000 cash. During
the first year merchandise was shipped to branch, invoiced at $75,000.
Page 603
An auditor checking up the business at the close of the year finds the following: Merchandise sales were
$60,000, with selling price of goods 20% advance on invoice. Proper vouchers were on file duly receipted for
following payments: rebates and allowances on damaged goods $1,500; salaries and other expenses $4,500;
freights $2,500.
The books also showed: remittances to head office $35,000; uncollected accounts $15,000. The balance of the
sales having been realized in cash, less rebates and allowances as noted.
The cash on hand and inventory of unsold goods, together with the foregoing records, properly accounts for
everything.
Prepare statement, such as an auditor would make in reporting to the head office, balancing the business of the
branch house.
27. The condition of the Atlantic Co. at the close of business December 31, 1918, is reported by them as
follows:
Assets Liabilities
Real Estate $150,000.00 Capital Stock $500,000.00
Machinery 200,000.00 Mortgage on Real Estate 100,000.00
Cash 24,500.40 Accounts Payable 67,000.00
Accounts Receivable 320,800.50 Notes Payable 100,000.00
Merchandise 375,480.70
Surplus 200,000.00
Profit and Loss 103,781.60
$1,070,781.60 $1,070,781.60
The company has a branch to which it sells its goods at 20% over inventory prices and carries this account,
together with other branch assets, as a receivable. The statement of the branch on the same date was:
Assets Liabilities
Fixtures $6,205.79 Atlantic Co.$25,033.43
Cash 1,107.55
Accounts Receivable 12,478.14
Merchandise at price billed to Branch 5,241.95
$25,033.43 $25,033.43
(a) What was the inventoried value of the branch merchandise?
(b) Prepare a corrected statement of the Atlantic Co.
Sinking Fund
28. A corporation issues 10-year bonds to the amount of $50,000, securing same by a mortgage on its property,
which is placed in the hands of a trust company.
The trust deed provides for the establishment of a sinking fund to retire the bonds at maturity and that equal
annual payments be made on the first of January in each year. Give the amount of this annual payment, interest
compounded at 6%.
29. The United Manufacturing Co., on January 1, 1918, placed in service a piece of machinery which would
depreciate, according to its chief engineer, at the rate of 15% per annum. The original cost of this machinery was
$60,000, with selling price of goods 20% advance on invoice. Proper vouchers were on file duly receipted for
following payments: rebates and allowances on damaged goods $1,500; salaries and other expenses $4,500;
freights $2,500.
The books also showed: remittances to head office $35,000; uncollected accounts $15,000. The balance of the
sales having been realized in cash, less rebates and allowances as noted.
The cash on hand and inventory of unsold goods, together with the foregoing records, properly accounts for
everything.
Prepare statement, such as an auditor would make in reporting to the head office, balancing the business of the
branch house.
27. The condition of the Atlantic Co. at the close of business December 31, 1918, is reported by them as
follows:
Assets Liabilities
Real Estate $150,000.00 Capital Stock $500,000.00
Machinery 200,000.00 Mortgage on Real Estate 100,000.00
Cash 24,500.40 Accounts Payable 67,000.00
Accounts Receivable 320,800.50 Notes Payable 100,000.00
Merchandise 375,480.70
Surplus 200,000.00
Profit and Loss 103,781.60
$1,070,781.60 $1,070,781.60
The company has a branch to which it sells its goods at 20% over inventory prices and carries this account,
together with other branch assets, as a receivable. The statement of the branch on the same date was:
Assets Liabilities
Fixtures $6,205.79 Atlantic Co.$25,033.43
Cash 1,107.55
Accounts Receivable 12,478.14
Merchandise at price billed to Branch 5,241.95
$25,033.43 $25,033.43
(a) What was the inventoried value of the branch merchandise?
(b) Prepare a corrected statement of the Atlantic Co.
Sinking Fund
28. A corporation issues 10-year bonds to the amount of $50,000, securing same by a mortgage on its property,
which is placed in the hands of a trust company.
The trust deed provides for the establishment of a sinking fund to retire the bonds at maturity and that equal
annual payments be made on the first of January in each year. Give the amount of this annual payment, interest
compounded at 6%.
29. The United Manufacturing Co., on January 1, 1918, placed in service a piece of machinery which would
depreciate, according to its chief engineer, at the rate of 15% per annum. The original cost of this machinery was
Page 604
$84,000 and the board of directors agreed to set aside annually a sinking fund which, together with interest
thereon, will amount to the original cost at the end of the prospective life of the machinery.
This sinking fund is to be deposited with a trust company on December 31 of each year, and a proportionate
amount at the end of the last partial year of the life of the machine. Interest is to be credited by the trust company
at each of these dates at the rate of 4% per annum.
Show how the amount of the annual sinking fund payments may be arrived at, and prepare a detailed statement
for the board of directors proving that the amount so obtained is correct.
Consolidations, Mergers,
and Reorganizations
30. Three manufacturers, each having an independent business and wishing to effect a consolidation of their
respective interests, organize the United States Manufacturing Corporation, with an authorized capital stock of
$1,500,000, consisting of 7,500 shares of preferred stock and 7,500 shares of common stock, of $100 each. They
sell to the new company all of their real estate, buildings, machinery, tools, fixtures, merchandise, and supplies, in
consideration of $1,500,000, and agree to accept in payment $750,000 of preferred and $750,000 of common stock
of the United States Manufacturing Corporation at par. The vendors donate to the treasury of the company
$150,000 of preferred stock and $150,000 of common stock to provide for working capital. The company sells
$100,000 of its preferred stock in the treasury for 80% cash, giving a bonus to the purchaser of 20% in common
stock.
For the purpose of raising additional funds for improvements and additions to plants, the company mortgages
its real estate and buildings, as security for an issue of bonds amounting to $250,000. These bonds the company
sells to bankers at 90%, giving as a bonus 10% of preferred stock and 20% of common stock.
Draft entries to express correctly the above transaction on the books of the corporation, and prepare a statement
of assets and liabilities of the company.
31. It is proposed to organize a corporation for the purpose of acquiring the stock and controlling three existing
corporations, A, B, and C, two of which latter, A and B, have been in operation for five and three years,
respectively, while C has been newly organized. The assets and liabilities of the several existing companies and the
dividends paid are as follows:
Assets
A B C
Plant $400,000.00 $300,000.00
Material 295,000.00 425,000.00
Cash 40,000.00 15,000.00 $500,000.00
$735,000.00 $740,000.00 $500,000.00
Liabilities
A B C
Capital $100,000.00 $300,000.00 $500,000.00
Surplus 60,000.00 40,000.00
6% Bond at 5 years 500,000.00 300,000.00
Current Liabilities 75,000.00 100,000.00
$735,000.00 $740,000.00 $500,000.00
Dividends Paid
$120,000.00 $30,000.00
thereon, will amount to the original cost at the end of the prospective life of the machinery.
This sinking fund is to be deposited with a trust company on December 31 of each year, and a proportionate
amount at the end of the last partial year of the life of the machine. Interest is to be credited by the trust company
at each of these dates at the rate of 4% per annum.
Show how the amount of the annual sinking fund payments may be arrived at, and prepare a detailed statement
for the board of directors proving that the amount so obtained is correct.
Consolidations, Mergers,
and Reorganizations
30. Three manufacturers, each having an independent business and wishing to effect a consolidation of their
respective interests, organize the United States Manufacturing Corporation, with an authorized capital stock of
$1,500,000, consisting of 7,500 shares of preferred stock and 7,500 shares of common stock, of $100 each. They
sell to the new company all of their real estate, buildings, machinery, tools, fixtures, merchandise, and supplies, in
consideration of $1,500,000, and agree to accept in payment $750,000 of preferred and $750,000 of common stock
of the United States Manufacturing Corporation at par. The vendors donate to the treasury of the company
$150,000 of preferred stock and $150,000 of common stock to provide for working capital. The company sells
$100,000 of its preferred stock in the treasury for 80% cash, giving a bonus to the purchaser of 20% in common
stock.
For the purpose of raising additional funds for improvements and additions to plants, the company mortgages
its real estate and buildings, as security for an issue of bonds amounting to $250,000. These bonds the company
sells to bankers at 90%, giving as a bonus 10% of preferred stock and 20% of common stock.
Draft entries to express correctly the above transaction on the books of the corporation, and prepare a statement
of assets and liabilities of the company.
31. It is proposed to organize a corporation for the purpose of acquiring the stock and controlling three existing
corporations, A, B, and C, two of which latter, A and B, have been in operation for five and three years,
respectively, while C has been newly organized. The assets and liabilities of the several existing companies and the
dividends paid are as follows:
Assets
A B C
Plant $400,000.00 $300,000.00
Material 295,000.00 425,000.00
Cash 40,000.00 15,000.00 $500,000.00
$735,000.00 $740,000.00 $500,000.00
Liabilities
A B C
Capital $100,000.00 $300,000.00 $500,000.00
Surplus 60,000.00 40,000.00
6% Bond at 5 years 500,000.00 300,000.00
Current Liabilities 75,000.00 100,000.00
$735,000.00 $740,000.00 $500,000.00
Dividends Paid
$120,000.00 $30,000.00
Page 605
For the purpose of the issuance of stock in the new company to the holders of stock in the three existing
companies, it is proposed to capitalize the latter upon the following basis:
Money assets at double their value; plant at 80% of book values; material at 70% of book values; annual net
earnings at 8%; and the liabilities at par.
The new company will be organized with a capital stock of $2,200,000, all of which is to be used in acquiring
the stock of the existing companies.
(a) What amount of stock in the new company are the owners of the stock in each
of the existing companies entitled to receive?
(b) Give a short criticism attacking the above basis of stock allotment and submit a
more equitable basis.
32. The Smith Brewing Co. with $1,000,000 capital stock, the Young Brewing Co. with $500,000 capital stock,
and the Star Brewery with $400,000 capital stock, agree to consolidate as the Universal Brewing Corporation, the
new company to buy all the properties of the old companies at a valuation to be fixed by appraisal, payment
therefor to be made in full-paid stock of the new company, the old companies to pay off their own indebtedness.
The appraised values of the old companies are as follows:
Real Estate Horses,
Bills Office
and Plant Cash Wagons and To
Receivable Furniture
Buildings Harness
Smith $680,000 $390,000 $15,000 $10,000 $4,000 $1,000 $1,10
Young 327,000 160,000 3,000 6,000 3,000 1,000 50
Star 126,000 71,000 1,000 1,500 500 20
Total Appraised
Value $1,80
On this valuation, the Universal Brewing Corporation issued $2,000,000 of stock, shares $100 each, which was
divided pro rata among the old companies on the basis of their appraised value, no fractional shares of stock to be
issued, odd amounts to be paid old companies in cash.
Give journal entries necessary to set up property accounts and credit old companies with their pro rata on
books of the new company.
At the time of the consolidation the ledger accounts of the Star Brewery were as follows:
Real Estate and Buildings $250,000.00 Capital Stock $400,000.00
Plant 247,000.00 Bills Payable 50,000.00
Cash 1,000.00 Accounts Payable 51,000.00
Horses, Wagons, and Harness 1,800.00
Office Furniture 1,200.00
$501,000.00 $501,000.00
Make the proper journal entries to liquidate in stock of the new company the liabilities other than capital stock,
to apportion the remaining stock and cash, and to close the books of the Star Brewery.
33. The Elton Manufacturing Co. and the Star Manufacturing Co. were engaged in manufacturing the same
kind of goods. To avoid the losses due to competition, the two companies decided to combine their plants into one
corporation under the name of the Union Manufacturing Co. and finally agreed upon the following plan for the
merger:
companies, it is proposed to capitalize the latter upon the following basis:
Money assets at double their value; plant at 80% of book values; material at 70% of book values; annual net
earnings at 8%; and the liabilities at par.
The new company will be organized with a capital stock of $2,200,000, all of which is to be used in acquiring
the stock of the existing companies.
(a) What amount of stock in the new company are the owners of the stock in each
of the existing companies entitled to receive?
(b) Give a short criticism attacking the above basis of stock allotment and submit a
more equitable basis.
32. The Smith Brewing Co. with $1,000,000 capital stock, the Young Brewing Co. with $500,000 capital stock,
and the Star Brewery with $400,000 capital stock, agree to consolidate as the Universal Brewing Corporation, the
new company to buy all the properties of the old companies at a valuation to be fixed by appraisal, payment
therefor to be made in full-paid stock of the new company, the old companies to pay off their own indebtedness.
The appraised values of the old companies are as follows:
Real Estate Horses,
Bills Office
and Plant Cash Wagons and To
Receivable Furniture
Buildings Harness
Smith $680,000 $390,000 $15,000 $10,000 $4,000 $1,000 $1,10
Young 327,000 160,000 3,000 6,000 3,000 1,000 50
Star 126,000 71,000 1,000 1,500 500 20
Total Appraised
Value $1,80
On this valuation, the Universal Brewing Corporation issued $2,000,000 of stock, shares $100 each, which was
divided pro rata among the old companies on the basis of their appraised value, no fractional shares of stock to be
issued, odd amounts to be paid old companies in cash.
Give journal entries necessary to set up property accounts and credit old companies with their pro rata on
books of the new company.
At the time of the consolidation the ledger accounts of the Star Brewery were as follows:
Real Estate and Buildings $250,000.00 Capital Stock $400,000.00
Plant 247,000.00 Bills Payable 50,000.00
Cash 1,000.00 Accounts Payable 51,000.00
Horses, Wagons, and Harness 1,800.00
Office Furniture 1,200.00
$501,000.00 $501,000.00
Make the proper journal entries to liquidate in stock of the new company the liabilities other than capital stock,
to apportion the remaining stock and cash, and to close the books of the Star Brewery.
33. The Elton Manufacturing Co. and the Star Manufacturing Co. were engaged in manufacturing the same
kind of goods. To avoid the losses due to competition, the two companies decided to combine their plants into one
corporation under the name of the Union Manufacturing Co. and finally agreed upon the following plan for the
merger:
Page 606
The assets received from, and the liabilities assumed for, the separate companies were taken at the values given
in the respective balance sheets, subject to the following adjustments: the buildings, machinery, and patents at 90%
of their stated value; delivery equipment, and furniture and fixtures at 80% of their value. A reserve of 2% on
accounts receivable was established by the Star Manufacturing Co.
Elton Manufacturing Co.
Balance Sheet, June 30, 1918
Land $10,000.00 Accounts Payable $ 30,000.00
Buildings 60,000.00 Mortgage Payable 14,000.00
Machinery and Tools 30,000.00 Accrued Wages 1,500.00
Delivery Equipment 3,500.00 Reserve for Bad Debts 1,500.00
Furniture and Fixtures 1,500.00 Stock, Capital 100,000.00
Inventory, Materials 10,000.00 Surplus 10,000.00
Finished Goods 2,500.00
Accounts Receivable 35,000.00
Unexpired Insurance 500.00
Cash 4,000.00
$157,000.00 $157,000.00
Star Manufacturing Co.
Balance Sheet, June 30, 1918
Machinery and Tools $35,000.00 Accounts Payable $30,000.00
Motor Trucks 4,000.00 Notes Payable 19,000.00
Patents 6,000.00 Capital Stock 50,000.00
Furniture and Fixtures 500.00 Surplus 11,000.00
Inventory, Materials, etc. 8,000.00
Finished Goods 5,000.00
Accounts Receivable 50,000.00
Cash 1,500.00
$110,000.00 $110,000.00
After making the adjustments and allowing interest at 6% on the invested capital, the excess earnings were
capitalized on a basis of 10% to obtain the amount of the good-will.
Average net profits for a period of three years: Elton Manufacturing Co. $17,000; Star Manufacturing Co.
$10,800.
The Union Manufacturing Co. was capitalized at an amount equal to the net assets (after adjustments) and the
good-will of the two merged companies.
(a) Find the capitalization of the Union Manufacturing Co. and the amount of
preferred and common stock allotted to each of the merged companies.
(b) Write the journal entries to open the books of the Union Manufacturing Co.
(c) Prepare the balance sheet for the Union Manufacturing Co.
(d) Write the closing journal entries for the Star Manufacturing Co.
in the respective balance sheets, subject to the following adjustments: the buildings, machinery, and patents at 90%
of their stated value; delivery equipment, and furniture and fixtures at 80% of their value. A reserve of 2% on
accounts receivable was established by the Star Manufacturing Co.
Elton Manufacturing Co.
Balance Sheet, June 30, 1918
Land $10,000.00 Accounts Payable $ 30,000.00
Buildings 60,000.00 Mortgage Payable 14,000.00
Machinery and Tools 30,000.00 Accrued Wages 1,500.00
Delivery Equipment 3,500.00 Reserve for Bad Debts 1,500.00
Furniture and Fixtures 1,500.00 Stock, Capital 100,000.00
Inventory, Materials 10,000.00 Surplus 10,000.00
Finished Goods 2,500.00
Accounts Receivable 35,000.00
Unexpired Insurance 500.00
Cash 4,000.00
$157,000.00 $157,000.00
Star Manufacturing Co.
Balance Sheet, June 30, 1918
Machinery and Tools $35,000.00 Accounts Payable $30,000.00
Motor Trucks 4,000.00 Notes Payable 19,000.00
Patents 6,000.00 Capital Stock 50,000.00
Furniture and Fixtures 500.00 Surplus 11,000.00
Inventory, Materials, etc. 8,000.00
Finished Goods 5,000.00
Accounts Receivable 50,000.00
Cash 1,500.00
$110,000.00 $110,000.00
After making the adjustments and allowing interest at 6% on the invested capital, the excess earnings were
capitalized on a basis of 10% to obtain the amount of the good-will.
Average net profits for a period of three years: Elton Manufacturing Co. $17,000; Star Manufacturing Co.
$10,800.
The Union Manufacturing Co. was capitalized at an amount equal to the net assets (after adjustments) and the
good-will of the two merged companies.
(a) Find the capitalization of the Union Manufacturing Co. and the amount of
preferred and common stock allotted to each of the merged companies.
(b) Write the journal entries to open the books of the Union Manufacturing Co.
(c) Prepare the balance sheet for the Union Manufacturing Co.
(d) Write the closing journal entries for the Star Manufacturing Co.
Page 607
34. The following is abstracted from an agreement of merger and consolidation made December 31, 1917,
between the Pennsylvania Tool Co., party of the first part, and the Keystone Tool Co., party of the second part.
Said parties of both parts being corporations duly organized and existing under the laws of the State of
Pennsylvania, by this agreement merge and consolidate into a single corporation.
The name of the corporation hereby formed by said consolidation shall be the Pennsylvania Tool Co.
The amount of capital stock of the new corporation is $100,000, all of which shall be common stock divided
into 1,000 shares of a par value of $100. The manner of distributing capital stock shall be as follows:
The capital stock of the Pennsylvania Tool Co., party of the first part, shall be exchangeable for capital stock of
the new corporation, share for share, and the balance of the capital stock of the new corporation hereby formed
shall be distributed to the stockholders of the Keystone Tool Co., in proportion to their present holdings.
The Pennsylvania Tool Co., party of the first part, was incorporated shortly before the date of the merger, and
had transacted no business other than the issuance of ten shares of capital stock, $100 each, for which payment of
$1,000 had been received, and which was on hand in the treasury of the company on the date of the merger, and
directly after the merger transferred to the bank deposit account of the consolidated company and credited to an
account called “Suspense.”
The Keystone Tool Co. had for a number of years been actively engaged in business. Its fiscal year ended
September 30, 1917, at which time an inventory was taken and its accounts had been properly closed. At the date
of the merger the following trial balance was drawn from the books:
Cash $ 20,000.00
Accounts Receivable 15,000.00
Merchandise Inventory, September 30, 1917 130,000.00
Merchandise Purchased 250,000.00
Expenses 25,000.00
Accounts Payable $ 10,000.00
Sales 300,000.00
Capital Stock 30,000.00
Undivided Profits Balance, September 30, 1917 100,000.00
$440,000.00 $440,000.00
The account books of this concern were not closed at the date of the merger and no inventory was taken,
although the exchange of capital stock was effected and also all business after December 31, 1917, was transacted
under the name of the Pennsylvania Tool Co., and it was not until March 31, 1918, that an accountant was asked to
state the accounts of the new company from the date of the consolidation.
At March 31, 1918, before the accountant had commenced his work, an inventory was taken which showed the
value of merchandise on hand as at that date, to be $216,250, and the following trial balance was abstracted from
the books:
Trial Balance, March 31, 1918
Cash $ 26,000.00
Accounts Receivable 10,000.00
Merchandise Inventory, September 30, 1917 130,000.00
Merchandise Purchased 600,000.00
Expenses 60,000.00
Accounts Payable $ 10,000.00
Sales 685,000.00
Suspense 1,000.00
Capital Stock 30,000.00
Undivided Profits 100,000.00
between the Pennsylvania Tool Co., party of the first part, and the Keystone Tool Co., party of the second part.
Said parties of both parts being corporations duly organized and existing under the laws of the State of
Pennsylvania, by this agreement merge and consolidate into a single corporation.
The name of the corporation hereby formed by said consolidation shall be the Pennsylvania Tool Co.
The amount of capital stock of the new corporation is $100,000, all of which shall be common stock divided
into 1,000 shares of a par value of $100. The manner of distributing capital stock shall be as follows:
The capital stock of the Pennsylvania Tool Co., party of the first part, shall be exchangeable for capital stock of
the new corporation, share for share, and the balance of the capital stock of the new corporation hereby formed
shall be distributed to the stockholders of the Keystone Tool Co., in proportion to their present holdings.
The Pennsylvania Tool Co., party of the first part, was incorporated shortly before the date of the merger, and
had transacted no business other than the issuance of ten shares of capital stock, $100 each, for which payment of
$1,000 had been received, and which was on hand in the treasury of the company on the date of the merger, and
directly after the merger transferred to the bank deposit account of the consolidated company and credited to an
account called “Suspense.”
The Keystone Tool Co. had for a number of years been actively engaged in business. Its fiscal year ended
September 30, 1917, at which time an inventory was taken and its accounts had been properly closed. At the date
of the merger the following trial balance was drawn from the books:
Cash $ 20,000.00
Accounts Receivable 15,000.00
Merchandise Inventory, September 30, 1917 130,000.00
Merchandise Purchased 250,000.00
Expenses 25,000.00
Accounts Payable $ 10,000.00
Sales 300,000.00
Capital Stock 30,000.00
Undivided Profits Balance, September 30, 1917 100,000.00
$440,000.00 $440,000.00
The account books of this concern were not closed at the date of the merger and no inventory was taken,
although the exchange of capital stock was effected and also all business after December 31, 1917, was transacted
under the name of the Pennsylvania Tool Co., and it was not until March 31, 1918, that an accountant was asked to
state the accounts of the new company from the date of the consolidation.
At March 31, 1918, before the accountant had commenced his work, an inventory was taken which showed the
value of merchandise on hand as at that date, to be $216,250, and the following trial balance was abstracted from
the books:
Trial Balance, March 31, 1918
Cash $ 26,000.00
Accounts Receivable 10,000.00
Merchandise Inventory, September 30, 1917 130,000.00
Merchandise Purchased 600,000.00
Expenses 60,000.00
Accounts Payable $ 10,000.00
Sales 685,000.00
Suspense 1,000.00
Capital Stock 30,000.00
Undivided Profits 100,000.00
Page 608
$826,000.00 $826,000.00
Prepare:
(a) Balance sheet of the consolidated company as at March 31, 1918.
(b) Profit and loss account arranged to show the profits of the consolidated
company for the three months ended March 31.
(c) Profit and loss account of the Keystone Tool Co., for the three months ended
December 31.
(d) Statement showing the disposition of profits taken over by the new company.
(e) State what basis you make use of in determining the approximate value of
merchandise on hand at December 31.
Miscellaneous
35. A manufacturer is desirous of selling his business, and furnishes a statement showing the condition of
affairs for the past five years as follows:
Amount of Sales averaging per year $800,000.00
Wages Paid ” ” ” 200,000.00
Expenses Paid ” ” ” 80,000.00
Raw Material Purchased ” ” 350,000.00
Supplies on Hand at present time 40,000.00
Machinery in use at commencement of the five years 150,000.00
(50% of the above amount has been in use for 10
years previous, and all additions made at cost
prices, and nothing marked off for depreciation.)
Carried at present at $225,000.00
(All repairs have been charged to expense.)
Real Estate valued at 200,000.00
What report would you make as to a fair valuation of this business? Explain fully your reasons for same.
36. The factory of an automobile company assembles its cars only on receipt of orders from the main office. A
summary of the factory operations for a certain period is as follows:
Parts Purchased $ 162,500.00
Parts Manufactured (material cost) 562,500.00
Productive Labor (125% of material) 703,125.00
Factory Expense 1,128,000.00
Cost of Cars:
Parts Purchased, Consumed 137,500.00
Parts Manufactured (material cost) 187,500.00
Productive Labor (145% of material) 471,250.00
Factory Expense 565,500.00
Material on Hand, Unmanufactured 500,000.00
Prepare a technical trial balance of the cost ledger and an inventory of the stock room.
37. John Doe commenced business with a cash capital of $15,000. At the close of his fiscal period the ledger
accounts were: accounts receivable $4,312.50; merchandise debit balance $5,062.50; accounts payable $5,375;
expense $900. Doe’s total loss was $2,775.
Prepare:
(a) Balance sheet of the consolidated company as at March 31, 1918.
(b) Profit and loss account arranged to show the profits of the consolidated
company for the three months ended March 31.
(c) Profit and loss account of the Keystone Tool Co., for the three months ended
December 31.
(d) Statement showing the disposition of profits taken over by the new company.
(e) State what basis you make use of in determining the approximate value of
merchandise on hand at December 31.
Miscellaneous
35. A manufacturer is desirous of selling his business, and furnishes a statement showing the condition of
affairs for the past five years as follows:
Amount of Sales averaging per year $800,000.00
Wages Paid ” ” ” 200,000.00
Expenses Paid ” ” ” 80,000.00
Raw Material Purchased ” ” 350,000.00
Supplies on Hand at present time 40,000.00
Machinery in use at commencement of the five years 150,000.00
(50% of the above amount has been in use for 10
years previous, and all additions made at cost
prices, and nothing marked off for depreciation.)
Carried at present at $225,000.00
(All repairs have been charged to expense.)
Real Estate valued at 200,000.00
What report would you make as to a fair valuation of this business? Explain fully your reasons for same.
36. The factory of an automobile company assembles its cars only on receipt of orders from the main office. A
summary of the factory operations for a certain period is as follows:
Parts Purchased $ 162,500.00
Parts Manufactured (material cost) 562,500.00
Productive Labor (125% of material) 703,125.00
Factory Expense 1,128,000.00
Cost of Cars:
Parts Purchased, Consumed 137,500.00
Parts Manufactured (material cost) 187,500.00
Productive Labor (145% of material) 471,250.00
Factory Expense 565,500.00
Material on Hand, Unmanufactured 500,000.00
Prepare a technical trial balance of the cost ledger and an inventory of the stock room.
37. John Doe commenced business with a cash capital of $15,000. At the close of his fiscal period the ledger
accounts were: accounts receivable $4,312.50; merchandise debit balance $5,062.50; accounts payable $5,375;
expense $900. Doe’s total loss was $2,775.
Page 609
Prepare a statement of assets and liabilities and the profit or loss.
38. John Adams lost his stock of merchandise May 1, 1918, through a flood in the Mississippi River.
Adams applied to the local Mutual Flood Insurance Society for reimbursements, claiming a loss of $5,886.35
on merchandise stock. From the following data ascertain his merchandise inventory:
Net profits May 1, 1918, $4,452.91; drawings $1,598; legal expenses $17.50; interest debit $313; advertising
$14; commissions debit $961.01; insurance $196.23; sales $81,688.04; inventory, December, 1917, $1,568.62;
purchases $55,415.82; labor, productive $19,499.58; telephone $416.06; sundry factory expenses $3,201.92;
repairs $16; surplus May 1, 1918, $2,854.91.
39. The directors of a manufacturing company, before the closing and auditing of the books for the half-year
ending December 31, declared out of the net earnings of the company a dividend for the half-year of 4% on the
preferred stock of $100,000 and 3% on the common stock of $100,000. There has been brought forward from the
last half-year, an undivided balance of profit of $4,000, and after the audit of the books the trial balance is found to
be as follows:
Trial Balance, December 31
Real Estate and Building $ 32,500.00
Plant and Machinery 40,000.00
Patents and Good-Will 80,000.00
Inventory, July 1 29,000.00
Purchases 82,500.00
Labor 88,000.00
Coal 6,000.00
Salaries, General 11,000.00
Salaries, Management 5,000.00
Insurance 875.00
Allowances 6,250.00
Freight 1,500.00
Discount and Interest 750.00
Cash in Bank 8,000.00
Investments 15,500.00
Miscellaneous Expense 4,300.00
Book Debts 42,000.00
Preferred Stock in Treasury 5,000.00
Repairs 1,000.00
Preferred Stock 100,000.00
Common Stock 100,000.00
Sales 219,175.00
Notes Payable 26,000.00
Accounts Payable 14,000.00
$459,175.00 $459,175.00
Stock on hand $26,500.
From the above prepare profit and loss and income statement and balance sheet, giving effect in accounts to
depreciation at the rate of 7½% a year, on plant and machinery, and making an allowance of 5% on the book debts
to provide for bad debts; also create a liability in the balance sheet for dividend as stated.
40. Wm. Bates commenced business June 1, 1917, with a capital consisting of cash $60,000, and a building
and lot worth $85,000, subject to a mortgage of $25,000, dated June 1, 1917, bearing interest at 6%.
38. John Adams lost his stock of merchandise May 1, 1918, through a flood in the Mississippi River.
Adams applied to the local Mutual Flood Insurance Society for reimbursements, claiming a loss of $5,886.35
on merchandise stock. From the following data ascertain his merchandise inventory:
Net profits May 1, 1918, $4,452.91; drawings $1,598; legal expenses $17.50; interest debit $313; advertising
$14; commissions debit $961.01; insurance $196.23; sales $81,688.04; inventory, December, 1917, $1,568.62;
purchases $55,415.82; labor, productive $19,499.58; telephone $416.06; sundry factory expenses $3,201.92;
repairs $16; surplus May 1, 1918, $2,854.91.
39. The directors of a manufacturing company, before the closing and auditing of the books for the half-year
ending December 31, declared out of the net earnings of the company a dividend for the half-year of 4% on the
preferred stock of $100,000 and 3% on the common stock of $100,000. There has been brought forward from the
last half-year, an undivided balance of profit of $4,000, and after the audit of the books the trial balance is found to
be as follows:
Trial Balance, December 31
Real Estate and Building $ 32,500.00
Plant and Machinery 40,000.00
Patents and Good-Will 80,000.00
Inventory, July 1 29,000.00
Purchases 82,500.00
Labor 88,000.00
Coal 6,000.00
Salaries, General 11,000.00
Salaries, Management 5,000.00
Insurance 875.00
Allowances 6,250.00
Freight 1,500.00
Discount and Interest 750.00
Cash in Bank 8,000.00
Investments 15,500.00
Miscellaneous Expense 4,300.00
Book Debts 42,000.00
Preferred Stock in Treasury 5,000.00
Repairs 1,000.00
Preferred Stock 100,000.00
Common Stock 100,000.00
Sales 219,175.00
Notes Payable 26,000.00
Accounts Payable 14,000.00
$459,175.00 $459,175.00
Stock on hand $26,500.
From the above prepare profit and loss and income statement and balance sheet, giving effect in accounts to
depreciation at the rate of 7½% a year, on plant and machinery, and making an allowance of 5% on the book debts
to provide for bad debts; also create a liability in the balance sheet for dividend as stated.
40. Wm. Bates commenced business June 1, 1917, with a capital consisting of cash $60,000, and a building
and lot worth $85,000, subject to a mortgage of $25,000, dated June 1, 1917, bearing interest at 6%.
Page 610
One year later, June 1, 1918, an abstract of his books disclosed the following accounts: purchases $78,000;
sales $85,000; sinking fund $8,000; cash drawings $6,000; goods returned to creditors $5,000; expenses paid in
cash $9,000; profit and loss, debit $3,500; contingent fund $3,000; due to creditors $49,000; reserve for bad debts
$4,250; due from customers $32,620; discounts allowed customers on accounts paid $755; returned sales $4,520;
discounts on accounts paid to creditors $650. No goods were sold to creditors or purchased from customers.
Unsold goods June 1, 1918, $9,500.
From the above data, prepare a trial balance, income statement, and balance sheet.
Note: Two items affecting accounts in the trial balance are missing and must be supplied.
41. In taking off a trial balance a bookkeeper finds that his debit footings exceed the credit by $131.56, which
he carried to a suspense account. Later, he discovers that a purchase amounting to $417.50 has been debited to a
creditor as $192.94; that $312.50 for depreciation of furniture has not been posted to depreciation account; that
$500 withdrawn by the proprietor has been charged against wages account; that a discount of $76.13 allowed to a
customer has been credited to him as $71.13, and that the total of sales returned was footed $5 short. Give detailed
entries showing how you would remedy these errors, and starting with the original difference prepare a
supplemental trial balance showing whether the books balance or not.
42. A and B are partners owning two retail stores, one in Paterson and the other in Newark. They agree to
dissolve partnership as of July 1, 1918. The two stores are valued July 1, 1918, as follows: Paterson $4,573.50;
Newark $3,600. On this basis B contemplates purchasing A’s interest. On being furnished with the following data,
B requests you to inform him if the inventory of the Paterson store, January 1, 1918, was correct as A claims:
Value of alleged Inventory, January 1, 1918,
in the Paterson store $3,800.00
Purchases for both stores, January to July, paid for 5,128.80
Due to Creditors on account of both stores, July 1 1,500.00
Cash Sales, Newark store 1,875.00
Cash Sales, Paterson store 3,105.00
Purchases, Paterson store, January to July 3,326.00
Profits 50% of Sales
Prepare a statement proving whether or not the inventory of the Paterson store, January 1, 1918, was correct as
stated.
43. On paper ruled as for a stock ledger, make entry of the following stock transactions of William Henderson,
closing the account as of October 31, 1918, and carrying down the balance:
100 shares (par value $100) originally issued, full paid at par to William Henderson by certificate No. 5.
August 16, 1918.
William Henderson sells 50 shares of the original 100 to Charles Gibbons at $120, September 14, 1918,
receiving certificate No. 37 for shares retained.
October 28, 1918, William Henderson purchases from John Hogan 25 shares at $115 and receives certificate
No. 78.
44. Stockholders of the Deep Canal Company donated 400 shares of stock of a par value of $100 per share for
the purpose of providing working capital.
Three hundred shares of the treasury stock were sold by agents at 90. A commission of 10% and expenses of
$516 was allowed the agents for selling. The 300 shares of treasury stock were sold on the instalment plan, 10%
down and 10% a month for the balance. Certificates of stock not to be issued until paid in full.
Six months later you are to enter the total amount of cash paid on instalments, excluding the initial payment
which was made at the time of subscription.
At the end of eight months 100 subscribers defaulted on their subscription contracts. Their subscriptions were
canceled and the payments they had made declared forfeited.
The balance of all subscription accounts except those canceled by default have been paid in full and stock
certificates therefor duly issued.
sales $85,000; sinking fund $8,000; cash drawings $6,000; goods returned to creditors $5,000; expenses paid in
cash $9,000; profit and loss, debit $3,500; contingent fund $3,000; due to creditors $49,000; reserve for bad debts
$4,250; due from customers $32,620; discounts allowed customers on accounts paid $755; returned sales $4,520;
discounts on accounts paid to creditors $650. No goods were sold to creditors or purchased from customers.
Unsold goods June 1, 1918, $9,500.
From the above data, prepare a trial balance, income statement, and balance sheet.
Note: Two items affecting accounts in the trial balance are missing and must be supplied.
41. In taking off a trial balance a bookkeeper finds that his debit footings exceed the credit by $131.56, which
he carried to a suspense account. Later, he discovers that a purchase amounting to $417.50 has been debited to a
creditor as $192.94; that $312.50 for depreciation of furniture has not been posted to depreciation account; that
$500 withdrawn by the proprietor has been charged against wages account; that a discount of $76.13 allowed to a
customer has been credited to him as $71.13, and that the total of sales returned was footed $5 short. Give detailed
entries showing how you would remedy these errors, and starting with the original difference prepare a
supplemental trial balance showing whether the books balance or not.
42. A and B are partners owning two retail stores, one in Paterson and the other in Newark. They agree to
dissolve partnership as of July 1, 1918. The two stores are valued July 1, 1918, as follows: Paterson $4,573.50;
Newark $3,600. On this basis B contemplates purchasing A’s interest. On being furnished with the following data,
B requests you to inform him if the inventory of the Paterson store, January 1, 1918, was correct as A claims:
Value of alleged Inventory, January 1, 1918,
in the Paterson store $3,800.00
Purchases for both stores, January to July, paid for 5,128.80
Due to Creditors on account of both stores, July 1 1,500.00
Cash Sales, Newark store 1,875.00
Cash Sales, Paterson store 3,105.00
Purchases, Paterson store, January to July 3,326.00
Profits 50% of Sales
Prepare a statement proving whether or not the inventory of the Paterson store, January 1, 1918, was correct as
stated.
43. On paper ruled as for a stock ledger, make entry of the following stock transactions of William Henderson,
closing the account as of October 31, 1918, and carrying down the balance:
100 shares (par value $100) originally issued, full paid at par to William Henderson by certificate No. 5.
August 16, 1918.
William Henderson sells 50 shares of the original 100 to Charles Gibbons at $120, September 14, 1918,
receiving certificate No. 37 for shares retained.
October 28, 1918, William Henderson purchases from John Hogan 25 shares at $115 and receives certificate
No. 78.
44. Stockholders of the Deep Canal Company donated 400 shares of stock of a par value of $100 per share for
the purpose of providing working capital.
Three hundred shares of the treasury stock were sold by agents at 90. A commission of 10% and expenses of
$516 was allowed the agents for selling. The 300 shares of treasury stock were sold on the instalment plan, 10%
down and 10% a month for the balance. Certificates of stock not to be issued until paid in full.
Six months later you are to enter the total amount of cash paid on instalments, excluding the initial payment
which was made at the time of subscription.
At the end of eight months 100 subscribers defaulted on their subscription contracts. Their subscriptions were
canceled and the payments they had made declared forfeited.
The balance of all subscription accounts except those canceled by default have been paid in full and stock
certificates therefor duly issued.
Page 611
(a) Write all the necessary journal entries.
(b) Construct a suitable instalment book and record in it the above transactions.
(b) Construct a suitable instalment book and record in it the above transactions.
Page 612
APPENDIX D
REVIEW QUESTIONS
Chapter I
1. Name the two general classes of corporations, and subclassify
each.
2. Discuss briefly the working organization of the stock corporation.
3. Name the different classes of stock and discuss each briefly.
4. What is meant by watered stock?
5. How, on the balance sheet, would you show discount on stock?
Premium on stock?
6. What are the correct journal entries covering the receipt of
treasury stock, and its sale at a discount? At a premium?
7. To what uses is donated surplus restricted?
8. What is bonus stock, and when may it be issued?
9. What kind of an expense does bonus stock constitute when given
with an issue of bonds which would otherwise be sold at a
discount?
10. When treasury stock is purchased by the issuing company at a
discount, how would the transaction appear on the ledger? How
if bought at a premium?
11. Contrast the redemption at a premium of a preferred stock issue,
with the purchase of treasury stock at a premium.
12. What is meant by stock of no par value? Explain fully.
13. How is the issue of no par value stock handled on the books?
14. Name and discuss those records peculiar to the corporation.
REVIEW QUESTIONS
Chapter I
1. Name the two general classes of corporations, and subclassify
each.
2. Discuss briefly the working organization of the stock corporation.
3. Name the different classes of stock and discuss each briefly.
4. What is meant by watered stock?
5. How, on the balance sheet, would you show discount on stock?
Premium on stock?
6. What are the correct journal entries covering the receipt of
treasury stock, and its sale at a discount? At a premium?
7. To what uses is donated surplus restricted?
8. What is bonus stock, and when may it be issued?
9. What kind of an expense does bonus stock constitute when given
with an issue of bonds which would otherwise be sold at a
discount?
10. When treasury stock is purchased by the issuing company at a
discount, how would the transaction appear on the ledger? How
if bought at a premium?
11. Contrast the redemption at a premium of a preferred stock issue,
with the purchase of treasury stock at a premium.
12. What is meant by stock of no par value? Explain fully.
13. How is the issue of no par value stock handled on the books?
14. Name and discuss those records peculiar to the corporation.
Page 613
15. Of what value to the accountant are the records kept in the
minute book?
Chapter II
1. In what way are the purchasing activities of a manufacturing
concern more complex than those of a concern selling stock-in-
trade?
2. Why is the old purchase journal inadequate to meet the needs of
the manufacturing concern? In what way, however, can it be
improved to meet these needs?
3. Discuss the development of the voucher register, showing its
improvement over the purchase journal.
4. What is a voucher?
5. State the essential characteristics of a formal voucher.
6. Describe in detail the operation of a voucher system.
7. What are the advantages of the voucher check?
8. What are “treasurer’s numbers,” and why are they sometimes put
on vouchers?
9. In what way does the use of the voucher register eliminate much
of the work that is usually done on the cash book?
10. How is it possible, when using the voucher system, to keep a
record of the volume of business done with each creditor?
11. How is the general ledger account, Vouchers Payable, proven?
12. State the steps that must be taken when substituting the voucher
system for the old journal method of handling purchases.
13. Explain two methods of treating purchases returns and
allowances on the voucher register. Which method is the most
satisfactory for a concern doing a large volume of business?
14. Explain in detail the methods of handling the following items on
the voucher register: (a) Partial payments on vouchers. (b)
minute book?
Chapter II
1. In what way are the purchasing activities of a manufacturing
concern more complex than those of a concern selling stock-in-
trade?
2. Why is the old purchase journal inadequate to meet the needs of
the manufacturing concern? In what way, however, can it be
improved to meet these needs?
3. Discuss the development of the voucher register, showing its
improvement over the purchase journal.
4. What is a voucher?
5. State the essential characteristics of a formal voucher.
6. Describe in detail the operation of a voucher system.
7. What are the advantages of the voucher check?
8. What are “treasurer’s numbers,” and why are they sometimes put
on vouchers?
9. In what way does the use of the voucher register eliminate much
of the work that is usually done on the cash book?
10. How is it possible, when using the voucher system, to keep a
record of the volume of business done with each creditor?
11. How is the general ledger account, Vouchers Payable, proven?
12. State the steps that must be taken when substituting the voucher
system for the old journal method of handling purchases.
13. Explain two methods of treating purchases returns and
allowances on the voucher register. Which method is the most
satisfactory for a concern doing a large volume of business?
14. Explain in detail the methods of handling the following items on
the voucher register: (a) Partial payments on vouchers. (b)
Page 614
Payment by means of a note payable. (c) Cash discounts on
purchases.
15. Enumerate the advantages claimed for the voucher system. The
disadvantages.
Chapter III
1. In what respect does factory accounting differ from financial
accounting?
2. What three main elements enter into the manufacture of a
product? Discuss each.
3. For what special purposes are cost records kept?
4. What is meant by raw materials from the manufacturer’s
viewpoint?
5. Describe the two methods used in accounting for material cost.
Which method is preferable for the large concern?
6. How would you classify labor for factory accounting?
7. Explain the use of the time card.
8. Describe the general content of a pay-roll.
9. Why and how should the pay-roll be safeguarded?
10. How are the workmen paid from the pay-roll?
11. How is distribution of the pay-roll made? Distribution of
accrued wages?
12. Name a few items which enter into overhead expenses.
13. What constitutes the real difficulty in accounting for factory
expense or overhead?
14. Why is a common basis of distribution of expense usually
unsatisfactory?
15. What relation has a manufacturing statement to a profit and loss
statement?
purchases.
15. Enumerate the advantages claimed for the voucher system. The
disadvantages.
Chapter III
1. In what respect does factory accounting differ from financial
accounting?
2. What three main elements enter into the manufacture of a
product? Discuss each.
3. For what special purposes are cost records kept?
4. What is meant by raw materials from the manufacturer’s
viewpoint?
5. Describe the two methods used in accounting for material cost.
Which method is preferable for the large concern?
6. How would you classify labor for factory accounting?
7. Explain the use of the time card.
8. Describe the general content of a pay-roll.
9. Why and how should the pay-roll be safeguarded?
10. How are the workmen paid from the pay-roll?
11. How is distribution of the pay-roll made? Distribution of
accrued wages?
12. Name a few items which enter into overhead expenses.
13. What constitutes the real difficulty in accounting for factory
expense or overhead?
14. Why is a common basis of distribution of expense usually
unsatisfactory?
15. What relation has a manufacturing statement to a profit and loss
statement?
Page 615
Chapter IV
1. Discuss the growing importance of the balance sheet in its
relations to the business world.
2. What relation is there between the trial balance and the balance
sheet? Between the post-closing trial balance and the balance
sheet?
3. What is the purpose of the balance sheet? What uses may it
serve?
4. Differentiate between the English and the American or
Continental form of balance sheet.
5. How is the origin of the English form of balance sheet explained?
6. What is the “Statement of Receipts and Expenditures on Capital
Account?”
7. Name and criticize a few of the balance sheet titles met with.
8. What is the purpose in classifying the items appearing in the
different sections of a balance sheet?
9. What controlling principle usually governs the order of these
sections and the items within each section?
10. Give an outline of the group arrangement of the balance sheet.
11. State and describe the two methods of arranging the three main
classes of balance sheet items. Which method is usually
preferred?
12. How is a valuation account usually shown on the balance sheet?
Give examples.
13. Tell what you know of the statutory requirements governing the
frequency of financial statements of both financial and public
service corporations.
14. What are the reasons for having a condensed balance sheet?
What precautions must be taken when condensing a balance
sheet?
1. Discuss the growing importance of the balance sheet in its
relations to the business world.
2. What relation is there between the trial balance and the balance
sheet? Between the post-closing trial balance and the balance
sheet?
3. What is the purpose of the balance sheet? What uses may it
serve?
4. Differentiate between the English and the American or
Continental form of balance sheet.
5. How is the origin of the English form of balance sheet explained?
6. What is the “Statement of Receipts and Expenditures on Capital
Account?”
7. Name and criticize a few of the balance sheet titles met with.
8. What is the purpose in classifying the items appearing in the
different sections of a balance sheet?
9. What controlling principle usually governs the order of these
sections and the items within each section?
10. Give an outline of the group arrangement of the balance sheet.
11. State and describe the two methods of arranging the three main
classes of balance sheet items. Which method is usually
preferred?
12. How is a valuation account usually shown on the balance sheet?
Give examples.
13. Tell what you know of the statutory requirements governing the
frequency of financial statements of both financial and public
service corporations.
14. What are the reasons for having a condensed balance sheet?
What precautions must be taken when condensing a balance
sheet?
Page 616
15. Enumerate several of the purposes which a balance sheet may
serve.
Chapter V
1. What points demand consideration before an accountant can
definitely arrive at the content of a balance sheet?
2. State the chief purpose for valuing the assets of public utilities.
3. Give a few principles involved in the valuation of property for the
purpose of sale or purchase.
4. Name three kinds of valuations relating chiefly to the commercial
balance sheet.
5. What principles are involved in the valuation of a going concern?
6. What is meant by cost value?
7. Give a few sources of data as to value.
8. What is an “experience figure” in connection with an appraisal?
9. What is the most usual basis for values which are shown in the
commercial balance sheet.
10. Define and explain:
(a) Capital expenditures.
(b) Revenue expenditures.
(c) Capital receipts.
(d) Capital expense.
11. Do the expenses of organization constitute capital or revenue
expenditures?
12. Define and discuss: (a) Maintenance. (b) Replacements. (c)
Renewals. (d) Repairs.
13. When should a renewal be considered an expenditure on capital
account?
serve.
Chapter V
1. What points demand consideration before an accountant can
definitely arrive at the content of a balance sheet?
2. State the chief purpose for valuing the assets of public utilities.
3. Give a few principles involved in the valuation of property for the
purpose of sale or purchase.
4. Name three kinds of valuations relating chiefly to the commercial
balance sheet.
5. What principles are involved in the valuation of a going concern?
6. What is meant by cost value?
7. Give a few sources of data as to value.
8. What is an “experience figure” in connection with an appraisal?
9. What is the most usual basis for values which are shown in the
commercial balance sheet.
10. Define and explain:
(a) Capital expenditures.
(b) Revenue expenditures.
(c) Capital receipts.
(d) Capital expense.
11. Do the expenses of organization constitute capital or revenue
expenditures?
12. Define and discuss: (a) Maintenance. (b) Replacements. (c)
Renewals. (d) Repairs.
13. When should a renewal be considered an expenditure on capital
account?
Page 617
14. Describe the best method of handling expenses involved in
making “cost-cutting” changes.
15. How may expenditures for assets subject to depreciation be
considered as deferred charges to operations?
16. The cost of repairs upon second-hand equipment, immediately
after purchase, constitutes what kind of an expenditure?
17. Name a few construction costs which may justly be considered
as capital expenditures.
18. Upon what is the distinction between capital and revenue
expenditures often based?
19. Name the three general heads under which the assets may be
classed on the balance sheet.
20. What are the principles of valuation for the assets appearing
under each group?
21. Are the principles of valuation applicable to liability items?
22. Would you say that a balance sheet is a statement of fact, or
merely an opinion based on experience? Why?
Chapter VI
1. Define depreciation and show why the depreciation factor
demands consideration.
2. Distinguish between “absolute or actual” and “theoretical”
depreciation.
3. Define “accounting” depreciation.
4. What is meant by complete depreciation? Incomplete?
5. How can a consideration of complete depreciation be of value?
6. What is the relation of individual depreciation to composite
depreciation?
7. What is meant by “normal” or “average” value in connection with
composite depreciation?
making “cost-cutting” changes.
15. How may expenditures for assets subject to depreciation be
considered as deferred charges to operations?
16. The cost of repairs upon second-hand equipment, immediately
after purchase, constitutes what kind of an expenditure?
17. Name a few construction costs which may justly be considered
as capital expenditures.
18. Upon what is the distinction between capital and revenue
expenditures often based?
19. Name the three general heads under which the assets may be
classed on the balance sheet.
20. What are the principles of valuation for the assets appearing
under each group?
21. Are the principles of valuation applicable to liability items?
22. Would you say that a balance sheet is a statement of fact, or
merely an opinion based on experience? Why?
Chapter VI
1. Define depreciation and show why the depreciation factor
demands consideration.
2. Distinguish between “absolute or actual” and “theoretical”
depreciation.
3. Define “accounting” depreciation.
4. What is meant by complete depreciation? Incomplete?
5. How can a consideration of complete depreciation be of value?
6. What is the relation of individual depreciation to composite
depreciation?
7. What is meant by “normal” or “average” value in connection with
composite depreciation?
Page 618
8. Define “deferred maintenance,” “accrued depreciation.”
9. What is the attitude of the law in regard to depreciation?
10. Give a clear distinction between repairs and renewals.
11. What relation is there between the reserve for depreciation and
the productive efficiency of the plant?
12. Explain how the efficiency of the unit bears a different relation
to depreciation than does that of the plant as a whole. Give an
example.
13. Is it correct to allow fluctuations in market value to influence the
charges to depreciations?
14. Give a clear distinction between depreciation and depletion.
Chapter VII
1. Give a complete outline showing the cause of depreciation as
related to: (a) Tangible property. (b) Intangible property.
2. In what ways is age a distinct cause of depreciation? Wear and
tear?
3. Explain “functional” depreciation.
4. What two main factors or compelling forces may bring about
inadequacy?
5. Name and discuss each of the forces of internal origin which may
bring about inadequacy. Those of external origin.
6. Discuss obsolescence as a cause of functional depreciation.
7. Do the courts recognize obsolescence as a factor of depreciation?
8. Name the various items comprising contingent depreciation.
9. When must provision be made for the depreciation of intangible
property, or rights?
10. What constitutes the effective depreciation for any given asset?
Chapter VIII
9. What is the attitude of the law in regard to depreciation?
10. Give a clear distinction between repairs and renewals.
11. What relation is there between the reserve for depreciation and
the productive efficiency of the plant?
12. Explain how the efficiency of the unit bears a different relation
to depreciation than does that of the plant as a whole. Give an
example.
13. Is it correct to allow fluctuations in market value to influence the
charges to depreciations?
14. Give a clear distinction between depreciation and depletion.
Chapter VII
1. Give a complete outline showing the cause of depreciation as
related to: (a) Tangible property. (b) Intangible property.
2. In what ways is age a distinct cause of depreciation? Wear and
tear?
3. Explain “functional” depreciation.
4. What two main factors or compelling forces may bring about
inadequacy?
5. Name and discuss each of the forces of internal origin which may
bring about inadequacy. Those of external origin.
6. Discuss obsolescence as a cause of functional depreciation.
7. Do the courts recognize obsolescence as a factor of depreciation?
8. Name the various items comprising contingent depreciation.
9. When must provision be made for the depreciation of intangible
property, or rights?
10. What constitutes the effective depreciation for any given asset?
Chapter VIII
Page 619
1. State the real purpose of the depreciation charge as viewed first
from the standpoint of the balance sheet, and second from that
of the profit and loss statement.
2. Among what items of expense do accountants include
depreciation charges?
3. What two methods of distributing depreciation charges over
several fiscal periods are possible?
4. Show how the factor of idle time would affect the charges of
depreciation for different fiscal periods.
5. What three views must an accountant always consider when
making the depreciation charge?
6. Have there been any successful efforts to standardize depreciation
rates?
7. Of what importance are local conditions in determining an
individual depreciation rate?
8. Name the important normal and contingent factors which must be
taken into account in determining the depreciation rate.
9. Upon which of these factors must the rate be based at the time of
installation?
10. Upon what considerations is the normal rate based?
11. What influence has the policy as to repairs upon the normal rate?
12. Explain the three methods of handling repairs and renewals on
the books.
Chapter IX
1. What are the usual factors which enter into the calculation of
depreciation charges under most methods?
2. Name and subclassify the four general methods of calculating
depreciation charges.
3. Explain and give the essential characteristics of each of the
methods used for estimating depreciation.
from the standpoint of the balance sheet, and second from that
of the profit and loss statement.
2. Among what items of expense do accountants include
depreciation charges?
3. What two methods of distributing depreciation charges over
several fiscal periods are possible?
4. Show how the factor of idle time would affect the charges of
depreciation for different fiscal periods.
5. What three views must an accountant always consider when
making the depreciation charge?
6. Have there been any successful efforts to standardize depreciation
rates?
7. Of what importance are local conditions in determining an
individual depreciation rate?
8. Name the important normal and contingent factors which must be
taken into account in determining the depreciation rate.
9. Upon which of these factors must the rate be based at the time of
installation?
10. Upon what considerations is the normal rate based?
11. What influence has the policy as to repairs upon the normal rate?
12. Explain the three methods of handling repairs and renewals on
the books.
Chapter IX
1. What are the usual factors which enter into the calculation of
depreciation charges under most methods?
2. Name and subclassify the four general methods of calculating
depreciation charges.
3. Explain and give the essential characteristics of each of the
methods used for estimating depreciation.
Page 620
4. What is meant by condition per cent?
Chapter X
1. Name the causes of depreciation as viewed from the aspect of
time. As viewed from the aspect of service.
2. What is the ideal basis for distributing the depreciation charge?
3. Discuss the advantages and disadvantages of the various
depreciation methods as outlined in Chapter IX, and state the
conditions under which each method might work to advantage.
4. Should stability of income on the investment be considered in
commercial valuations?
Chapter XI
1. What are the two methods of booking depreciation in the ledger?
Which method is preferable?
2. Explain and criticize the two methods of handling the
depreciation reserve account at the time of the renewal of parts
or replacement of the asset.
3. Why are subsidiary records necessary in accounting for a group
of assets which are subject to depreciation?
4. Upon what basis are plant assets usually grouped?
5. Name the five headings under which a record of each plant unit
should be kept.
6. Discuss the importance of a periodic revision of depreciation
rates. Upon what does the frequency of such a revision depend?
7. What is meant by the rate of composite depreciation?
8. Explain, by assuming data from which to work, the two methods
of estimating the composite life of a group of assets, and also
their composite rate of depreciation.
9. What does a depreciation reserve on the balance sheet show as to
the management’s policy in treating plant properties?
Chapter X
1. Name the causes of depreciation as viewed from the aspect of
time. As viewed from the aspect of service.
2. What is the ideal basis for distributing the depreciation charge?
3. Discuss the advantages and disadvantages of the various
depreciation methods as outlined in Chapter IX, and state the
conditions under which each method might work to advantage.
4. Should stability of income on the investment be considered in
commercial valuations?
Chapter XI
1. What are the two methods of booking depreciation in the ledger?
Which method is preferable?
2. Explain and criticize the two methods of handling the
depreciation reserve account at the time of the renewal of parts
or replacement of the asset.
3. Why are subsidiary records necessary in accounting for a group
of assets which are subject to depreciation?
4. Upon what basis are plant assets usually grouped?
5. Name the five headings under which a record of each plant unit
should be kept.
6. Discuss the importance of a periodic revision of depreciation
rates. Upon what does the frequency of such a revision depend?
7. What is meant by the rate of composite depreciation?
8. Explain, by assuming data from which to work, the two methods
of estimating the composite life of a group of assets, and also
their composite rate of depreciation.
9. What does a depreciation reserve on the balance sheet show as to
the management’s policy in treating plant properties?
Page 621
10. Upon studying the depreciation reserve account for successive
periods, what conclusions might be drawn in the case of: (a) A
fluctuating reserve? (b) An increasing reserve? (c) A decreasing
reserve?
11. Should the depreciation reserve ever serve as a means of
financing the replacement of plant equipment?
12. Name the three courses which the management might pursue in
financing plant replacements.
13. Explain the secret reserve. Is the policy of carrying a secret
reserve advisable? What is the result of carrying too low a
reserve?
14. Name the various causes of the appreciation in value of an asset.
15. When is one justified in offsetting depreciation with
appreciation?
16. What effect might an over-or under-charge for depreciation have
upon the stockholders of the corporation?
Chapter XII
1. Discuss some of the items often considered as cash, and give
reasons why many of them should not be included in that
account.
2. Explain fully the customary method of receiving stamps as cash
payments.
3. Discuss the impropriety of accepting and listing I O U’s and due
bills as cash.
4. How should the disposition of the various cash funds be shown
when listing the cash items?
5. What rate of exchange should be used by the home office in
valuing cash held in a foreign branch?
6. What is the important problem in valuing accounts and notes
receivable?
periods, what conclusions might be drawn in the case of: (a) A
fluctuating reserve? (b) An increasing reserve? (c) A decreasing
reserve?
11. Should the depreciation reserve ever serve as a means of
financing the replacement of plant equipment?
12. Name the three courses which the management might pursue in
financing plant replacements.
13. Explain the secret reserve. Is the policy of carrying a secret
reserve advisable? What is the result of carrying too low a
reserve?
14. Name the various causes of the appreciation in value of an asset.
15. When is one justified in offsetting depreciation with
appreciation?
16. What effect might an over-or under-charge for depreciation have
upon the stockholders of the corporation?
Chapter XII
1. Discuss some of the items often considered as cash, and give
reasons why many of them should not be included in that
account.
2. Explain fully the customary method of receiving stamps as cash
payments.
3. Discuss the impropriety of accepting and listing I O U’s and due
bills as cash.
4. How should the disposition of the various cash funds be shown
when listing the cash items?
5. What rate of exchange should be used by the home office in
valuing cash held in a foreign branch?
6. What is the important problem in valuing accounts and notes
receivable?
Page 622
7. Why is the title “accounts receivable” objectionable?
8. How may large losses from bad debts be avoided?
9. What relation does the percentage of loss from bad debts bear to
the term of credit granted?
10. Explain how customers’ accounts are analyzed as a basis for
estimating bad debts. When is such an analysis of value?
11. What three bases are used in estimating the percentage of bad
debts? Give a criticism of each base.
12. What allowance should be made for discounts and collection
costs when valuing the trade debtor’s accounts?
13. What is the common practice in providing for loss on bad notes
receivable?
14. How should non-interest bearing notes be valued?
15. What items should be included under the title of “notes
receivable”?
Chapter XIII
1. Define the term “stock-in-trade.”
2. What is the most conservative basis upon which to value stock-in-
trade? Criticize other bases of valuation which may be used.
3. Explain the use of balance sheet footnotes to indicate the market
value of stock-in-trade.
4. What is the proper basis of valuation for depreciated stock-in-
trade?
5. Discuss all of the items that may go to make up the cost of stock-
in-trade.
6. How may items of cost, which are not directly attributable to any
one department, be equitably distributed?
7. Discuss some of the problems met in valuing inventories.
8. How may large losses from bad debts be avoided?
9. What relation does the percentage of loss from bad debts bear to
the term of credit granted?
10. Explain how customers’ accounts are analyzed as a basis for
estimating bad debts. When is such an analysis of value?
11. What three bases are used in estimating the percentage of bad
debts? Give a criticism of each base.
12. What allowance should be made for discounts and collection
costs when valuing the trade debtor’s accounts?
13. What is the common practice in providing for loss on bad notes
receivable?
14. How should non-interest bearing notes be valued?
15. What items should be included under the title of “notes
receivable”?
Chapter XIII
1. Define the term “stock-in-trade.”
2. What is the most conservative basis upon which to value stock-in-
trade? Criticize other bases of valuation which may be used.
3. Explain the use of balance sheet footnotes to indicate the market
value of stock-in-trade.
4. What is the proper basis of valuation for depreciated stock-in-
trade?
5. Discuss all of the items that may go to make up the cost of stock-
in-trade.
6. How may items of cost, which are not directly attributable to any
one department, be equitably distributed?
7. Discuss some of the problems met in valuing inventories.
Page 623
8. In the case of a manufacturing concern, discuss the valuation of
the following inventories: (a) Finished goods. (b) Raw materials.
(c) Goods in process. (d) Uncompleted contracts. (e) Scrap.
9. State the two rules to be observed when taking a physical
inventory and discuss their application.
10. How may a perpetual inventory be kept?
11. Is a physical inventory necessary when a perpetual inventory is
kept?
Chapter XIV
1. What is the usual basis upon which temporary investments should
be valued?
2. What are the advantages in the use of the “Reserve for Investment
Fluctuations” account?
3. Explain the method of valuing stock rights.
4. How are temporary investment costs handled on the books?
5. Discuss the principles governing the valuation of bonds
purchased at either a discount or a premium for temporary
account.
6. What kind of an asset is unissued stock?
7. Differentiate between the valuation of unissued stock and that of
treasury stock.
8. Give a summary of the principles of valuation of temporary
investment assets.
9. Define and give a few examples of accrued income.
10. Explain the cash method of handling accruals and tell why it is
inadequate.
11. Explain the “accrual method.”
12. On what basis should accrued items be valued, and how should
they be classed on the balance sheet?
the following inventories: (a) Finished goods. (b) Raw materials.
(c) Goods in process. (d) Uncompleted contracts. (e) Scrap.
9. State the two rules to be observed when taking a physical
inventory and discuss their application.
10. How may a perpetual inventory be kept?
11. Is a physical inventory necessary when a perpetual inventory is
kept?
Chapter XIV
1. What is the usual basis upon which temporary investments should
be valued?
2. What are the advantages in the use of the “Reserve for Investment
Fluctuations” account?
3. Explain the method of valuing stock rights.
4. How are temporary investment costs handled on the books?
5. Discuss the principles governing the valuation of bonds
purchased at either a discount or a premium for temporary
account.
6. What kind of an asset is unissued stock?
7. Differentiate between the valuation of unissued stock and that of
treasury stock.
8. Give a summary of the principles of valuation of temporary
investment assets.
9. Define and give a few examples of accrued income.
10. Explain the cash method of handling accruals and tell why it is
inadequate.
11. Explain the “accrual method.”
12. On what basis should accrued items be valued, and how should
they be classed on the balance sheet?
Page 624
13. Discuss and illustrate the methods of accounting for accrued
income.
14. Define and give examples of prepaid expense items.
15. On what basis should they be valued, and how should they be
shown on the balance sheet?
Chapter XV
1. State the characteristics of permanent investments.
2. In what three ways may a permanent or fixed investment be
effected so as to act as an aid in the operation of any business?
3. What is the chief problem in valuing those investments which aid
operation?
4. When may the “consolidated balance sheet” be used to advantage
by holding companies?
5. Discuss the factors involved in valuing claims against subsidiary
concerns on account of advances.
6. Under what conditions would it be advisable to value partial or
minor holdings at cost?
7. On what basis should investments producing no income be
valued?
8. Explain the influence of interest rates upon the valuation of
bonds.
9. Describe the nature of bond discount and of bond premium.
10. Explain the two methods of recording bond investments.
11. What data must necessarily be known in order to calculate the
periodic amortization of bond discount or premium?
12. Derive the formula for the present worth of a given sum at
compound interest.
13. Derive the formulas for the sum and present worth of an annuity.
14. Explain the three methods for valuing bonds.
income.
14. Define and give examples of prepaid expense items.
15. On what basis should they be valued, and how should they be
shown on the balance sheet?
Chapter XV
1. State the characteristics of permanent investments.
2. In what three ways may a permanent or fixed investment be
effected so as to act as an aid in the operation of any business?
3. What is the chief problem in valuing those investments which aid
operation?
4. When may the “consolidated balance sheet” be used to advantage
by holding companies?
5. Discuss the factors involved in valuing claims against subsidiary
concerns on account of advances.
6. Under what conditions would it be advisable to value partial or
minor holdings at cost?
7. On what basis should investments producing no income be
valued?
8. Explain the influence of interest rates upon the valuation of
bonds.
9. Describe the nature of bond discount and of bond premium.
10. Explain the two methods of recording bond investments.
11. What data must necessarily be known in order to calculate the
periodic amortization of bond discount or premium?
12. Derive the formula for the present worth of a given sum at
compound interest.
13. Derive the formulas for the sum and present worth of an annuity.
14. Explain the three methods for valuing bonds.
Page 625
15. On what basis should sinking funds be valued?
16. On what basis should investments in land be valued?
Chapter XVI
1. What principles are particularly applicable to the valuation of
equipment assets?
2. Distinguish clearly between real and personal property.
3. Why is it necessary to keep separate records of machinery and
tools?
4. Describe the operation of the machine account where subsidiary
records are kept.
5. What is the valuation formula for machinery?
6. Is there any necessity for a periodic revision of the depreciation
rate?
7. State the advantages of keeping a life history of units of
machinery in the subsidiary records.
8. What effect has the standardization of methods of operation and
of use of machinery and tools upon the rates of depreciation of
these assets?
9. Enumerate a few points that demand consideration in the
calculation of the depreciation rate for a machine subject to
abnormal operation.
10. When should scrap material be disposed of?
11. Due to the possibility of losing small tools, what precautions
must be taken in accounting for this class of assets?
12. Why is depreciation often ignored when estimating the value of
tools?
13. Upon what basis should tools made in the home factory be
valued?
16. On what basis should investments in land be valued?
Chapter XVI
1. What principles are particularly applicable to the valuation of
equipment assets?
2. Distinguish clearly between real and personal property.
3. Why is it necessary to keep separate records of machinery and
tools?
4. Describe the operation of the machine account where subsidiary
records are kept.
5. What is the valuation formula for machinery?
6. Is there any necessity for a periodic revision of the depreciation
rate?
7. State the advantages of keeping a life history of units of
machinery in the subsidiary records.
8. What effect has the standardization of methods of operation and
of use of machinery and tools upon the rates of depreciation of
these assets?
9. Enumerate a few points that demand consideration in the
calculation of the depreciation rate for a machine subject to
abnormal operation.
10. When should scrap material be disposed of?
11. Due to the possibility of losing small tools, what precautions
must be taken in accounting for this class of assets?
12. Why is depreciation often ignored when estimating the value of
tools?
13. Upon what basis should tools made in the home factory be
valued?
Page 626
14. When might it be proper to capitalize expenditures made for the
rearrangement of machinery within the plant?
15. Will the capitalization of this expense affect profits considered
over the life of the asset?
16. State the basis for valuing: (a) Furniture and fixtures. (b)
Delivery equipment. (c) Carriers and containers. (d) Patterns,
molds, electrotypes, etc.
17. Show the entries necessary to book the disposal of an asset
subject to depreciation.
Chapter XVII
1. What objection is there to the account title “real estate”?
2. What items enter into the cost of buildings?
3. What is the basis for valuing: (a) Buildings? (b) Betterments on
leased buildings?
4. What considerations must be taken into account in applying
depreciation to buildings?
5. What is the basis for valuing land used for operations?
6. What account should be taken of depreciation and appreciation of
land?
7. How should the carrying costs of land held for investment be
treated?
8. State fully the points to be considered in handling and valuing
donated land.
9. Where land is stock-in-trade, what objection is there to loading
the loss suffered on the sale of some portions onto the carrying
value of the unsold portions?
10. Distinguish between depletion and depreciation.
11. How is periodic depletion calculated? Explain fully.
12. Discuss fully the valuation of leaseholds.
rearrangement of machinery within the plant?
15. Will the capitalization of this expense affect profits considered
over the life of the asset?
16. State the basis for valuing: (a) Furniture and fixtures. (b)
Delivery equipment. (c) Carriers and containers. (d) Patterns,
molds, electrotypes, etc.
17. Show the entries necessary to book the disposal of an asset
subject to depreciation.
Chapter XVII
1. What objection is there to the account title “real estate”?
2. What items enter into the cost of buildings?
3. What is the basis for valuing: (a) Buildings? (b) Betterments on
leased buildings?
4. What considerations must be taken into account in applying
depreciation to buildings?
5. What is the basis for valuing land used for operations?
6. What account should be taken of depreciation and appreciation of
land?
7. How should the carrying costs of land held for investment be
treated?
8. State fully the points to be considered in handling and valuing
donated land.
9. Where land is stock-in-trade, what objection is there to loading
the loss suffered on the sale of some portions onto the carrying
value of the unsold portions?
10. Distinguish between depletion and depreciation.
11. How is periodic depletion calculated? Explain fully.
12. Discuss fully the valuation of leaseholds.
Page 627
Chapter XVIII
1. Discuss the valuation of patents: (a) When purchased. (b) When
developed within the plant. (c) Patents purchased but not used.
2. What elements of depreciation are effective on patents? In what
way?
3. What items enter into the cost of patents?
4. How may the life of basic patents be indefinitely extended?
5. What is the basis of valuation for:
(a) Copyrights?
(b) Trade secrets?
(c) Trade-marks?
6. Discuss the commercial valuation of franchises as distinguished
from the valuation allowed by public service boards.
7. How should organization expenses be handled and valued?
8. Define good-will and state its characteristics. What is its essence?
9. When may good-will be shown on the books? Discuss the several
cases.
10. State and explain three ways of valuing good-will.
11. Is good-will subject to depreciation? Discuss.
12. What objection is there to using good-will to absorb the water in
watered stock?
Chapter XIX
1. State the general problem of valuation as applied to liabilities.
2. How should the liabilities be classified?
3. What considerations must be taken into account to make sure that
all liabilities are shown on the balance sheet?
4. How should current liabilities be classified?
1. Discuss the valuation of patents: (a) When purchased. (b) When
developed within the plant. (c) Patents purchased but not used.
2. What elements of depreciation are effective on patents? In what
way?
3. What items enter into the cost of patents?
4. How may the life of basic patents be indefinitely extended?
5. What is the basis of valuation for:
(a) Copyrights?
(b) Trade secrets?
(c) Trade-marks?
6. Discuss the commercial valuation of franchises as distinguished
from the valuation allowed by public service boards.
7. How should organization expenses be handled and valued?
8. Define good-will and state its characteristics. What is its essence?
9. When may good-will be shown on the books? Discuss the several
cases.
10. State and explain three ways of valuing good-will.
11. Is good-will subject to depreciation? Discuss.
12. What objection is there to using good-will to absorb the water in
watered stock?
Chapter XIX
1. State the general problem of valuation as applied to liabilities.
2. How should the liabilities be classified?
3. What considerations must be taken into account to make sure that
all liabilities are shown on the balance sheet?
4. How should current liabilities be classified?
Page 628
5. What different classes of items may be included under the head,
accounts payable? Under trade creditors?
6. What classes of items are listed under accrued expenses?
7. In what sense is deferred income a liability?
8. Name six different classes of contingent liabilities and show how
they should be treated: (a) On the balance sheet. (b) On the
books.
Chapter XX
1. What is the basis of separation of fixed from current liabilities?
2. From a financial standpoint, what is the purpose of the incurrence
of fixed liabilities?
3. Distinguish between a corporation bond and an ordinary
mortgage or bond and mortgage.
4. What financial considerations are involved in the determination
of the advisability of a bond issue?
5. State fully the methods of accounting for a bond issue.
6. Explain fully the entries necessary to record properly bond
interest, including the amortization of premium or discount.
7. How should unissued bonds be treated on the balance sheet?
8. How should notes payable secured by real estate mortgage be
shown on the balance sheet?
9. How would you treat the securities pledged as collateral for a
bond or note issue?
10. What are short-term securities and under what conditions are
they issued?
Chapter XXI
1. What problem is involved in the valuation of capital stock?
2. Define the different kinds of value of stocks.
accounts payable? Under trade creditors?
6. What classes of items are listed under accrued expenses?
7. In what sense is deferred income a liability?
8. Name six different classes of contingent liabilities and show how
they should be treated: (a) On the balance sheet. (b) On the
books.
Chapter XX
1. What is the basis of separation of fixed from current liabilities?
2. From a financial standpoint, what is the purpose of the incurrence
of fixed liabilities?
3. Distinguish between a corporation bond and an ordinary
mortgage or bond and mortgage.
4. What financial considerations are involved in the determination
of the advisability of a bond issue?
5. State fully the methods of accounting for a bond issue.
6. Explain fully the entries necessary to record properly bond
interest, including the amortization of premium or discount.
7. How should unissued bonds be treated on the balance sheet?
8. How should notes payable secured by real estate mortgage be
shown on the balance sheet?
9. How would you treat the securities pledged as collateral for a
bond or note issue?
10. What are short-term securities and under what conditions are
they issued?
Chapter XXI
1. What problem is involved in the valuation of capital stock?
2. Define the different kinds of value of stocks.
Page 629
3. What is watered stock? Illustrate.
4. What is the objection to earning capacity as the basis of
capitalization?
5. What attitude does the law take towards capitalization?
6. How would you treat stock discount and premium on the books?
On the balance sheet?
7. How would you value: (a) Stock issued for property. (b) Treasury
stock.
8. How is the redemption or reduction of capital stock handled on
the books? Explain fully.
9. How would you value: (a) Dividend stock. (b) Bonus stock.
10. How should unissued and treasury stock be shown on the
balance sheet?
11. What is the problem of a preferred stock covered by a
redemption contract imposing definite dates of redemption on
the company?
Chapter XXII
1. What are profits? Distinguish between the economic, legal, and
accounting uses of the term.
2. What two methods are used to determine profits?
3. How are profits related to the problem of valuation?
4. What effect have asset losses on profits? Discuss fully.
5. In what three ways may such losses be treated on the books and
balance sheet?
6. How would you treat profit on goods being made for stock?
7. How would you treat profit on long-term contracts?
8. How would you treat profit on goods awaiting delivery?
9. What about profits due to appreciation of assets?
4. What is the objection to earning capacity as the basis of
capitalization?
5. What attitude does the law take towards capitalization?
6. How would you treat stock discount and premium on the books?
On the balance sheet?
7. How would you value: (a) Stock issued for property. (b) Treasury
stock.
8. How is the redemption or reduction of capital stock handled on
the books? Explain fully.
9. How would you value: (a) Dividend stock. (b) Bonus stock.
10. How should unissued and treasury stock be shown on the
balance sheet?
11. What is the problem of a preferred stock covered by a
redemption contract imposing definite dates of redemption on
the company?
Chapter XXII
1. What are profits? Distinguish between the economic, legal, and
accounting uses of the term.
2. What two methods are used to determine profits?
3. How are profits related to the problem of valuation?
4. What effect have asset losses on profits? Discuss fully.
5. In what three ways may such losses be treated on the books and
balance sheet?
6. How would you treat profit on goods being made for stock?
7. How would you treat profit on long-term contracts?
8. How would you treat profit on goods awaiting delivery?
9. What about profits due to appreciation of assets?
Page 630
10. How would capital profits be handled?
11. Sum up briefly the considerations governing the determination
of profits.
Chapter XXIII
1. Define surplus; margin. What are the sources of margin?
2. Explain the booking of the appropriation of profits.
3. In what different ways is the term reserve used?
4. What is the effect of an under-or over-estimate of valuation
reserves?
5. How would you handle expected sales discounts on outstanding
accounts?
6. How should expected collection costs be handled?
7. Distinguish between reserves and accrued items.
8. What are contingent reserves?
9. What are proprietorship reserves?
10. In what different ways may secret reserves be created?
11. Give the arguments for and against secret reserves.
12. What are covered reserves?
13. What is meant by earmarking reserves? How may continuity of
a reserve policy be secured?
14. Give a logical classification of reserves.
15. Under best practice what should the Surplus account represent?
16. Give the form for the statement of surplus.
Chapter XXIV
1. What are the stockholders’ rights as to profits? As to dividends?
2. What control have the directors over profits and dividends?
11. Sum up briefly the considerations governing the determination
of profits.
Chapter XXIII
1. Define surplus; margin. What are the sources of margin?
2. Explain the booking of the appropriation of profits.
3. In what different ways is the term reserve used?
4. What is the effect of an under-or over-estimate of valuation
reserves?
5. How would you handle expected sales discounts on outstanding
accounts?
6. How should expected collection costs be handled?
7. Distinguish between reserves and accrued items.
8. What are contingent reserves?
9. What are proprietorship reserves?
10. In what different ways may secret reserves be created?
11. Give the arguments for and against secret reserves.
12. What are covered reserves?
13. What is meant by earmarking reserves? How may continuity of
a reserve policy be secured?
14. Give a logical classification of reserves.
15. Under best practice what should the Surplus account represent?
16. Give the form for the statement of surplus.
Chapter XXIV
1. What are the stockholders’ rights as to profits? As to dividends?
2. What control have the directors over profits and dividends?
Page 631
3. How are dividends declared? May they be revoked?
4. What is the liability of directors as to dividends.
5. In what different ways may dividends be paid? Explain fully.
6. What can be said of the policy of borrowing to pay dividends?
7. What is the problem involved in stock dividends in estate
accounting?
8. How are the declaration and payment of dividends booked?
9. What is the relation of capital losses to dividends:
(a) From a legal standpoint.
(b) From a business standpoint.
10. What are liquidating dividends? How are such dividends
handled as related to wasting assets?
Chapter XXV
1. Define a sinking fund and trace its origin.
2. State the problem of the calculation of a sinking fund. Derive the
formula.
3. What other basis than the compound interest basis is often used
for the accumulation of a sinking fund?
4. Explain fully the relation of the sinking fund to profits.
5. In what four ways may the sinking fund be handled on the
balance sheet? Explain the meaning of each.
6. How should the sinking fund assets be shown on the balance
sheet?
7. Explain fully the entries needed to book the sinking fund
transactions: (a) The origin of the fund. (b) The trustee’s
periodic report. (c) The redemption of bonds and final
disposition of the fund.
4. What is the liability of directors as to dividends.
5. In what different ways may dividends be paid? Explain fully.
6. What can be said of the policy of borrowing to pay dividends?
7. What is the problem involved in stock dividends in estate
accounting?
8. How are the declaration and payment of dividends booked?
9. What is the relation of capital losses to dividends:
(a) From a legal standpoint.
(b) From a business standpoint.
10. What are liquidating dividends? How are such dividends
handled as related to wasting assets?
Chapter XXV
1. Define a sinking fund and trace its origin.
2. State the problem of the calculation of a sinking fund. Derive the
formula.
3. What other basis than the compound interest basis is often used
for the accumulation of a sinking fund?
4. Explain fully the relation of the sinking fund to profits.
5. In what four ways may the sinking fund be handled on the
balance sheet? Explain the meaning of each.
6. How should the sinking fund assets be shown on the balance
sheet?
7. Explain fully the entries needed to book the sinking fund
transactions: (a) The origin of the fund. (b) The trustee’s
periodic report. (c) The redemption of bonds and final
disposition of the fund.
Page 632
8. Discuss fully the relation between the reserve for depreciation
and the sinking fund.
Chapter XXVI
1. Is the profit and loss a statement of fact or of opinion? Explain.
2. For what purposes is the periodic profit and loss summary
inadequate? Discuss fully.
3. Give the arguments for inclusion of interest as an item of
manufacturing cost.
4. Give the arguments against its inclusion. If its inclusion is
allowed, how must it be booked?
5. State fully the case of bringing unrealized profits on the books.
6. What distinctive problems arise in closing the books of a
corporation? Discuss.
7. How are errors of previous periods to be corrected?
Chapter XXVII
1. Give the various titles used for the profit and loss summary and
indicate their special uses, if any.
2. Indicate the subsections, and their content, of the manufacturing
section.
3. Indicate the content of the trading section.
4. Indicate the content of the general administrative section.
5. Indicate the content of any other sections and show their uses.
6. State and discuss the different methods of handling some items,
such as goods in process, discounts, outfreight, rent, insurance,
etc.
7. What purpose does the use of schedules serve?
8. Is the profit and loss the proper place to show all adjustments of
surplus?
and the sinking fund.
Chapter XXVI
1. Is the profit and loss a statement of fact or of opinion? Explain.
2. For what purposes is the periodic profit and loss summary
inadequate? Discuss fully.
3. Give the arguments for inclusion of interest as an item of
manufacturing cost.
4. Give the arguments against its inclusion. If its inclusion is
allowed, how must it be booked?
5. State fully the case of bringing unrealized profits on the books.
6. What distinctive problems arise in closing the books of a
corporation? Discuss.
7. How are errors of previous periods to be corrected?
Chapter XXVII
1. Give the various titles used for the profit and loss summary and
indicate their special uses, if any.
2. Indicate the subsections, and their content, of the manufacturing
section.
3. Indicate the content of the trading section.
4. Indicate the content of the general administrative section.
5. Indicate the content of any other sections and show their uses.
6. State and discuss the different methods of handling some items,
such as goods in process, discounts, outfreight, rent, insurance,
etc.
7. What purpose does the use of schedules serve?
8. Is the profit and loss the proper place to show all adjustments of
surplus?
Page 633
Chapter XXVIII
1. Under what conditions may a corporation liquidate? Distinguish
between actual and legal insolvency.
2. Name and discuss seven causes or conditions resulting in
insolvency.
3. Name the methods of liquidation.
4. What are acts of bankruptcy? Discuss.
5. Outline the process of liquidation under bankruptcy.
6. Outline the process of liquidation under voluntary dissolution.
7. Outline the process of liquidation under receivership.
8. What is the status of the several claimants to shares in the assets
of a liquidating concern?
9. What are the fundamental principles of accounting involved in
accounting for a liquidation?
Chapter XXIX
1. What various kinds of consolidations are there?
2. What is a holding company and how does it operate?
3. Distinguish between a consolidation and a merger.
4. What are some of the problems involved in the valuation of the
various companies to a merger or consolidation? Discuss their
treatment.
5. In such a valuation, why is it necessary to equalize conditions and
what are the conditions which must usually be equalized?
6. In a partnership what particular items must be considered?
7. What is meant by earning capacity?
8. What factors enter into a determination of the amount of
capitalization?
1. Under what conditions may a corporation liquidate? Distinguish
between actual and legal insolvency.
2. Name and discuss seven causes or conditions resulting in
insolvency.
3. Name the methods of liquidation.
4. What are acts of bankruptcy? Discuss.
5. Outline the process of liquidation under bankruptcy.
6. Outline the process of liquidation under voluntary dissolution.
7. Outline the process of liquidation under receivership.
8. What is the status of the several claimants to shares in the assets
of a liquidating concern?
9. What are the fundamental principles of accounting involved in
accounting for a liquidation?
Chapter XXIX
1. What various kinds of consolidations are there?
2. What is a holding company and how does it operate?
3. Distinguish between a consolidation and a merger.
4. What are some of the problems involved in the valuation of the
various companies to a merger or consolidation? Discuss their
treatment.
5. In such a valuation, why is it necessary to equalize conditions and
what are the conditions which must usually be equalized?
6. In a partnership what particular items must be considered?
7. What is meant by earning capacity?
8. What factors enter into a determination of the amount of
capitalization?
Page 634
9. How may the interests of the various parties to a merger or
consolidation be settled?
10. State the method of opening the books of the merger.
11. State the method of closing the books of the merged companies.
Chapter XXX
1. Discuss the branch and agency methods of marketing.
2. Differentiate between the branch and agency.
3. Discuss the problem of control over the branch by the head office.
4. What are the fundamental principles of branch accounting?
5. How may agency accounts be kept?
6. Indicate the method of keeping both the branch books and the
branch activities on the head office books where goods are billed
by the head office to the branch: (a) At cost price. (b) At some
other price than cost.
7. Discuss briefly the handling of branch purchases, sales, and cash
in order to secure head office control over them.
8. Discuss fully the periodic summary of results and the adjustments
necessary at such a time between the branch and head office
books.
9. What reports should the branch make the head office?
Chapter XXXI
1. What problems beyond those of the domestic branch are met in
accounting for the foreign branch?
2. What control accounts are usually carried on the head office
books?
3. State and explain the principles of the conversion of branch
results and their incorporation with the head office results.
4. How are fluctuations of exchange handled? Discuss fully.
consolidation be settled?
10. State the method of opening the books of the merger.
11. State the method of closing the books of the merged companies.
Chapter XXX
1. Discuss the branch and agency methods of marketing.
2. Differentiate between the branch and agency.
3. Discuss the problem of control over the branch by the head office.
4. What are the fundamental principles of branch accounting?
5. How may agency accounts be kept?
6. Indicate the method of keeping both the branch books and the
branch activities on the head office books where goods are billed
by the head office to the branch: (a) At cost price. (b) At some
other price than cost.
7. Discuss briefly the handling of branch purchases, sales, and cash
in order to secure head office control over them.
8. Discuss fully the periodic summary of results and the adjustments
necessary at such a time between the branch and head office
books.
9. What reports should the branch make the head office?
Chapter XXXI
1. What problems beyond those of the domestic branch are met in
accounting for the foreign branch?
2. What control accounts are usually carried on the head office
books?
3. State and explain the principles of the conversion of branch
results and their incorporation with the head office results.
4. How are fluctuations of exchange handled? Discuss fully.
Page 635
5. What peculiarities of regulation over accounts are sometimes met
in foreign countries?
6. Explain fully the method of keeping foreign customers’ accounts
on the head office books and the periodic adjustment of their
control account.
7. Explain the similar method of keeping creditors’ accounts.
Chapter XXXII
1. What are suspense accounts? Give several examples of different
kinds of suspense accounts.
2. In what sense are valuation accounts suspense accounts?
3. What is the suspense ledger? What does its use indicate? What
information should such a ledger present?
4. What is the process of hypothecating accounts receivable? What
does such a practice usually indicate?
5. Discuss fully the problem of accounting for hypothecated
accounts.
6. What advantage has the system of numbering accounts over that
of naming them?
7. Show how a numeric-alphabetic system may be constructed.
8. Present a complete schedule of numbered accounts.
9. Explain the insurance contract.
10. How should fire-damaged property be handled in order to base a
claim for loss?
11. How is the amount of the liability of the insurance company
determined?
12. What is the effect of the coinsurance clause? Illustrate the three
cases.
13. How should the records be kept to facilitate adjustment of fire
losses?
in foreign countries?
6. Explain fully the method of keeping foreign customers’ accounts
on the head office books and the periodic adjustment of their
control account.
7. Explain the similar method of keeping creditors’ accounts.
Chapter XXXII
1. What are suspense accounts? Give several examples of different
kinds of suspense accounts.
2. In what sense are valuation accounts suspense accounts?
3. What is the suspense ledger? What does its use indicate? What
information should such a ledger present?
4. What is the process of hypothecating accounts receivable? What
does such a practice usually indicate?
5. Discuss fully the problem of accounting for hypothecated
accounts.
6. What advantage has the system of numbering accounts over that
of naming them?
7. Show how a numeric-alphabetic system may be constructed.
8. Present a complete schedule of numbered accounts.
9. Explain the insurance contract.
10. How should fire-damaged property be handled in order to base a
claim for loss?
11. How is the amount of the liability of the insurance company
determined?
12. What is the effect of the coinsurance clause? Illustrate the three
cases.
13. How should the records be kept to facilitate adjustment of fire
losses?
Page 636
14. Explain fully the method of booking a fire loss and its
adjustment.
Chapter XXXIII
1. State some of the uses to which statistics may be put in business.
2. What is the importance of statistics in railroad accounting and
management?
3. What kinds of manufacturing data may be presented in statistical
form?
4. What kinds of trading data may be presented in statistical form?
5. Discuss the use of graphs in the presentation of statistics.
6. What principles should be observed in graphical presentation?
7. Explain the purpose, content, and operation of private books.
8. What is a journal voucher, its purpose and method of use?
9. Explain the two ways in which income and expenses of buildings
owned may be treated and the purposes each method serves.
10. How should the expense of social betterment work be treated?
Chapter XXXIV
1. In what respects is the balance sheet of the holding company
deficient and unsatisfactory?
2. Differentiate between the consolidated balance sheet and the
holding company’s balance sheet.
3. When, in the case of partial ownership of the subsidiaries, does
the consolidated balance sheet reflect true condition?
4. State fully how partial ownership may best be shown.
5. How are intercompany accounts handled on the consolidated
balance sheet?
6. How are the various inventories valued for the consolidated
balance sheet?
adjustment.
Chapter XXXIII
1. State some of the uses to which statistics may be put in business.
2. What is the importance of statistics in railroad accounting and
management?
3. What kinds of manufacturing data may be presented in statistical
form?
4. What kinds of trading data may be presented in statistical form?
5. Discuss the use of graphs in the presentation of statistics.
6. What principles should be observed in graphical presentation?
7. Explain the purpose, content, and operation of private books.
8. What is a journal voucher, its purpose and method of use?
9. Explain the two ways in which income and expenses of buildings
owned may be treated and the purposes each method serves.
10. How should the expense of social betterment work be treated?
Chapter XXXIV
1. In what respects is the balance sheet of the holding company
deficient and unsatisfactory?
2. Differentiate between the consolidated balance sheet and the
holding company’s balance sheet.
3. When, in the case of partial ownership of the subsidiaries, does
the consolidated balance sheet reflect true condition?
4. State fully how partial ownership may best be shown.
5. How are intercompany accounts handled on the consolidated
balance sheet?
6. How are the various inventories valued for the consolidated
balance sheet?
Page 637
7. Explain the manner of showing capital stock on the consolidated
balance sheet.
8. Explain the manner of showing surplus (or deficit) on the
consolidated balance sheet.
9. Explain how the consolidated profit and loss summary should be
drawn up. How does it differ from the holding company’s profit
and loss summary?
Chapter XXXV
1. Distinguish between assignee, receiver, and trustee, and state their
respective duties.
2. What accounts should a receiver in equity keep? What reports
should he make to the court?
3. What initial statements are presented to the court in: (a) Voluntary
bankruptcy proceedings? (b) In involuntary bankruptcy?
4. What reports does the court require of the trustee? How often?
5. What is a liquidating dividend?
6. In a case of bankruptcy what classes of creditors are there?
7. What is the statement of affairs and what information does it
attempt to present?
8. What basis of valuation of the assets is used for the statement of
affairs?
9. What is the realization and liquidation statement? What purpose
does it serve?
10. What theories underlie its make-up?
11. How are cash and valuation reserves best handled?
12. What problem is involved in partnership liquidation by
instalments?
13. How should it be solved theoretically? How is it often solved in
practice?
balance sheet.
8. Explain the manner of showing surplus (or deficit) on the
consolidated balance sheet.
9. Explain how the consolidated profit and loss summary should be
drawn up. How does it differ from the holding company’s profit
and loss summary?
Chapter XXXV
1. Distinguish between assignee, receiver, and trustee, and state their
respective duties.
2. What accounts should a receiver in equity keep? What reports
should he make to the court?
3. What initial statements are presented to the court in: (a) Voluntary
bankruptcy proceedings? (b) In involuntary bankruptcy?
4. What reports does the court require of the trustee? How often?
5. What is a liquidating dividend?
6. In a case of bankruptcy what classes of creditors are there?
7. What is the statement of affairs and what information does it
attempt to present?
8. What basis of valuation of the assets is used for the statement of
affairs?
9. What is the realization and liquidation statement? What purpose
does it serve?
10. What theories underlie its make-up?
11. How are cash and valuation reserves best handled?
12. What problem is involved in partnership liquidation by
instalments?
13. How should it be solved theoretically? How is it often solved in
practice?
Page 638
INDEX
A
Accidents, Contingent Depreciation, 131
Accounting,
branch house (See “Branch house accounting”)
department, organization, manufacturing business, 26
difference between factory and financial, 49
Accounts,
branch (See “Branch house accounting”)
current,
reconcilement of, consolidated balance sheet, 607
deficiency, 633
Forms, 635, 638
doubtful, reserve for,
a suspense account, 558
head office, 531
impairment of capital, 633
valuation of, 222
manufacturing, 690
numbered (See “Numbered accounts”)
open,
discounted, accounting for, 562
discounting, 560
operating expense, classification, 567
operating revenue, classification, 566
payable, 345
consigned goods sold, 349
definition, 347
deposits, 348
dividends not yet paid, 349
future deliveries, 349
long-term notes, 349
“not due” and “past due,” 348
realization and liquidation, 639-650
Forms, 642
receivable,
A
Accidents, Contingent Depreciation, 131
Accounting,
branch house (See “Branch house accounting”)
department, organization, manufacturing business, 26
difference between factory and financial, 49
Accounts,
branch (See “Branch house accounting”)
current,
reconcilement of, consolidated balance sheet, 607
deficiency, 633
Forms, 635, 638
doubtful, reserve for,
a suspense account, 558
head office, 531
impairment of capital, 633
valuation of, 222
manufacturing, 690
numbered (See “Numbered accounts”)
open,
discounted, accounting for, 562
discounting, 560
operating expense, classification, 567
operating revenue, classification, 566
payable, 345
consigned goods sold, 349
definition, 347
deposits, 348
dividends not yet paid, 349
future deliveries, 349
long-term notes, 349
“not due” and “past due,” 348
realization and liquidation, 639-650
Forms, 642
receivable,
Page 639
analysis of customers’ accounts as basis for estimate
of bad debts, 217
basis of estimate of bad debts, 219
discounted, 560
discounted, accounting for, 562
items included, 215
objection to title, 215
“trade debtors,” 216
valuation of, 215
receivers’ (See “Receivers”)
reserve (See “Reserves”)
salvage, 188
showing of intercompany, 606
surplus (See “Surplus”)
suspense (See “Suspense accounts”)
trustee (See “Trustee”)
valuation, 187
bond investments, 267
showing on the balance sheet, 77
Accrual method, 250
Accrued depreciation (See “Depreciation”)
Accrued expenses (See “Expenses”)
Accrued income (See “Income”)
Adaptation, appreciation due to, 207
Adjustment,
fire losses (See “Fire losses”)
plant ledger, 193
Administrative schedules, profit and loss summary, 491
Advances,
to subsidiaries, 262
rules for valuation, 263
Advertising,
creation of good-will by, 334
statistics, 584
Agency,
accounts, 525
branch and, differentiated, 522
foreign purchasing, 555
foreign sales, 552
periodic conversion of results, 553
of bad debts, 217
basis of estimate of bad debts, 219
discounted, 560
discounted, accounting for, 562
items included, 215
objection to title, 215
“trade debtors,” 216
valuation of, 215
receivers’ (See “Receivers”)
reserve (See “Reserves”)
salvage, 188
showing of intercompany, 606
surplus (See “Surplus”)
suspense (See “Suspense accounts”)
trustee (See “Trustee”)
valuation, 187
bond investments, 267
showing on the balance sheet, 77
Accrual method, 250
Accrued depreciation (See “Depreciation”)
Accrued expenses (See “Expenses”)
Accrued income (See “Income”)
Adaptation, appreciation due to, 207
Adjustment,
fire losses (See “Fire losses”)
plant ledger, 193
Administrative schedules, profit and loss summary, 491
Advances,
to subsidiaries, 262
rules for valuation, 263
Advertising,
creation of good-will by, 334
statistics, 584
Agency,
accounts, 525
branch and, differentiated, 522
foreign purchasing, 555
foreign sales, 552
periodic conversion of results, 553
Page 640
Allowances,
purchase, under voucher system, 40
Amortization,
bond discount and premium, 269
schedule showing, 270
leaseholds, 315
Annuity,
compound interest, formulas, 164
formulas, 272-276
method of calculating depreciation,
Chart, 166
appraisal of, 181
compound interest method, 161, 163-167
fixed periodic amount, 165
interest, 165
Appraisal method of calculating depreciation, 169, 170, 183
Appraisal schedule,
sinking fund method of calculating depreciation, 162
Appraisals (See “Valuation, principles of”)
Appreciation,
due to physical changes, 207
adaptation, 207
solidification and seasoning, 207
land values, 304
issue of bonds, 305
sale of old and erection of plant on less valuable land, 305
offset to depreciation, 206
profits due to, 404
unearned increment, 209
Assessment, Stock,
creation of a margin, 409
Assets,
contingent, 81
current,
depreciation, 119
transfer of, into fixed assets common cause of insolvency, 494
disposal of, 295
effect of losses on future profits, 393
grouping on balance sheet, 70-74
immovable tangible fixed,
purchase, under voucher system, 40
Amortization,
bond discount and premium, 269
schedule showing, 270
leaseholds, 315
Annuity,
compound interest, formulas, 164
formulas, 272-276
method of calculating depreciation,
Chart, 166
appraisal of, 181
compound interest method, 161, 163-167
fixed periodic amount, 165
interest, 165
Appraisal method of calculating depreciation, 169, 170, 183
Appraisal schedule,
sinking fund method of calculating depreciation, 162
Appraisals (See “Valuation, principles of”)
Appreciation,
due to physical changes, 207
adaptation, 207
solidification and seasoning, 207
land values, 304
issue of bonds, 305
sale of old and erection of plant on less valuable land, 305
offset to depreciation, 206
profits due to, 404
unearned increment, 209
Assessment, Stock,
creation of a margin, 409
Assets,
contingent, 81
current,
depreciation, 119
transfer of, into fixed assets common cause of insolvency, 494
disposal of, 295
effect of losses on future profits, 393
grouping on balance sheet, 70-74
immovable tangible fixed,
Page 641
buildings, land, and wasting assets, 297-315
intangible, 316-338
losses,
charged against current profits, 396
charged to capital, 397
legal decisions as to, 394
treated as deferred expense charge, 396
movable fixed,
machinery and tools, furniture and fixtures, and other
equipment, 279-296
plant, grouping and classification of, 191
profits due to appreciation of, 404
subject to depreciation a deferred charge to operations, 93
undervaluation, creating a secret reserve, 418
valuation of,
current assets, 96
deferred charges to operation, 96
fixed assets, 96
wasting (See “Wasting assets”)
Assignee,
accounting features same as for receiver and trustee, 621
appointment of, 620
function of, 620
Average clause,
fire insurance contract, 574
Averages,
theory of, repairs, 147
B
Bad debts (See “Debts, bad”)
Balance sheet, 60-80
account form of, 74-76
accrued items, 250
anticipation of profits or losses on stock-in-trade, 227
bonds,
presentation of, 369
valuation, 266
business methods under the microscope, 60
capital stock, 374, 383
cash, 210-214
intangible, 316-338
losses,
charged against current profits, 396
charged to capital, 397
legal decisions as to, 394
treated as deferred expense charge, 396
movable fixed,
machinery and tools, furniture and fixtures, and other
equipment, 279-296
plant, grouping and classification of, 191
profits due to appreciation of, 404
subject to depreciation a deferred charge to operations, 93
undervaluation, creating a secret reserve, 418
valuation of,
current assets, 96
deferred charges to operation, 96
fixed assets, 96
wasting (See “Wasting assets”)
Assignee,
accounting features same as for receiver and trustee, 621
appointment of, 620
function of, 620
Average clause,
fire insurance contract, 574
Averages,
theory of, repairs, 147
B
Bad debts (See “Debts, bad”)
Balance sheet, 60-80
account form of, 74-76
accrued items, 250
anticipation of profits or losses on stock-in-trade, 227
bonds,
presentation of, 369
valuation, 266
business methods under the microscope, 60
capital stock, 374, 383
cash, 210-214
Page 642
classification, 70
comparative, receiver’s report to the court, 627
condensation of information in, 77
condensed, 693
consolidated (See “Consolidated balance sheet”)
content and valuation, 81
contingent assets, 81
contingent liabilities, 81
contingent liabilities, kinds of, 352
definition, 62
depreciation reserve, 199
accounts, 187
English form,
double-account form, 68
Form, 69
origin of, 65
variation of, 67
form of, 63
groups, 70
arrangement of, 72
distinction between current and working assets, 71
main, of asset items, 95
suggested scheme, 74
titles, 71
intangible assets, 316-338
interrelation of profit and loss and, 466
lack of clearness, 79
estimates rather than facts, 80
purposeful misrepresentation, 80
vagueness of terminology, 79
land, donated, contingent value of, 713
liabilities, 339-342
arrangement, 340
cancellation of, against assets, 341
items within groups, 341
notes payable, classification of, 346, 347
purposes and uses, 64, 77
reading of, 61
knowledge of accounts, 61
knowledge of the principles of valuation, 61
comparative, receiver’s report to the court, 627
condensation of information in, 77
condensed, 693
consolidated (See “Consolidated balance sheet”)
content and valuation, 81
contingent assets, 81
contingent liabilities, 81
contingent liabilities, kinds of, 352
definition, 62
depreciation reserve, 199
accounts, 187
English form,
double-account form, 68
Form, 69
origin of, 65
variation of, 67
form of, 63
groups, 70
arrangement of, 72
distinction between current and working assets, 71
main, of asset items, 95
suggested scheme, 74
titles, 71
intangible assets, 316-338
interrelation of profit and loss and, 466
lack of clearness, 79
estimates rather than facts, 80
purposeful misrepresentation, 80
vagueness of terminology, 79
land, donated, contingent value of, 713
liabilities, 339-342
arrangement, 340
cancellation of, against assets, 341
items within groups, 341
notes payable, classification of, 346, 347
purposes and uses, 64, 77
reading of, 61
knowledge of accounts, 61
knowledge of the principles of valuation, 61
Page 643
relation between, and trial balance, 62, 77
report form of, 74-76
sales discounts on, 415
sinking fund, 457
valuation of, 276
statutory requirements as to frequency of, 77
stock-in-trade, 225-240
temporary investments; accrued and deferred items, 241-257
titles, 70
notes receivable, 223
treasury stock, 383
types of, 65
Continental, 65
English, 65
use of supporting schedules, 79
valuation accounts, 77
valuation and content rather than form, the problem, 97
Bank,
account, voucher checks given a new series of numbers to
facilitate reconciliation with, 37
disposition of cash funds, 211, 213
loans, 347
Bankruptcy, 620-654
appointment,
receiver, 621, 622
trustee, 621, 622
creditors’, first meeting of, 622
deficiency account, 633
Form, 635, 638
disposing of property, 629
duty of trustee, 502
involuntary, 622
liquidating dividends,
declaration of, in hands of referee, 630
method of liquidating, 502
proceedings, initial statements presented to the court, 627
realization and liquidation account, 639-650
Forms, 642
receiver, reports to the court, 625
relative standing of creditors, 630
report form of, 74-76
sales discounts on, 415
sinking fund, 457
valuation of, 276
statutory requirements as to frequency of, 77
stock-in-trade, 225-240
temporary investments; accrued and deferred items, 241-257
titles, 70
notes receivable, 223
treasury stock, 383
types of, 65
Continental, 65
English, 65
use of supporting schedules, 79
valuation accounts, 77
valuation and content rather than form, the problem, 97
Bank,
account, voucher checks given a new series of numbers to
facilitate reconciliation with, 37
disposition of cash funds, 211, 213
loans, 347
Bankruptcy, 620-654
appointment,
receiver, 621, 622
trustee, 621, 622
creditors’, first meeting of, 622
deficiency account, 633
Form, 635, 638
disposing of property, 629
duty of trustee, 502
involuntary, 622
liquidating dividends,
declaration of, in hands of referee, 630
method of liquidating, 502
proceedings, initial statements presented to the court, 627
realization and liquidation account, 639-650
Forms, 642
receiver, reports to the court, 625
relative standing of creditors, 630
Page 644
statement of affairs, 631
Forms, 634-638
basis of valuation, 633
voluntary, 622
Barrels, valuation of, 293
Baskets, valuation of, 293
Betterments, 89-93
distinction between repairs and renewals, 113
leased buildings, 300
recording depreciation on the books, 189
Bonds,
accounting for issue of, 363
entry of interest payments on books, 366
entry of premium or discount on books, 365
entry on books, 364
relation of interest to premiums or discount, 367
amortization of discount and premium, 269
authority for issue of, 361
bonus, 13
classification, 359-361
character of issuing corporation, 359
conditions incident upon payment of principal and interest, 360
purpose of the issue, 359
security underlying, 359
difference between, and real estate mortgages, 358
discount,
nature of, 266
profit and loss summary, 474
example of true interest cost, 368
financial considerations involved in issue, 361
fixed liability, 357
interest rate, 267
issue of, on appreciated land values, 305
kinds of, 358
methods of valuing,
annuities, formulas for, 272-276
compound interest, formulas for, 271
nature of, 357
payment of dividends in, 438
premium, 343
Forms, 634-638
basis of valuation, 633
voluntary, 622
Barrels, valuation of, 293
Baskets, valuation of, 293
Betterments, 89-93
distinction between repairs and renewals, 113
leased buildings, 300
recording depreciation on the books, 189
Bonds,
accounting for issue of, 363
entry of interest payments on books, 366
entry of premium or discount on books, 365
entry on books, 364
relation of interest to premiums or discount, 367
amortization of discount and premium, 269
authority for issue of, 361
bonus, 13
classification, 359-361
character of issuing corporation, 359
conditions incident upon payment of principal and interest, 360
purpose of the issue, 359
security underlying, 359
difference between, and real estate mortgages, 358
discount,
nature of, 266
profit and loss summary, 474
example of true interest cost, 368
financial considerations involved in issue, 361
fixed liability, 357
interest rate, 267
issue of, on appreciated land values, 305
kinds of, 358
methods of valuing,
annuities, formulas for, 272-276
compound interest, formulas for, 271
nature of, 357
payment of dividends in, 438
premium, 343
Page 645
nature of, 266
presentation on balance sheet, 369
priority of lien, 361
record of investments, 267
sinking fund, 447-465
surety, signature to, contingent liability, 355
valuation of, when held for temporary investment, 245
values and market interest rates, 265
versus stock issues, 362
Bonus,
bonds, 13
stock, 13, 16
stock issued as, 383
treated as entries to a margin account, 409
Books (See “Records”)
private (See “Private books”)
Borrowing, to pay dividends, 436
Bottles, valuation of, 293
Boxes, valuation of, 293
Branch house accounting, 521-555
adjustment on branch and head office books, 535
advantages of branch and agency system, 521
agency accounts, 525
agency and branch differentiated, 522
agency, foreign sales, 552
periodic conversion of results, 553
books, 529
degree of control desired, 523
example of adjusting entries, 537
factors of successful management, 523
foreign branch
accounts opened on books, 544
conversion of branch results, 546
example of a London control account, 550
example of journal entries to adjust
New York books, 549, 550
example of trial balance, 548, 549
handling fluctuations in exchange, 545
illustrative bookkeeping problem, 548
local supervision of, 552
presentation on balance sheet, 369
priority of lien, 361
record of investments, 267
sinking fund, 447-465
surety, signature to, contingent liability, 355
valuation of, when held for temporary investment, 245
values and market interest rates, 265
versus stock issues, 362
Bonus,
bonds, 13
stock, 13, 16
stock issued as, 383
treated as entries to a margin account, 409
Books (See “Records”)
private (See “Private books”)
Borrowing, to pay dividends, 436
Bottles, valuation of, 293
Boxes, valuation of, 293
Branch house accounting, 521-555
adjustment on branch and head office books, 535
advantages of branch and agency system, 521
agency accounts, 525
agency and branch differentiated, 522
agency, foreign sales, 552
periodic conversion of results, 553
books, 529
degree of control desired, 523
example of adjusting entries, 537
factors of successful management, 523
foreign branch
accounts opened on books, 544
conversion of branch results, 546
example of a London control account, 550
example of journal entries to adjust
New York books, 549, 550
example of trial balance, 548, 549
handling fluctuations in exchange, 545
illustrative bookkeeping problem, 548
local supervision of, 552
Page 646
problem of, 543
foreign exchange, 542
handling fluctuations in, 545
foreign purchasing agency, 555
head office accounts, 531
illustration of complex accounts, 529
illustration of simple accounts, 526
main principles of, 524
purchases, 533
records, 526
reports from branch, 539
customers’ accounts collected, 541
examples of, 540
periodic cash summary, 540
sales, 534
Brokers,
stocks and bonds as stock-in-trade, valuation of, 245
Buildings,
cost of, 298
issue of stocks or bonds, 298
purchased outright for cash, 298
put up by the concern itself, 299
depreciation,
application of, 301
rates, 301
uses and construction determine life, 301
expense and income,
allocation of, 596
methods of bookkeeping, 598
workmen’s dwellings and social betterment work, 599
leased betterments on, 300
owned as freehold for life, 302
ownership versus renting, 597
real property, 297
valuation of, 300
Burden, definition of, 50
C
Capital,
deficiency, false good-will to cover, 336
foreign exchange, 542
handling fluctuations in, 545
foreign purchasing agency, 555
head office accounts, 531
illustration of complex accounts, 529
illustration of simple accounts, 526
main principles of, 524
purchases, 533
records, 526
reports from branch, 539
customers’ accounts collected, 541
examples of, 540
periodic cash summary, 540
sales, 534
Brokers,
stocks and bonds as stock-in-trade, valuation of, 245
Buildings,
cost of, 298
issue of stocks or bonds, 298
purchased outright for cash, 298
put up by the concern itself, 299
depreciation,
application of, 301
rates, 301
uses and construction determine life, 301
expense and income,
allocation of, 596
methods of bookkeeping, 598
workmen’s dwellings and social betterment work, 599
leased betterments on, 300
owned as freehold for life, 302
ownership versus renting, 597
real property, 297
valuation of, 300
Burden, definition of, 50
C
Capital,
deficiency, false good-will to cover, 336
Page 647
expenditures (See “Capital expenditures” below)
liquidating dividends, 445
losses,
charged to, 397
relation to dividends, 443
profits, 405
return of, in form of dividends when property is subject
to depletion, 311
working, donated, disposition of, 475
Capital expenditures, 87
asset subject to depreciation a deferred
charge to operations, 93
authorization for booking, 94
construction costs, 94
defined, 87
distinction between, and revenue, 95
repairs on second-hand plant, 94
treatment of cost-cutting changes, 92
Capitalization,
combinations and consolidation, 516
cost, 376
earnings, 375
increase of book, 375
of profits, valuation of good-will based on, 335
Capital receipts, 87
Capital stock (See “Stock”)
Carriers, valuation of, 293
Cash, 210-214
disposition of funds, 213
bank, 213
petty cash, 213
safe or drawer, 213
various working funds, 213
held abroad, 214
petty, 211
imprest system, 211
principles of valuation, 210
realization and liquidation statement, 643
sale of capital stock or bond issues, 213
stamps remitted as, 212
liquidating dividends, 445
losses,
charged to, 397
relation to dividends, 443
profits, 405
return of, in form of dividends when property is subject
to depletion, 311
working, donated, disposition of, 475
Capital expenditures, 87
asset subject to depreciation a deferred
charge to operations, 93
authorization for booking, 94
construction costs, 94
defined, 87
distinction between, and revenue, 95
repairs on second-hand plant, 94
treatment of cost-cutting changes, 92
Capitalization,
combinations and consolidation, 516
cost, 376
earnings, 375
increase of book, 375
of profits, valuation of good-will based on, 335
Capital receipts, 87
Capital stock (See “Stock”)
Carriers, valuation of, 293
Cash, 210-214
disposition of funds, 213
bank, 213
petty cash, 213
safe or drawer, 213
various working funds, 213
held abroad, 214
petty, 211
imprest system, 211
principles of valuation, 210
realization and liquidation statement, 643
sale of capital stock or bond issues, 213
stamps remitted as, 212
Page 648
statistics, 584
temporary disbursements, 213
tying up, in stocks of material, cause of insolvency, 494
unwise use of, for paying dividends, 495
what the term includes, 210
working funds, 211
imprest system, 211
Cash book,
separate, for special bank account, 670
Casks, valuation of, 293
Certificate of stock, 9, 10
Charts (See “Graphs”)
Check,
voucher, 32
canceled, 32
distribution of charges, 32
folded, 32
Forms, 33
given a new series of numbers to facilitate reconciliation
with bank account, 37
single, 32
Forms, 34
Classification,
accounting, of depreciation on patents, 322
accounts (See “Numbered accounts”)
plant assets, 191
alphabetic numeric system, 191
combined alphabetical and decimal numerical system, 191
numerical, 191
Climatic conditions, factor in determining depreciation rate, 143
“Close” corporations, 2
Coinsurance clause, 574
Collateral, loans on, 370
Collections costs,
allocation of, 414
statistics, 584
valuation of trade debtors, 221
Combinations and consolidations, 507-520
capitalization, 516
closing the books of the merged concerns, 518
temporary disbursements, 213
tying up, in stocks of material, cause of insolvency, 494
unwise use of, for paying dividends, 495
what the term includes, 210
working funds, 211
imprest system, 211
Cash book,
separate, for special bank account, 670
Casks, valuation of, 293
Certificate of stock, 9, 10
Charts (See “Graphs”)
Check,
voucher, 32
canceled, 32
distribution of charges, 32
folded, 32
Forms, 33
given a new series of numbers to facilitate reconciliation
with bank account, 37
single, 32
Forms, 34
Classification,
accounting, of depreciation on patents, 322
accounts (See “Numbered accounts”)
plant assets, 191
alphabetic numeric system, 191
combined alphabetical and decimal numerical system, 191
numerical, 191
Climatic conditions, factor in determining depreciation rate, 143
“Close” corporations, 2
Coinsurance clause, 574
Collateral, loans on, 370
Collections costs,
allocation of, 414
statistics, 584
valuation of trade debtors, 221
Combinations and consolidations, 507-520
capitalization, 516
closing the books of the merged concerns, 518
Page 649
consolidations,
distinction between, and merger, 510
formation of, 511
earning capacity, 515
equalization of conditions, 513
good-will, 515
merger,
formation of, 511
opening the books, of, 519
payment of amalgamated interests, 517
principles of valuation of the constituent companies, 512
reasons for, 507
types of, 507
valuation of, principle, 514
Commercial corporations, 2
Common stock (See “Stock”)
Comparative statement of profit and loss
(See “Profit and loss summary”)
Composite life method,
calculating depreciation, 155
appraisement of, 177
Compound interest,
formulas for, 271
Condensation, balance sheet, 77
Condition per cent, 172
test of, 195
Consigned goods sold, current liability, 349
Consolidated balance sheet, 261, 600-619
capital stock, 611
conditions under which used, 602
current accounts, reconciliation of, 607
deficit, 612
function, 600
holding company, 602
illustration of, 616-619
intercompany accounts, 606
notes discounted, 607
partial ownership, 601
profit and loss summary, 612-615
purpose, 600
distinction between, and merger, 510
formation of, 511
earning capacity, 515
equalization of conditions, 513
good-will, 515
merger,
formation of, 511
opening the books, of, 519
payment of amalgamated interests, 517
principles of valuation of the constituent companies, 512
reasons for, 507
types of, 507
valuation of, principle, 514
Commercial corporations, 2
Common stock (See “Stock”)
Comparative statement of profit and loss
(See “Profit and loss summary”)
Composite life method,
calculating depreciation, 155
appraisement of, 177
Compound interest,
formulas for, 271
Condensation, balance sheet, 77
Condition per cent, 172
test of, 195
Consigned goods sold, current liability, 349
Consolidated balance sheet, 261, 600-619
capital stock, 611
conditions under which used, 602
current accounts, reconciliation of, 607
deficit, 612
function, 600
holding company, 602
illustration of, 616-619
intercompany accounts, 606
notes discounted, 607
partial ownership, 601
profit and loss summary, 612-615
purpose, 600
Page 650
setting up of, 603
surplus, 611
valuation of inventory, 607
minority interests, 610
valuation of liabilities, 611
Consolidated profit and loss summary, 612-615
Consolidations (See “Combinations and consolidations”)
Construction costs, 94
Containers, valuation of, 293
Contingent depreciation (See “Depreciation”)
Contingent liabilities (See “Liabilities”)
Contracts,
length of cost period, 236
long-term, profits on, 401
redemption, covering preferred stock, 384
uncompleted, valuation of, 234
valuation of, 234
Control, permanent investment for, 261
Convertible preferred stock, 6
Copyrights, 325
valuation of, 325
Corporations, 1-25
bonds (See “Bonds”)
classification, 1
commercial or trading, 2
de facto, 2
de jure, 2
domestic, 2
financial, 2
foreign, 2
industrial or manufacturing, 2
private corporations, 2
public corporations, 1
public utility or quasi-public, 2
stock and non-stock private corporations, 2
combinations and consolidations, 507-520
definition, 1
dividends (See “Dividends”)
holding companies, accounting for, 500
liquidation (See “Liquidation, corporations”)
surplus, 611
valuation of inventory, 607
minority interests, 610
valuation of liabilities, 611
Consolidated profit and loss summary, 612-615
Consolidations (See “Combinations and consolidations”)
Construction costs, 94
Containers, valuation of, 293
Contingent depreciation (See “Depreciation”)
Contingent liabilities (See “Liabilities”)
Contracts,
length of cost period, 236
long-term, profits on, 401
redemption, covering preferred stock, 384
uncompleted, valuation of, 234
valuation of, 234
Control, permanent investment for, 261
Convertible preferred stock, 6
Copyrights, 325
valuation of, 325
Corporations, 1-25
bonds (See “Bonds”)
classification, 1
commercial or trading, 2
de facto, 2
de jure, 2
domestic, 2
financial, 2
foreign, 2
industrial or manufacturing, 2
private corporations, 2
public corporations, 1
public utility or quasi-public, 2
stock and non-stock private corporations, 2
combinations and consolidations, 507-520
definition, 1
dividends (See “Dividends”)
holding companies, accounting for, 500
liquidation (See “Liquidation, corporations”)
Page 651
organization, working, 3
board of directors, 3
committees, 3
officers, 3
ownership, method of, 2
advantages, 3
“close,” 2
“open,” 2
“sole,” 3
profits (See “Profits”)
records,
dividend book, 20
instalment book, 20
minute book, 20
register of transfers, 20
stock certificate book, 20
stock ledger, 20, 21
Form, 22
stock register, 21
stock transfer book, 20
subscription book, 20
subscription ledger, 20
transfer book,
Form, 21
stock (See “Stock”)
Costs,
accrued, operating reserves for, 413
buildings, 298
bought by issue of stocks or bonds, 298
purchased outright for cash, 298
put up by the concern itself, 299
capitalization on basis of, 376
collection,
allocation of, 414
valuation of trade debtors, 221
construction, capital expenditures, 94
factory (See “Costs, factory,” below)
goods sold,
manufacturing concern, 478
trading concern, 479
board of directors, 3
committees, 3
officers, 3
ownership, method of, 2
advantages, 3
“close,” 2
“open,” 2
“sole,” 3
profits (See “Profits”)
records,
dividend book, 20
instalment book, 20
minute book, 20
register of transfers, 20
stock certificate book, 20
stock ledger, 20, 21
Form, 22
stock register, 21
stock transfer book, 20
subscription book, 20
subscription ledger, 20
transfer book,
Form, 21
stock (See “Stock”)
Costs,
accrued, operating reserves for, 413
buildings, 298
bought by issue of stocks or bonds, 298
purchased outright for cash, 298
put up by the concern itself, 299
capitalization on basis of, 376
collection,
allocation of, 414
valuation of trade debtors, 221
construction, capital expenditures, 94
factory (See “Costs, factory,” below)
goods sold,
manufacturing concern, 478
trading concern, 479
Page 652
land, 303
original, factor in calculating depreciation, 150
statistics, 584
stock-in-trade, 230
cash discount, 230
distribution of, 231
objections to valuation at less than, 226
summary argument for valuing at, 228
valuation at, 225
temporary investments, 245
Costs, factory, 49-59
contracts and length of cost period, 236
cost-cutting changes, treatment of, 92
definitions of terms, 49
direct costs, 50
factory expense, overhead or burden, 50
full cost, 50
indirect cost, 50
prime cost, 50
total manufacturing cost, 50
depreciation and plant efficiency, 113
difference between factory and financial
accounting, 49
expense,
basis of distribution, 58
elements entering into, 58
inventory-taking, 237
methods, 238
perpetual, 239
rules, 238
labor,
accrued wages, 57
direct and indirect, 53
distribution of charges, 57
materials,
accounting for, 52
auxiliary, 51
nature of, 51
perpetual inventory system, 53
record of purchases and periodical inventory, 52
original, factor in calculating depreciation, 150
statistics, 584
stock-in-trade, 230
cash discount, 230
distribution of, 231
objections to valuation at less than, 226
summary argument for valuing at, 228
valuation at, 225
temporary investments, 245
Costs, factory, 49-59
contracts and length of cost period, 236
cost-cutting changes, treatment of, 92
definitions of terms, 49
direct costs, 50
factory expense, overhead or burden, 50
full cost, 50
indirect cost, 50
prime cost, 50
total manufacturing cost, 50
depreciation and plant efficiency, 113
difference between factory and financial
accounting, 49
expense,
basis of distribution, 58
elements entering into, 58
inventory-taking, 237
methods, 238
perpetual, 239
rules, 238
labor,
accrued wages, 57
direct and indirect, 53
distribution of charges, 57
materials,
accounting for, 52
auxiliary, 51
nature of, 51
perpetual inventory system, 53
record of purchases and periodical inventory, 52
Page 653
operation of machine accounts, 282
patents, effect of rate of depreciation, 324
pay-roll, 55
methods of payment, 56
safeguarding, 55
prime costs,
direct and indirect labor, 53
materials, 52
special purposes of cost records, 50
predetermination of selling price, 51
stores department,
function of, 52
summary of manufacturing cost, 59
supplies,
manufacturing, 52
nature of, 51
operating, 52
time-keeping records, 54
cards, 54
valuation of manufacturing inventory, 233-236
contracts, 234
finished goods, 233
goods in process, 234
raw material, 234
valuation of scrap, 236
Credit, mercantile, 216-224
application for, balance sheet as basis for, 79
bad debts,
analysis of customers’ accounts as basis for estimate of, 217
basis for estimate of, 219
classification of accounts according to time overdue, 218
estimating, 216
length of credit period, 217
trade debtors as basis of estimate of, 219
classification of accounts according to length of time overdue, 218
deferred, 351
discounts and collection costs, 221
notes receivable,
balance sheet titles for, 223
interest on, 223
patents, effect of rate of depreciation, 324
pay-roll, 55
methods of payment, 56
safeguarding, 55
prime costs,
direct and indirect labor, 53
materials, 52
special purposes of cost records, 50
predetermination of selling price, 51
stores department,
function of, 52
summary of manufacturing cost, 59
supplies,
manufacturing, 52
nature of, 51
operating, 52
time-keeping records, 54
cards, 54
valuation of manufacturing inventory, 233-236
contracts, 234
finished goods, 233
goods in process, 234
raw material, 234
valuation of scrap, 236
Credit, mercantile, 216-224
application for, balance sheet as basis for, 79
bad debts,
analysis of customers’ accounts as basis for estimate of, 217
basis for estimate of, 219
classification of accounts according to time overdue, 218
estimating, 216
length of credit period, 217
trade debtors as basis of estimate of, 219
classification of accounts according to length of time overdue, 218
deferred, 351
discounts and collection costs, 221
notes receivable,
balance sheet titles for, 223
interest on, 223
Page 654
loss on, 222
risk and length of credit period, 217
risk from losses, 216
valuation of receivable items on open account, 221
Creditors,
bankruptcy proceedings, final meeting, 629
first meeting of, in bankruptcy proceedings, 622
relative standing of, receiver in equity, 630
status of, in liquidation, 504
voucher index of, 38
Crystallization, cause of depreciation, 133
Cumulative preferred stock, 5
Current assets,
depreciation, 119
valuation of, 96
Current liabilities (See “Liabilities”)
Cuts, valuation of, 294
D
Debenture stock, 4, 8
Debts,
bad (See “Debts, bad,” below)
settled by—
conversion of an asset, 453
creation of another liability, 453
increase in net worth, 453
sinking fund, effect of, 448, 452
Debts, bad,
basis for estimate of, 216, 219
analysis of customers’ accounts, 217
classification of accounts according to length of
time overdue, 218
sales as, 220
summary, 220
trade debtors as, 219
loss of notes receivable, 222
reserve for, 411
risk and length of credit period, 21
Decrepitude, 173
De facto corporations, 2
risk and length of credit period, 217
risk from losses, 216
valuation of receivable items on open account, 221
Creditors,
bankruptcy proceedings, final meeting, 629
first meeting of, in bankruptcy proceedings, 622
relative standing of, receiver in equity, 630
status of, in liquidation, 504
voucher index of, 38
Crystallization, cause of depreciation, 133
Cumulative preferred stock, 5
Current assets,
depreciation, 119
valuation of, 96
Current liabilities (See “Liabilities”)
Cuts, valuation of, 294
D
Debenture stock, 4, 8
Debts,
bad (See “Debts, bad,” below)
settled by—
conversion of an asset, 453
creation of another liability, 453
increase in net worth, 453
sinking fund, effect of, 448, 452
Debts, bad,
basis for estimate of, 216, 219
analysis of customers’ accounts, 217
classification of accounts according to length of
time overdue, 218
sales as, 220
summary, 220
trade debtors as, 219
loss of notes receivable, 222
reserve for, 411
risk and length of credit period, 21
Decrepitude, 173
De facto corporations, 2
Page 655
Deferred—
charges,
accounting for, 256
danger of overvaluation, 255
definitions, 253
kinds of, 253
to operation, valuation of, 96
valuation of, 254
credits, 351
income, 343
misuse of term, 417
maintenance, 109
Deficiency, shares of,
liquidation of partnership by instalments, 652
Deficit, shown on consolidated balance sheet, 612
De jure corporations, 2
Delivery equipment (See “Equipment”)
Depletion,
application of income tax law to, 312
assets subject to (See also “Wasting assets”)
basis of charge, 312
contingent cause of depreciation, 134
distinction between depreciation and, 117
leaseholds, 314
reserves, 413
return of capital in form of dividends, 311
unusual risks, 313
wasting assets (See “Wasting assets”)
Deposits, Current liabilities, 348
Depreciation,
“accounting” and “fair,” 107
accrued, 109
a cost of operation, 137
actual or absolute, 104
a means of financing, 140
danger of viewpoint, 141
appraisement of methods, 173-186
annuity method, 181
appraisal method, 183
arbitrary methods, 179
charges,
accounting for, 256
danger of overvaluation, 255
definitions, 253
kinds of, 253
to operation, valuation of, 96
valuation of, 254
credits, 351
income, 343
misuse of term, 417
maintenance, 109
Deficiency, shares of,
liquidation of partnership by instalments, 652
Deficit, shown on consolidated balance sheet, 612
De jure corporations, 2
Delivery equipment (See “Equipment”)
Depletion,
application of income tax law to, 312
assets subject to (See also “Wasting assets”)
basis of charge, 312
contingent cause of depreciation, 134
distinction between depreciation and, 117
leaseholds, 314
reserves, 413
return of capital in form of dividends, 311
unusual risks, 313
wasting assets (See “Wasting assets”)
Deposits, Current liabilities, 348
Depreciation,
“accounting” and “fair,” 107
accrued, 109
a cost of operation, 137
actual or absolute, 104
a means of financing, 140
danger of viewpoint, 141
appraisement of methods, 173-186
annuity method, 181
appraisal method, 183
arbitrary methods, 179
Page 656
composite life method, 177
compound interest methods, 179
effect on return on investment, 185
fifty per cent method, 183
fixed per cent of diminishing value method, 178
general considerations, 173, 174
insurance method, 184
maintenance method, 182
percentage of gross earnings method, 184
proportional methods, 175-178
replacement method, 183
service output method, 177
sinking fund method, 181
straight line method, 175
sum of expected life-periods method, 179
unit cost method, 182
variable percentage methods, 178-179
working hours method, 176
appreciation,
as an offset to, 206
due to adaptation to use, 207
due to physical changes, 207
unearned increment, 209
aspects and definitions, 99-119
asset subject to, a deferred charge to operations, 93
attitude of law, 110
authoritative opinions, 101
buildings, 301
freehold for life, 301
rates, 301
buildings and machinery of a wasting asset, 313
calculating, 150-172
annuity, 161, 163-167
formulas, 164
appraisal method, 169, 170
arbitrary interest rate, 150
arbitrary with decreasing amounts, 157, 160
arbitrary with increasing amounts, 157, 160
changing percentages of cost less scrap method, 157, 159
composite life, 152, 155
compound interest methods, 179
effect on return on investment, 185
fifty per cent method, 183
fixed per cent of diminishing value method, 178
general considerations, 173, 174
insurance method, 184
maintenance method, 182
percentage of gross earnings method, 184
proportional methods, 175-178
replacement method, 183
service output method, 177
sinking fund method, 181
straight line method, 175
sum of expected life-periods method, 179
unit cost method, 182
variable percentage methods, 178-179
working hours method, 176
appreciation,
as an offset to, 206
due to adaptation to use, 207
due to physical changes, 207
unearned increment, 209
aspects and definitions, 99-119
asset subject to, a deferred charge to operations, 93
attitude of law, 110
authoritative opinions, 101
buildings, 301
freehold for life, 301
rates, 301
buildings and machinery of a wasting asset, 313
calculating, 150-172
annuity, 161, 163-167
formulas, 164
appraisal method, 169, 170
arbitrary interest rate, 150
arbitrary with decreasing amounts, 157, 160
arbitrary with increasing amounts, 157, 160
changing percentages of cost less scrap method, 157, 159
composite life, 152, 155
Page 657
compound interest methods, 150, 160
condition per cent, 171
estimated service life, 150
factors to be considered, 150
fifty per cent method, 169, 170
fixed percentage of diminishing value method, 157
chart, 158
gross earnings method, 169, 171
insurance method, 169, 170
maintenance method, 169
methods of, 150
original cost of asset, 150
proportional methods, 150
replacement method, 169
scrap or residual value, 150
service output, 152, 156
sinking fund, 161
straight line method, 152
symbols to be used, 151
unit cost method, 161, 167-169
variable percentage methods, 150
working hours, 152-155
causes, 120-135
accidents, 122
age, 120
analysis of, 120
chart showing, 121
contingent depreciation, 130-134
decrepitude, 122
depletion, 134
effective depreciation, 135
functional depreciation, 123
inadequacy as a factor, 123
inadequacy due to unforeseen development, 125
inadequacy imposed from without, 126
inadequacy through change of policy, 124
inadequacy through motives of economy, 125
obsolescence, 127-130
terminable rights, 134
wear and tear of use, 122
condition per cent, 171
estimated service life, 150
factors to be considered, 150
fifty per cent method, 169, 170
fixed percentage of diminishing value method, 157
chart, 158
gross earnings method, 169, 171
insurance method, 169, 170
maintenance method, 169
methods of, 150
original cost of asset, 150
proportional methods, 150
replacement method, 169
scrap or residual value, 150
service output, 152, 156
sinking fund, 161
straight line method, 152
symbols to be used, 151
unit cost method, 161, 167-169
variable percentage methods, 150
working hours, 152-155
causes, 120-135
accidents, 122
age, 120
analysis of, 120
chart showing, 121
contingent depreciation, 130-134
decrepitude, 122
depletion, 134
effective depreciation, 135
functional depreciation, 123
inadequacy as a factor, 123
inadequacy due to unforeseen development, 125
inadequacy imposed from without, 126
inadequacy through change of policy, 124
inadequacy through motives of economy, 125
obsolescence, 127-130
terminable rights, 134
wear and tear of use, 122
Page 658
chart showing relation of efficiency to uniform depreciation, 115
comparison of actual and theoretical, 105
complete and incomplete, 108
complication of short fiscal periods, 138
contingent,
accidents, 131
depletion, 134
disease, 133
electrolysis, 134
current assets, 119
decision of Supreme Court, 111
deferred maintenance, 109
distinction between, and depletion, 117
distinction between repairs and renewals, 113
distribution of charge, 174
effective, 135
estimate of charges due to obsolescence, 129
fire losses, 579
fluctuations in market value, 116, 117
franchises, 328
ruling of Public Service Commission, 329
furniture and fixtures, 291
good-will, 337
hand tools, 289
individual and composite, 108
inefficiency a factor of, 116
journal vouchers, 595
land, 304, 306
leaseholds, 314, 315
machinery,
estimate of, 283
methods of applying, 286
merchandise, 119
methods (See “Depreciation, appraisement of methods” and
“Depreciation, calculating,” above)
patents, 319, 320
accounting classification, 322
booking, 322
effect on costs of manufacture, 324
obsolescence, 320
comparison of actual and theoretical, 105
complete and incomplete, 108
complication of short fiscal periods, 138
contingent,
accidents, 131
depletion, 134
disease, 133
electrolysis, 134
current assets, 119
decision of Supreme Court, 111
deferred maintenance, 109
distinction between, and depletion, 117
distinction between repairs and renewals, 113
distribution of charge, 174
effective, 135
estimate of charges due to obsolescence, 129
fire losses, 579
fluctuations in market value, 116, 117
franchises, 328
ruling of Public Service Commission, 329
furniture and fixtures, 291
good-will, 337
hand tools, 289
individual and composite, 108
inefficiency a factor of, 116
journal vouchers, 595
land, 304, 306
leaseholds, 314, 315
machinery,
estimate of, 283
methods of applying, 286
merchandise, 119
methods (See “Depreciation, appraisement of methods” and
“Depreciation, calculating,” above)
patents, 319, 320
accounting classification, 322
booking, 322
effect on costs of manufacture, 324
obsolescence, 320
Page 659
supersession, 320
time lapse, 319
physical and functional, 109
plant efficiency, 113
purpose of, fundamental, 136
rates, 136-149
accounting viewpoint, 141
attitude of regulatory bodies, 147
based only on normal factors at time
of installation, 144
basis of normal, 144
buildings, 301
change in ownership and policy, 144
change in requirements of the market, 144
climatic conditions, 143
complication of short fiscal periods, 138
composite and group, 197
contingent factors, 142, 144
cost of operation, 137
danger of financing viewpoint, 141
effect of local conditions, 142
engineering problem, 142, 146
engineering viewpoint, 141
exterior or movable apparatus, 144
factors in determining, 143
financing viewpoint, 140, 141
fixed equipment including boilers and piping, 145
frequency of revision of, 194
fundamental purpose, 136
idle time a factor, 139
installed operating and generating machinery, 144
insufficient charge, 205
load or normal intensity of operation, 143
means of financing, 140
methods of handling repairs, 147
misuse and neglect brought about by the demands of the trade, 144
normal climatic conditions, 143
operating conditions, 143
periodic revision of, 194
repairs policy, 143
time lapse, 319
physical and functional, 109
plant efficiency, 113
purpose of, fundamental, 136
rates, 136-149
accounting viewpoint, 141
attitude of regulatory bodies, 147
based only on normal factors at time
of installation, 144
basis of normal, 144
buildings, 301
change in ownership and policy, 144
change in requirements of the market, 144
climatic conditions, 143
complication of short fiscal periods, 138
composite and group, 197
contingent factors, 142, 144
cost of operation, 137
danger of financing viewpoint, 141
effect of local conditions, 142
engineering problem, 142, 146
engineering viewpoint, 141
exterior or movable apparatus, 144
factors in determining, 143
financing viewpoint, 140, 141
fixed equipment including boilers and piping, 145
frequency of revision of, 194
fundamental purpose, 136
idle time a factor, 139
installed operating and generating machinery, 144
insufficient charge, 205
load or normal intensity of operation, 143
means of financing, 140
methods of handling repairs, 147
misuse and neglect brought about by the demands of the trade, 144
normal climatic conditions, 143
operating conditions, 143
periodic revision of, 194
repairs policy, 143
Page 660
results achieved as the basis, 139
service life as the basis, 139
“stable or normal” factors, 142, 143
standardization of, 142
recognition of the depreciation factor, 112
Federal Income Tax Law, 112
Federal Trade Commission, 112
Interstate Commerce Commission, 112
Treasury decisions, 112
recording, 187-209
adjustment of value, on plant ledger, 193
asset record, 192
balance sheet, 187
cases when no determination of betterment values is made, 189
composite or group rates, 197
credit balance in the reserve, 189
debit balance in the reserve, 189
plant ledger, 191
Form, 193
frequency of revision of rates, 194
grouping and classification of plant assets, 191
mean age, direct method, 198
mean life, direct method, 197
mean life, dollar-year, or weighted ratio method, 198
methods commonly employed, 187
periodic adjusting entry, 187
periodic revision of rates, 194
renewals and replacements, 188
reserve account, 187
reserves, 199-204
subsidiary records, 190
table of expectancy, 196
test of condition per cent, 195
valuation account, 187
relation between, and sinking fund, 463
reserves,
decreasing, 200
distinction from reserve for doubtful accounts, 411
financing of replacements, 203
fluctuating, 199
service life as the basis, 139
“stable or normal” factors, 142, 143
standardization of, 142
recognition of the depreciation factor, 112
Federal Income Tax Law, 112
Federal Trade Commission, 112
Interstate Commerce Commission, 112
Treasury decisions, 112
recording, 187-209
adjustment of value, on plant ledger, 193
asset record, 192
balance sheet, 187
cases when no determination of betterment values is made, 189
composite or group rates, 197
credit balance in the reserve, 189
debit balance in the reserve, 189
plant ledger, 191
Form, 193
frequency of revision of rates, 194
grouping and classification of plant assets, 191
mean age, direct method, 198
mean life, direct method, 197
mean life, dollar-year, or weighted ratio method, 198
methods commonly employed, 187
periodic adjusting entry, 187
periodic revision of rates, 194
renewals and replacements, 188
reserve account, 187
reserves, 199-204
subsidiary records, 190
table of expectancy, 196
test of condition per cent, 195
valuation account, 187
relation between, and sinking fund, 463
reserves,
decreasing, 200
distinction from reserve for doubtful accounts, 411
financing of replacements, 203
fluctuating, 199
Page 661
increasing, 200
index of financial condition, 199
insufficient charge, 205
methods of financing replacements, 203
not leased on cost of replacement, 202
relation to efficiency, 201
relation to expanding plant, 201
secret, 204
suspense account, 558
stockholders’ relation to policy pursued, 209
stock-in-trade, 119, 229
terminable rights, 134
theoretical, 104
unit efficiency, 114
unusual risks, 313
“wasting” assets, 118
effect on different kinds of business, 118
why factor arises, 103
Deterioration, 140
rate of, 145
stock-in-trade, 229
Dewey decimal system, 564
advantages of the mnemonic over, 565
combined with mnemonic, 566
Dies, valuation of, 294
Direct cost, definition of, 50
Directors,
control over profits, 429
liability of, in the matter of dividends, 433
Disbursements, cash, temporary, 213
Discounts,
accounts receivable, 560-563
bond,
amortization of, 269
entry on books, 365
nature of, 266
profit and loss summary, 474
relation to interest, 367
schedule showing amortization of, 270
cash,
index of financial condition, 199
insufficient charge, 205
methods of financing replacements, 203
not leased on cost of replacement, 202
relation to efficiency, 201
relation to expanding plant, 201
secret, 204
suspense account, 558
stockholders’ relation to policy pursued, 209
stock-in-trade, 119, 229
terminable rights, 134
theoretical, 104
unit efficiency, 114
unusual risks, 313
“wasting” assets, 118
effect on different kinds of business, 118
why factor arises, 103
Deterioration, 140
rate of, 145
stock-in-trade, 229
Dewey decimal system, 564
advantages of the mnemonic over, 565
combined with mnemonic, 566
Dies, valuation of, 294
Direct cost, definition of, 50
Directors,
control over profits, 429
liability of, in the matter of dividends, 433
Disbursements, cash, temporary, 213
Discounts,
accounts receivable, 560-563
bond,
amortization of, 269
entry on books, 365
nature of, 266
profit and loss summary, 474
relation to interest, 367
schedule showing amortization of, 270
cash,
Page 662
inclusion of, in cost of stock-in-trade, 230
on purchases, voucher system, 44
permanent investments, treatment of, 257
sales,
on the balance sheet, 415
proper allocation of estimated, 413
stock, 13
charging to organization expense, not approved, 14
requirements of Interstate Commerce Commission, 13
treatment of, 378
valuation of trade debtors, 221
Disease, contingent depreciation, 133
Dissolution,
valuation for purposes of, 83
voluntary, 501
liquidation under, 503
Distribution of depreciation charge, 174
Dividends, 428-446
accounting record, 442
book, 20
corporation profits,
directors’ control over, 429
disposition of, 428
shareholders’ rights as to, 429
declaration of, 432
provisos as to, 430
definition, 428
ex-dividend, 442
in stock, 382
effect of, 382
liability of directors, 433
liquidating, 445, 506, 629
booking, 446
declaration of, in hands of referee, in bankruptcy, 630
method of payment, 434, 436
borrowing, 436
borrowing on property, 438
in bonds, 438
in property, 438
paid in form of salaries, 435
on purchases, voucher system, 44
permanent investments, treatment of, 257
sales,
on the balance sheet, 415
proper allocation of estimated, 413
stock, 13
charging to organization expense, not approved, 14
requirements of Interstate Commerce Commission, 13
treatment of, 378
valuation of trade debtors, 221
Disease, contingent depreciation, 133
Dissolution,
valuation for purposes of, 83
voluntary, 501
liquidation under, 503
Distribution of depreciation charge, 174
Dividends, 428-446
accounting record, 442
book, 20
corporation profits,
directors’ control over, 429
disposition of, 428
shareholders’ rights as to, 429
declaration of, 432
provisos as to, 430
definition, 428
ex-dividend, 442
in stock, 382
effect of, 382
liability of directors, 433
liquidating, 445, 506, 629
booking, 446
declaration of, in hands of referee, in bankruptcy, 630
method of payment, 434, 436
borrowing, 436
borrowing on property, 438
in bonds, 438
in property, 438
paid in form of salaries, 435
Page 663
scrip, 438
not yet paid, current liability, 349
paid but not yet charged against surplus, 688
payment, to whom payable, 441
profit and loss summary, 474
proportional to holdings, 441
relation of capital losses to, 443
resolution declaring, 441
return of capital included in, 311
revocation of, 434
shareholders’ rights to, 431
stock, 439
estate accounting, 440
unwise use of cash for paying, 495
Domestic corporations, 2
Donated—
land, 308
stock, 11, 15
creation of a surplus, 409
Doubtful accounts,
reserve for, as a suspense account, 558
Drafts,
negotiated, contingent liability, 352
sight, treated as cash transactions when honored, 673
Drawings, valuation of, 294
Drayage, cost of stock-in-trade, 230
E
Earnings, value of stock dependent upon, 374
Efficiency,
chart showing progress of uniform depreciation and of
diminishing efficiency, 115
employees’, statistics, 584
plant, depreciation, 113
relation of depreciation reserve to, 201
unit, 114
Electrolysis, cause of depreciation, 133
Electrotypes, valuation of, 294
Engineering,
rate of depreciation a problem of, 142, 146
not yet paid, current liability, 349
paid but not yet charged against surplus, 688
payment, to whom payable, 441
profit and loss summary, 474
proportional to holdings, 441
relation of capital losses to, 443
resolution declaring, 441
return of capital included in, 311
revocation of, 434
shareholders’ rights to, 431
stock, 439
estate accounting, 440
unwise use of cash for paying, 495
Domestic corporations, 2
Donated—
land, 308
stock, 11, 15
creation of a surplus, 409
Doubtful accounts,
reserve for, as a suspense account, 558
Drafts,
negotiated, contingent liability, 352
sight, treated as cash transactions when honored, 673
Drawings, valuation of, 294
Drayage, cost of stock-in-trade, 230
E
Earnings, value of stock dependent upon, 374
Efficiency,
chart showing progress of uniform depreciation and of
diminishing efficiency, 115
employees’, statistics, 584
plant, depreciation, 113
relation of depreciation reserve to, 201
unit, 114
Electrolysis, cause of depreciation, 133
Electrotypes, valuation of, 294
Engineering,
rate of depreciation a problem of, 142, 146
Page 664
Equipment,
average, normal use, 139
basis of normal rate, 144
delivery,
carriers, valuation of, 293
containers, valuation, 293
definition, 292
valuation, 292
disposal of assets, 295
distinction between personalty and real property, 279
furniture and fixtures,
definition of, 291
depreciation, 291
valuation of, 291
general considerations, 279
idle time, 139
machine accounts, operation of, 282
machinery,
abnormal operation, 285
basis of valuation, 287
estimate of depreciation, 283
expenditure for rearrangement, 290
history of, 284
home-made, valuation of, 289
map of location, 286
methods of application of depreciation, 286
scrap, 287
standards of operation, 285
valuation of, 283
machinery and tools, 281
accounting records, 281
molds, valuation of, 294
patterns, valuation of, 294
service, 139
tools,
accounting for, 288
hand, depreciation on, 289
home-made, valuation of, 289
issue on requisition, 289
valuation of, 279-296
average, normal use, 139
basis of normal rate, 144
delivery,
carriers, valuation of, 293
containers, valuation, 293
definition, 292
valuation, 292
disposal of assets, 295
distinction between personalty and real property, 279
furniture and fixtures,
definition of, 291
depreciation, 291
valuation of, 291
general considerations, 279
idle time, 139
machine accounts, operation of, 282
machinery,
abnormal operation, 285
basis of valuation, 287
estimate of depreciation, 283
expenditure for rearrangement, 290
history of, 284
home-made, valuation of, 289
map of location, 286
methods of application of depreciation, 286
scrap, 287
standards of operation, 285
valuation of, 283
machinery and tools, 281
accounting records, 281
molds, valuation of, 294
patterns, valuation of, 294
service, 139
tools,
accounting for, 288
hand, depreciation on, 289
home-made, valuation of, 289
issue on requisition, 289
valuation of, 279-296
Page 665
Estate accounting, stock dividends, 440
Estimates, principles of valuation, 97
Expectancy,
mean age, direct method, 198
mean life,
direct method, 197
dollar-year, or weighted ratio method, 198
table of, 196
Expenditures,
capital (See “Capital expenditures”)
revenue (See “Revenue expenditures”)
Expenses,
accrued, 343
booking of, 350
current liabilities, 350
capital, 87
factory,
basis of distribution, 58
definition of, 50
elements entering into, 58
organization, 88
F
Factory costs (See “Costs, factory”)
Federal Reserve Board,
statement required of contingent liability, 352
Financial accounting, difference between factory and, 49
Financing,
depreciation a means of, 140
danger of viewpoint, 141
Finished goods, valuation of, 233
Fire losses, adjustment of, 570-580
adjusting entries, 578
depreciation, 579
bases of settlement, 573
coinsurance clause, 574
examples of, how applied, 575, 576
determination of value, 572
insurance contract, 570
cancellation of, 571
Estimates, principles of valuation, 97
Expectancy,
mean age, direct method, 198
mean life,
direct method, 197
dollar-year, or weighted ratio method, 198
table of, 196
Expenditures,
capital (See “Capital expenditures”)
revenue (See “Revenue expenditures”)
Expenses,
accrued, 343
booking of, 350
current liabilities, 350
capital, 87
factory,
basis of distribution, 58
definition of, 50
elements entering into, 58
organization, 88
F
Factory costs (See “Costs, factory”)
Federal Reserve Board,
statement required of contingent liability, 352
Financial accounting, difference between factory and, 49
Financing,
depreciation a means of, 140
danger of viewpoint, 141
Finished goods, valuation of, 233
Fire losses, adjustment of, 570-580
adjusting entries, 578
depreciation, 579
bases of settlement, 573
coinsurance clause, 574
examples of, how applied, 575, 576
determination of value, 572
insurance contract, 570
cancellation of, 571
Page 666
inventory of stock-in-trade, 580
method of record-keeping to facilitate ready adjustments, 577
options of the insurance company as to settlement, 576
pro rata or contributing clause, 574
rates, 574
requirement in case of loss, 571
settlement of points in dispute, 573
valuations for, 83
Fiscal periods,
complication of short, in the case of depreciation, 138
Fixed assets, valuation of, 96
Fixed liabilities (See “Liabilities”)
Fixtures (See “Equipment”)
Fluctuations, reserve for investment, 243
Foreign branch (See “Branch house accounting”)
Foreign corporations, 2
Foreign countries, cash held in, 214
Foreign exchange, 542
handling fluctuations in, 545
Foreign purchasing agency, 555
Foreign sales agency, 552
periodic conversion of results, 553
Forfeited stock, 12, 19
Forms (See list in table of contents, page xxiii)
Founders’ shares, 4, 7
Franchises, 326-330
definition, 326
depreciation on, 328
ruling of Public Service Commission, 329
indeterminate, 328
kinds, 326
limited, 327
perpetual, 327
valuation, 328
Freight,
cost of stock-in-trade, 230
distributed over stock-in-trade, 231
Functional depreciation, 123
Furniture (See “Equipment”)
Future deliveries, liability, 349
method of record-keeping to facilitate ready adjustments, 577
options of the insurance company as to settlement, 576
pro rata or contributing clause, 574
rates, 574
requirement in case of loss, 571
settlement of points in dispute, 573
valuations for, 83
Fiscal periods,
complication of short, in the case of depreciation, 138
Fixed assets, valuation of, 96
Fixed liabilities (See “Liabilities”)
Fixtures (See “Equipment”)
Fluctuations, reserve for investment, 243
Foreign branch (See “Branch house accounting”)
Foreign corporations, 2
Foreign countries, cash held in, 214
Foreign exchange, 542
handling fluctuations in, 545
Foreign purchasing agency, 555
Foreign sales agency, 552
periodic conversion of results, 553
Forfeited stock, 12, 19
Forms (See list in table of contents, page xxiii)
Founders’ shares, 4, 7
Franchises, 326-330
definition, 326
depreciation on, 328
ruling of Public Service Commission, 329
indeterminate, 328
kinds, 326
limited, 327
perpetual, 327
valuation, 328
Freight,
cost of stock-in-trade, 230
distributed over stock-in-trade, 231
Functional depreciation, 123
Furniture (See “Equipment”)
Future deliveries, liability, 349
Page 667
G
Goods,
consigned, sold, current liability, 349
finished, valuation of, 233
in process, valuation of, 234
profits on,
awaiting delivery, 402
made for stock but not sold, 399
made to order, 400
work in progress, 399
returned, statistics, 584
sold, cost of,
manufacturing concern, 478
trading concern, 479
Good-will, 331-338
combination and consolidation, 515
creation of, by advertising, 334
definition of, 331
“going value,” 338
local and personal character of, 333
merger, 332
nature of, 331
valuation of, 333
based on capitalization of profits, 335
based on excess profits, 335
based on normal profits, 334
depreciation, 337
false, to cover capital deficiency, 336
periodic revaluation, 337
Graphs,
advantages of, 586
principles of construction, 587
use of, in presentation of statistics, 585
Gross earnings,
method of calculating depreciation, 169, 171
Guaranteed stock, 4, 7
Guarantees,
as contingent liability, 353
quality and performance, 348
Goods,
consigned, sold, current liability, 349
finished, valuation of, 233
in process, valuation of, 234
profits on,
awaiting delivery, 402
made for stock but not sold, 399
made to order, 400
work in progress, 399
returned, statistics, 584
sold, cost of,
manufacturing concern, 478
trading concern, 479
Good-will, 331-338
combination and consolidation, 515
creation of, by advertising, 334
definition of, 331
“going value,” 338
local and personal character of, 333
merger, 332
nature of, 331
valuation of, 333
based on capitalization of profits, 335
based on excess profits, 335
based on normal profits, 334
depreciation, 337
false, to cover capital deficiency, 336
periodic revaluation, 337
Graphs,
advantages of, 586
principles of construction, 587
use of, in presentation of statistics, 585
Gross earnings,
method of calculating depreciation, 169, 171
Guaranteed stock, 4, 7
Guarantees,
as contingent liability, 353
quality and performance, 348
Page 668
H
Holding company, 508 (See also “Combinations
and consolidations”)
accounting for, 509
advances to subsidiaries, 262
rules for valuation, 263
consolidated balance sheet, 600-619
consolidated profit and loss summary, 612-615
permanent investments of, 261
Housing workmen, and social betterment work, 599
Hypothecation accounts receivable, accounting for, 560
I
Idle time, factor in depreciation, 139
Impairment of capital account, 634
Imprest system, petty cash operated under, 211
Inadequacy, 173
factor in depreciation, 123-127
Income,
accrued,
accounting for, 251
correct method of handling, 250
illustration of different methods of recording, 251
inadequacy of cash method of handling accruals, 249
nature of, 248-253
showing on balance sheet, 250
valuation of items, 250
deferred, 343
misuse of term, 417
Income and expenditures (See “Profit and loss summary”)
Income statement (See “Profit and loss summary”)
Income tax law of 1916, application of, to wasting assets, 312
Increment, unearned, 209
Identification (See “Classification”)
Index,
journal vouchers, 594
Forms, 594, 595
voucher, of creditors, 38
Indirect cost, definition of, 50
Industrial corporations, 2
Holding company, 508 (See also “Combinations
and consolidations”)
accounting for, 509
advances to subsidiaries, 262
rules for valuation, 263
consolidated balance sheet, 600-619
consolidated profit and loss summary, 612-615
permanent investments of, 261
Housing workmen, and social betterment work, 599
Hypothecation accounts receivable, accounting for, 560
I
Idle time, factor in depreciation, 139
Impairment of capital account, 634
Imprest system, petty cash operated under, 211
Inadequacy, 173
factor in depreciation, 123-127
Income,
accrued,
accounting for, 251
correct method of handling, 250
illustration of different methods of recording, 251
inadequacy of cash method of handling accruals, 249
nature of, 248-253
showing on balance sheet, 250
valuation of items, 250
deferred, 343
misuse of term, 417
Income and expenditures (See “Profit and loss summary”)
Income statement (See “Profit and loss summary”)
Income tax law of 1916, application of, to wasting assets, 312
Increment, unearned, 209
Identification (See “Classification”)
Index,
journal vouchers, 594
Forms, 594, 595
voucher, of creditors, 38
Indirect cost, definition of, 50
Industrial corporations, 2
Page 669
Insolvency, causes of,
current assets transferred into fixed assets, 494
inability to secure cash for refunding operations, 496
tying up cash in stocks of material, 494
unwise use of cash for dividends, 495
Instalment accounts, valuation of, 22
Instalments,
book, 20
liquidation of a partnership by, 650
illustration of, 653, 654
Insurance,
buildings and equipment, leasehold, 688
cost of stock-in-trade, 230
fire (See “Fire losses, adjustment of”)
Insurance method,
calculating depreciation, 169, 170
appraisal of, 184
Interdepartmental profits, 404
Interest,
accrued, recording of, 268
annuity method of calculating depreciation, 165
arbitrary rate of,
methods of calculating depreciation, 150
as a cost of manufacture, 468
arguments against, 470-472
bonds,
example of true interest cost, 368
fixing the rate, 267
relation of, to premium or discount, 367
compound,
formulas for, 271
methods of calculating depreciation, 160, 179
notes receivable, 223
on money invested in stock-in-trade, 231
payments on bonds, entry on books, 366
problem of charging, on books, 471
rates, market, bond values and, 265
Interstate Commerce Commission,
method of handling depreciation reserve at the time of
replacement, 189
current assets transferred into fixed assets, 494
inability to secure cash for refunding operations, 496
tying up cash in stocks of material, 494
unwise use of cash for dividends, 495
Instalment accounts, valuation of, 22
Instalments,
book, 20
liquidation of a partnership by, 650
illustration of, 653, 654
Insurance,
buildings and equipment, leasehold, 688
cost of stock-in-trade, 230
fire (See “Fire losses, adjustment of”)
Insurance method,
calculating depreciation, 169, 170
appraisal of, 184
Interdepartmental profits, 404
Interest,
accrued, recording of, 268
annuity method of calculating depreciation, 165
arbitrary rate of,
methods of calculating depreciation, 150
as a cost of manufacture, 468
arguments against, 470-472
bonds,
example of true interest cost, 368
fixing the rate, 267
relation of, to premium or discount, 367
compound,
formulas for, 271
methods of calculating depreciation, 160, 179
notes receivable, 223
on money invested in stock-in-trade, 231
payments on bonds, entry on books, 366
problem of charging, on books, 471
rates, market, bond values and, 265
Interstate Commerce Commission,
method of handling depreciation reserve at the time of
replacement, 189
Page 670
requirements as to discounts and premiums, 13
Inventory,
adjustment of, profit and loss summary, 490
contracts and length of cost period, 236
finished goods, 690
goods in process, bringing on the books, 690
of liabilities, 342
periodical, 52
perpetual, 52, 238
necessity for physical count, 240
pricing of, 232
weighted average, 232
statistics, 584
stock-in-trade, fire loss, 580
taking, 237
methods, 238
rules, 238
valuation of,
consolidated balance sheet, 607
minority interests, 610
valuation of manufacturing, 233-236
contracts, 234
finished goods, 233
goods in process, 234
raw material, 234
scrap, 236
Investments,
effect on return on, under various methods of calculating
depreciation, 185
land, valuation of, 307
permanent, 258-278
accrued interest on bonds, 268
advances to subsidiaries, 262
advances to subsidiaries, rules for valuation, 263
amortization of bond discount and premium, 269
amortization of bond discount and premium, schedule showing, 270
annuities, formulas for, 272-276
as an aid to operation, 259
bond values and market interest rates, 265
controlling investment, 261
Inventory,
adjustment of, profit and loss summary, 490
contracts and length of cost period, 236
finished goods, 690
goods in process, bringing on the books, 690
of liabilities, 342
periodical, 52
perpetual, 52, 238
necessity for physical count, 240
pricing of, 232
weighted average, 232
statistics, 584
stock-in-trade, fire loss, 580
taking, 237
methods, 238
rules, 238
valuation of,
consolidated balance sheet, 607
minority interests, 610
valuation of manufacturing, 233-236
contracts, 234
finished goods, 233
goods in process, 234
raw material, 234
scrap, 236
Investments,
effect on return on, under various methods of calculating
depreciation, 185
land, valuation of, 307
permanent, 258-278
accrued interest on bonds, 268
advances to subsidiaries, 262
advances to subsidiaries, rules for valuation, 263
amortization of bond discount and premium, 269
amortization of bond discount and premium, schedule showing, 270
annuities, formulas for, 272-276
as an aid to operation, 259
bond values and market interest rates, 265
controlling investment, 261
Page 671
holding company and subsidiary enterprises, 261
in partial holdings, 264
interest, compound, formulas for, 271
land, valuation of, 278
nature of, 258
nature of bond discount or premium, 266
producing no income, 265
record of bond investments, 267
sinking funds, methods of employing, 276, 277
sinking funds, valuation of, 276
valuation account, 267
valuation of, 259
temporary, 241-248
cost of, 245
nature of, 241
reserve for fluctuations, 243
“stock rights,” 244
summary of valuation formula, 248
treasury stock, valuation of, 247
unissued stock, valuation of, 246
valuation of, 242
valuation of bonds, 245
Invoices,
voucher system, 26-48
distribution, 34
J
Journal,
methods of authorizing entries, 596
purchase, expansion, 27
Journal vouchers (See “Voucher system”)
L
Labor,
charges,
accrued wages, 57
distribution of, 57
direct and indirect, 53
Land, 302-310
accounting, 302
in partial holdings, 264
interest, compound, formulas for, 271
land, valuation of, 278
nature of, 258
nature of bond discount or premium, 266
producing no income, 265
record of bond investments, 267
sinking funds, methods of employing, 276, 277
sinking funds, valuation of, 276
valuation account, 267
valuation of, 259
temporary, 241-248
cost of, 245
nature of, 241
reserve for fluctuations, 243
“stock rights,” 244
summary of valuation formula, 248
treasury stock, valuation of, 247
unissued stock, valuation of, 246
valuation of, 242
valuation of bonds, 245
Invoices,
voucher system, 26-48
distribution, 34
J
Journal,
methods of authorizing entries, 596
purchase, expansion, 27
Journal vouchers (See “Voucher system”)
L
Labor,
charges,
accrued wages, 57
distribution of, 57
direct and indirect, 53
Land, 302-310
accounting, 302
Page 672
plots, 302
appreciation, 304
issue of bonds, 305
sale of old, and erection of new plant on less valuable land, 305
as stock-in-trade, 310
depreciation, 304
of values, 306
donated, 308
reserve of surplus covering, 713
mortgages on, 308
real property, 297
valuation of, 303
valuation of investments in, 278, 307
inflation of values, 307
Lasts, valuation of, 294
Law, stock issues, 377
Lawsuits, pending, contingent liability, 354
Leaseholds, 314, 315
appreciation in value, 315
depreciation and amortization, 315
distribution of depreciation on buildings, 688
insurance, distribution of, 688
length of leases, 314
long-term, contingent liability, 354
sale of, 314
Ledger,
classification of accounts, 568
methods of recording depreciation in, 187
plant, 191
Form, 193
purchase, used with voucher system, 46
stock, 20, 21
Forms, 21
stores, 53
subsidiary records, 190
suspense, use of, 559
trial balance, 62
Liabilities, 339-371
balance sheet, 339-371
arrangements on, 340
appreciation, 304
issue of bonds, 305
sale of old, and erection of new plant on less valuable land, 305
as stock-in-trade, 310
depreciation, 304
of values, 306
donated, 308
reserve of surplus covering, 713
mortgages on, 308
real property, 297
valuation of, 303
valuation of investments in, 278, 307
inflation of values, 307
Lasts, valuation of, 294
Law, stock issues, 377
Lawsuits, pending, contingent liability, 354
Leaseholds, 314, 315
appreciation in value, 315
depreciation and amortization, 315
distribution of depreciation on buildings, 688
insurance, distribution of, 688
length of leases, 314
long-term, contingent liability, 354
sale of, 314
Ledger,
classification of accounts, 568
methods of recording depreciation in, 187
plant, 191
Form, 193
purchase, used with voucher system, 46
stock, 20, 21
Forms, 21
stores, 53
subsidiary records, 190
suspense, use of, 559
trial balance, 62
Liabilities, 339-371
balance sheet, 339-371
arrangements on, 340
Page 673
cancellation of liabilities against assets, 341
items within groups, 341
contingent, 81, 344, 351-355
accumulated dividends on preferred
stock, 355
drafts negotiated, 352
guarantees as, 353
kinds of, 352
long-term leases, 354
notes discounted, sold, or otherwise transferred, 352
pending lawsuits, 354
purchases for future delivery, 354
signature to surety bond, 355
statement of, 351
stock not fully paid, 354
current, 345-351
accounts payable, 345, 347
accrued expenses, 350
accrued expenses, booking of, 350
consigned goods sold, 349
deferred credits, 351
deposits, 348
dividends not yet paid, 349
future deliveries, 349
guarantees, 348
loans from bank, 347
notes payable, 345
notes payable, classification of, 346, 347
fixed, 356-371
accounting for bond issue, 363-369
bonds, kinds of, 358
bonds, priority of liens, 361
corporation bonds, 357
difference between bond and real
estate mortgages, 358
loans on collateral, 370
nature of, 356
purpose of, 356
real estate mortgages, 369
short-term securities, 370
items within groups, 341
contingent, 81, 344, 351-355
accumulated dividends on preferred
stock, 355
drafts negotiated, 352
guarantees as, 353
kinds of, 352
long-term leases, 354
notes discounted, sold, or otherwise transferred, 352
pending lawsuits, 354
purchases for future delivery, 354
signature to surety bond, 355
statement of, 351
stock not fully paid, 354
current, 345-351
accounts payable, 345, 347
accrued expenses, 350
accrued expenses, booking of, 350
consigned goods sold, 349
deferred credits, 351
deposits, 348
dividends not yet paid, 349
future deliveries, 349
guarantees, 348
loans from bank, 347
notes payable, 345
notes payable, classification of, 346, 347
fixed, 356-371
accounting for bond issue, 363-369
bonds, kinds of, 358
bonds, priority of liens, 361
corporation bonds, 357
difference between bond and real
estate mortgages, 358
loans on collateral, 370
nature of, 356
purpose of, 356
real estate mortgages, 369
short-term securities, 370
Page 674
grouping on the balance sheet, 70-74
inventory of, 342
accrued expenses, 343
contingent, 344
deferred expenses, 344
deferred income, 343
premium on bonds, 343
overvaluation for purpose of creating secret reserve, 418
valuation of, 97
consolidated balance sheet, 611
Liquidating dividends, 445
Liquidation and realization account, 639-650
Forms, 642
Liquidation, corporations, 493-506
accounting for, 505
bankruptcy, 502
causes of insolvency, 494
current assets transferred into fixed assets, 494
inability to secure cash for refunding operations, 496
tying up cash in stocks of materials, 494
unwise use of cash for paying dividends, 495
complete, 493
dividends, 506
partial, 493
reasons for, 493
receivership, 501, 503
status of creditors in, 503
valuation for purpose of, 83
voluntary dissolution, 501, 503
Liquidation, partnership,
by instalment, 650
deduction from capital, 651
illustration of, 653, 654
Load,
normal factor in determining depreciation rate, 143
Loans,
bank,347
borrowing to pay dividends, 436-438
on collateral, 370
Location, map of machine, 286
inventory of, 342
accrued expenses, 343
contingent, 344
deferred expenses, 344
deferred income, 343
premium on bonds, 343
overvaluation for purpose of creating secret reserve, 418
valuation of, 97
consolidated balance sheet, 611
Liquidating dividends, 445
Liquidation and realization account, 639-650
Forms, 642
Liquidation, corporations, 493-506
accounting for, 505
bankruptcy, 502
causes of insolvency, 494
current assets transferred into fixed assets, 494
inability to secure cash for refunding operations, 496
tying up cash in stocks of materials, 494
unwise use of cash for paying dividends, 495
complete, 493
dividends, 506
partial, 493
reasons for, 493
receivership, 501, 503
status of creditors in, 503
valuation for purpose of, 83
voluntary dissolution, 501, 503
Liquidation, partnership,
by instalment, 650
deduction from capital, 651
illustration of, 653, 654
Load,
normal factor in determining depreciation rate, 143
Loans,
bank,347
borrowing to pay dividends, 436-438
on collateral, 370
Location, map of machine, 286
Page 675
Losses,
anticipation of, undesirable, 227
asset,
charged against current profits, 396
charged to capital, 397
effect on future profits, 393
legal decisions as to, 394
treated as deferred expense charge, 396
capital, relation of, to dividends, 443
credit, risk from, 216
fire (See “Fire losses, adjustment of”)
notes receivable, 222
M
Machinery (See “Equipment”)
Maintenance,
accrued, 123
cost of, standardized, 122
deferred, 109, 123
definition of, 89
distinction between repairs and renewals, 113
method of calculating depreciation, 169
policies as to, effect on rates of depreciation, 145
Maintenance method,
calculating depreciation, appraisement of, 182
Manufacturing account, handling of, 690
Manufacturing corporations, 2
Manufacturing inventory (See “Inventory”)
Manufacturing, purchasing for, 26
Map, machine location, 286
Margin (See “Surplus”)
Market value,
capital stock, 373
depreciation and fluctuations in, 116, 117
valuation of stock-in-trade at, 225, 228
Materials,
factory costs, 51
raw, valuation of, 234
stores department, 52
Mean age,
anticipation of, undesirable, 227
asset,
charged against current profits, 396
charged to capital, 397
effect on future profits, 393
legal decisions as to, 394
treated as deferred expense charge, 396
capital, relation of, to dividends, 443
credit, risk from, 216
fire (See “Fire losses, adjustment of”)
notes receivable, 222
M
Machinery (See “Equipment”)
Maintenance,
accrued, 123
cost of, standardized, 122
deferred, 109, 123
definition of, 89
distinction between repairs and renewals, 113
method of calculating depreciation, 169
policies as to, effect on rates of depreciation, 145
Maintenance method,
calculating depreciation, appraisement of, 182
Manufacturing account, handling of, 690
Manufacturing corporations, 2
Manufacturing inventory (See “Inventory”)
Manufacturing, purchasing for, 26
Map, machine location, 286
Margin (See “Surplus”)
Market value,
capital stock, 373
depreciation and fluctuations in, 116, 117
valuation of stock-in-trade at, 225, 228
Materials,
factory costs, 51
raw, valuation of, 234
stores department, 52
Mean age,
Page 676
plant expectancy, direct method, 198
Mean life of depreciation,
direct method, 197
dollar-year or weighted ratio method, 198
Mercantile credits (See “Credit, mercantile”)
Merchandise (See “Stock-in-trade”)
Mergers,
capitalization, 516
closing the books, 518
closing the books of the old companies, 518
distinction between consolidation and, 510
formation of, 511
opening the books, 519
Minute book, 20, 24
Mnemonic system, 564
advantage, 565
combined with Dewey decimal system 566
example of application to a machine, 566
Models, valuation of, 294
Molds, valuation of, 294
Monopoly patents, 317
Mortgages,
difference between, and bond, 358
on land, 308
real estate, fixed liabilities, 369
N
Non-cumulative preferred stock, 5
Non-participating preferred stock, 6
Non-stock corporations (See “Corporations”)
No par value stock, 9, 20
Notes,
discounted,
consolidated balance sheet, 607
sold or otherwise transferred, contingent liability, 352
long-term, 349
payable, 345
classification of, 346, 347
handling of, under voucher system, 43
statistics, 584
Mean life of depreciation,
direct method, 197
dollar-year or weighted ratio method, 198
Mercantile credits (See “Credit, mercantile”)
Merchandise (See “Stock-in-trade”)
Mergers,
capitalization, 516
closing the books, 518
closing the books of the old companies, 518
distinction between consolidation and, 510
formation of, 511
opening the books, 519
Minute book, 20, 24
Mnemonic system, 564
advantage, 565
combined with Dewey decimal system 566
example of application to a machine, 566
Models, valuation of, 294
Molds, valuation of, 294
Monopoly patents, 317
Mortgages,
difference between, and bond, 358
on land, 308
real estate, fixed liabilities, 369
N
Non-cumulative preferred stock, 5
Non-participating preferred stock, 6
Non-stock corporations (See “Corporations”)
No par value stock, 9, 20
Notes,
discounted,
consolidated balance sheet, 607
sold or otherwise transferred, contingent liability, 352
long-term, 349
payable, 345
classification of, 346, 347
handling of, under voucher system, 43
statistics, 584
Page 677
receivable,
balance sheet titles for, 223
interest on, 223
losses on, 222
valuation of, 215, 223
short-term securities, 370
Numbered accounts, 563-570
advantages, 564
allotment of numbers, 563
classification, 564
general ledger accounts, 568
main points, 570
manufacturing plant, 566
operating expense accounts, 567
operating revenue accounts, 566
primary accounts, 567
combination of mnemonic and Dewey decimal systems, 566
Dewey decimal system, 564
advantage of mnemonic over, 565
mnemonic system, 564
advantages over Dewey decimal system, 565
example of application to a machine, 565
symbols, 564
O
Obsolescence, 173
cause of depreciation, 127
treatment of, 128
estimate of depreciation charge due to 129
patents, 320
under Federal Income Tax of 1916, 130
“Open” corporations, 2
Operation,
abnormal machine, 285
asset subject to depreciation a deferred charge to, 93
depreciation a cost of, 157
load on normal intensity of determining depreciation rate, 143
normal conditions of, determining depreciation rate, 143
permanent investments as an aid to, 259
standards of machine, 285
balance sheet titles for, 223
interest on, 223
losses on, 222
valuation of, 215, 223
short-term securities, 370
Numbered accounts, 563-570
advantages, 564
allotment of numbers, 563
classification, 564
general ledger accounts, 568
main points, 570
manufacturing plant, 566
operating expense accounts, 567
operating revenue accounts, 566
primary accounts, 567
combination of mnemonic and Dewey decimal systems, 566
Dewey decimal system, 564
advantage of mnemonic over, 565
mnemonic system, 564
advantages over Dewey decimal system, 565
example of application to a machine, 565
symbols, 564
O
Obsolescence, 173
cause of depreciation, 127
treatment of, 128
estimate of depreciation charge due to 129
patents, 320
under Federal Income Tax of 1916, 130
“Open” corporations, 2
Operation,
abnormal machine, 285
asset subject to depreciation a deferred charge to, 93
depreciation a cost of, 157
load on normal intensity of determining depreciation rate, 143
normal conditions of, determining depreciation rate, 143
permanent investments as an aid to, 259
standards of machine, 285
Page 678
statistics, 584
Ordinary stock, 4
Organization,
accounting department, manufacturing business, 26
corporate,
board of directors, 3
committees, 3
officers, 3
expenses, 14, 18
treatment of, 330
Original cost,
factor in calculating depreciation, 150
Overhead, definition of, 50
Ownership (See also “Stock”)
Ownership, corporate,
advantages, 3
“close,” 2
“open,” 2
partial, consolidated balance sheet, 601
“sole,” 3
P
Parasites, cause of depreciation, 133
Partial payments, handling of, under voucher system, 42
Participating preferred stock, 6
Partnership,
liquidation of, by instalments, 650
deduction from capital, 651
illustration of, 653, 654
shares of deficiency, 652
valuation of, in a combination and consolidation, 514
Par value,
capital stock, 373
sale of stock at less than, 11
stock of no, 9, 20
Patents, 316-324
and costs of manufacture, 324
depreciation,
accounting classification of, 322
booking, 322
Ordinary stock, 4
Organization,
accounting department, manufacturing business, 26
corporate,
board of directors, 3
committees, 3
officers, 3
expenses, 14, 18
treatment of, 330
Original cost,
factor in calculating depreciation, 150
Overhead, definition of, 50
Ownership (See also “Stock”)
Ownership, corporate,
advantages, 3
“close,” 2
“open,” 2
partial, consolidated balance sheet, 601
“sole,” 3
P
Parasites, cause of depreciation, 133
Partial payments, handling of, under voucher system, 42
Participating preferred stock, 6
Partnership,
liquidation of, by instalments, 650
deduction from capital, 651
illustration of, 653, 654
shares of deficiency, 652
valuation of, in a combination and consolidation, 514
Par value,
capital stock, 373
sale of stock at less than, 11
stock of no, 9, 20
Patents, 316-324
and costs of manufacture, 324
depreciation,
accounting classification of, 322
booking, 322
Page 679
developed within the plant, 318
elements of depreciation, 319
obsolescence, 320
supersession, 320
time lapse, 319
infringement costs, 321
monopoly grant, 317
purchased and not used, 319
purchase of, 317
royalties, 323
sale price of, 324
service life of, 320
writing off the value, 321
Patterns, valuation of, 294, 317
Payments,
part, handling of, under voucher system, 42
Pay-roll, 55
checks drawn to order of treasurer of company, 671
distribution of labor charges, 57
methods of payment, 56
safeguarding, 55
Percentage,
variable, methods of calculating depreciation, 150
Perpetual inventory, 239
necessity for physical count, 240
Personalty, distinction between, and real property, 279
Petty cash, 211
imprest system, 211
Plant,
assets, grouping and classification of, 191
efficiency, depreciation and, 113
ledger, 191
Form, 193
Posting, summary totals, voucher system, 36
Preferred stock (See “Stock”)
Premium,
bond, 343
amortization of, 269
entry on books, 365
nature of, 266
elements of depreciation, 319
obsolescence, 320
supersession, 320
time lapse, 319
infringement costs, 321
monopoly grant, 317
purchased and not used, 319
purchase of, 317
royalties, 323
sale price of, 324
service life of, 320
writing off the value, 321
Patterns, valuation of, 294, 317
Payments,
part, handling of, under voucher system, 42
Pay-roll, 55
checks drawn to order of treasurer of company, 671
distribution of labor charges, 57
methods of payment, 56
safeguarding, 55
Percentage,
variable, methods of calculating depreciation, 150
Perpetual inventory, 239
necessity for physical count, 240
Personalty, distinction between, and real property, 279
Petty cash, 211
imprest system, 211
Plant,
assets, grouping and classification of, 191
efficiency, depreciation and, 113
ledger, 191
Form, 193
Posting, summary totals, voucher system, 36
Preferred stock (See “Stock”)
Premium,
bond, 343
amortization of, 269
entry on books, 365
nature of, 266
Page 680
relation to interest, 367
schedule showing amortization of, 270
permanent investments, treatment of, 257
stock, 14
creation of surplus, 408
requirements of Interstate Commerce Commission, 13
treatment of, 378
Prepaid items,
accounting for debit and other items, 256
danger of overvaluation, 255
definitions and kinds, 253
valuation of, 254
Price,
cost, valuation of stock-in-trade at, 225
market, valuation of stock-in-trade at, 225
Prime cost,
definition of, 50
direct and indirect labor, 53
raw materials, 52
Private books,
closing, 591
content, 589
operation, 590
illustration of, 590
purpose, 589
Private corporations, 2
non-stock, 2
stock, 2
Problems,
branch accounts,
complex, 529
foreign branch, 548
simple, 527
consolidated balance sheet, 616
different methods of recording accrued items, 252-253
liquidation by instalments, 653
realization and liquidation statement, 645
statement of affairs and deficiency account, 635
Production, statistics, 584
Profit and loss summary, 466-492
schedule showing amortization of, 270
permanent investments, treatment of, 257
stock, 14
creation of surplus, 408
requirements of Interstate Commerce Commission, 13
treatment of, 378
Prepaid items,
accounting for debit and other items, 256
danger of overvaluation, 255
definitions and kinds, 253
valuation of, 254
Price,
cost, valuation of stock-in-trade at, 225
market, valuation of stock-in-trade at, 225
Prime cost,
definition of, 50
direct and indirect labor, 53
raw materials, 52
Private books,
closing, 591
content, 589
operation, 590
illustration of, 590
purpose, 589
Private corporations, 2
non-stock, 2
stock, 2
Problems,
branch accounts,
complex, 529
foreign branch, 548
simple, 527
consolidated balance sheet, 616
different methods of recording accrued items, 252-253
liquidation by instalments, 653
realization and liquidation statement, 645
statement of affairs and deficiency account, 635
Production, statistics, 584
Profit and loss summary, 466-492
Page 681
adjustment of inventories, 490
closing the records of a corporation, for the fiscal year, 474
consolidated balance sheet, 612-615
content and manner of showing, 489
correction of closing errors, 476
cost of goods sold,
manufacturing concern, 478
trading concern, 479
discount on bonds, 474
dividend declaration, 474
form,
account form, 483
comparative statement of, 488
examples of two forms of presentation, 485
manufacturers and merchants, 487
non-technical or report form, 484
standardization of, 477
interest as a cost of manufacture, 468
arguments against, 470-472
problem of charging on books, 471
interrelation of, and balance sheet, 466
periodical adjustments, 467
profit, method of showing, 482
profits between departments, 473
schedules for special need, 492
selling expense and administrative schedules, 491
sinking fund, 475
statement, 410
supporting schedules, 489
terms,
desirability of uniformity in, 481
differentiation of, 480
synonymous, 478
unrealized profits, 472
working capital, 475
Profits, 387-406 (See also “Profit and loss summary,” above)
anticipation of, undesirable, 227
asset losses,
charged against current profits, 396
charged to capital, 397
closing the records of a corporation, for the fiscal year, 474
consolidated balance sheet, 612-615
content and manner of showing, 489
correction of closing errors, 476
cost of goods sold,
manufacturing concern, 478
trading concern, 479
discount on bonds, 474
dividend declaration, 474
form,
account form, 483
comparative statement of, 488
examples of two forms of presentation, 485
manufacturers and merchants, 487
non-technical or report form, 484
standardization of, 477
interest as a cost of manufacture, 468
arguments against, 470-472
problem of charging on books, 471
interrelation of, and balance sheet, 466
periodical adjustments, 467
profit, method of showing, 482
profits between departments, 473
schedules for special need, 492
selling expense and administrative schedules, 491
sinking fund, 475
statement, 410
supporting schedules, 489
terms,
desirability of uniformity in, 481
differentiation of, 480
synonymous, 478
unrealized profits, 472
working capital, 475
Profits, 387-406 (See also “Profit and loss summary,” above)
anticipation of, undesirable, 227
asset losses,
charged against current profits, 396
charged to capital, 397
Page 682
effect of, on future profits, 393
legal decisions as to, 394
treated as deferred expense charge, 396
capital, 405
margin account, 409
capitalization of,
valuation of good-will based on, 335
corporation,
directors’ control over, 429
disposition of, 428
shareholders’ rights as to, 429
definition,
accounting, 390
economics, 387
legal, 389
determining,
difficulty of, 387
double entry, 391
goods awaiting delivery, 402
goods made for stock but not sold, 399
goods made to order, 400
long-term contracts, 401
methods of, 391
single entry, 391
summary of principles governing, 405
work in progress, 399
disposition of, 410
due to appreciation of assets, 404
excess, valuation of good-will based on, 335
intercompany, reserve for, 610
interdepartment, 404
method of showing on profit and loss summary, 482
normal, valuation of good-will based on, 334
problem a question of valuation, 392
relation of sinking fund to, 454
reserves of, secret, 418
statistics, 584
unrealized, 472
Property,
payment of dividends in, 438
legal decisions as to, 394
treated as deferred expense charge, 396
capital, 405
margin account, 409
capitalization of,
valuation of good-will based on, 335
corporation,
directors’ control over, 429
disposition of, 428
shareholders’ rights as to, 429
definition,
accounting, 390
economics, 387
legal, 389
determining,
difficulty of, 387
double entry, 391
goods awaiting delivery, 402
goods made for stock but not sold, 399
goods made to order, 400
long-term contracts, 401
methods of, 391
single entry, 391
summary of principles governing, 405
work in progress, 399
disposition of, 410
due to appreciation of assets, 404
excess, valuation of good-will based on, 335
intercompany, reserve for, 610
interdepartment, 404
method of showing on profit and loss summary, 482
normal, valuation of good-will based on, 334
problem a question of valuation, 392
relation of sinking fund to, 454
reserves of, secret, 418
statistics, 584
unrealized, 472
Property,
payment of dividends in, 438
Page 683
real,
definition of, 297
distinction between personalty and, 279
stock issued for, 14
valuation of stock issued for, 380
Proportional methods (See “Depreciation”)
Proprietorship, reserves for, 417
Pro rata clause, 574
Public corporations, 1
quasi-public, 2
Public utility corporations, 2
valuation for rate regulation, 82
Purchases,
branch house, 533
foreign purchasing agency, 555
future delivery, contingent liability, 354
journal, expansion of, 27
manufacturing business, 26
returns and allowances, under voucher system, 40
valuation for, 83
voucher system (See “Voucher system”)
cash discount, 44
Q
Quasi-public corporations, 2
R
Railroad statistics, 582
Rate regulation, valuation for, 82
Rates, fire insurance, 574
Rates of depreciation (See “Depreciation”)
Raw material, valuation of, 234
Real estate (See “Buildings” and “Land”)
Realization and liquidation account, 639-650
Forms, 642
cash account, 643
evolution of, 640
handling of valuation reserves, 644
illustration of, 645
receiver’s cash account, 648
definition of, 297
distinction between personalty and, 279
stock issued for, 14
valuation of stock issued for, 380
Proportional methods (See “Depreciation”)
Proprietorship, reserves for, 417
Pro rata clause, 574
Public corporations, 1
quasi-public, 2
Public utility corporations, 2
valuation for rate regulation, 82
Purchases,
branch house, 533
foreign purchasing agency, 555
future delivery, contingent liability, 354
journal, expansion of, 27
manufacturing business, 26
returns and allowances, under voucher system, 40
valuation for, 83
voucher system (See “Voucher system”)
cash discount, 44
Q
Quasi-public corporations, 2
R
Railroad statistics, 582
Rate regulation, valuation for, 82
Rates, fire insurance, 574
Rates of depreciation (See “Depreciation”)
Raw material, valuation of, 234
Real estate (See “Buildings” and “Land”)
Realization and liquidation account, 639-650
Forms, 642
cash account, 643
evolution of, 640
handling of valuation reserves, 644
illustration of, 645
receiver’s cash account, 648
Page 684
supporting schedules, 643
theory underlying, 640
uses to which statement may be put, 644
Real property (See also “Buildings” and “Land”)
definition of, 297
distinction between personalty and, 279
Receipts and disbursements (See “Profit and loss summary”)
Receipts, capital, 87
Receivers, 620-654
accounts, 628
initial statements presented to the court in
bankruptcy proceedings, 627
appointment, 620
deficiency account, 633
Form, 635, 638
in bankruptcy, 620, 621
in equity, 621
accounts of, 623-625
relative standing of creditors, 630
reports of, 623-628
procedure, 622
realization and liquidation account,
cash account, 648
example of balance sheet, 645
illustration of statement, 646
realization and liquidation statement, 644
Forms, 646
reports, 628
“charge and discharge” form, 626
initial statements presented to court in
bankruptcy proceedings, 627
reports to the court, 625
comparative balance sheet, 627
items covered, 626
statement of affairs, 631
Forms, 634-638
basis of valuation, 632
Receivership,
method of liquidating, 501, 503
Records,
theory underlying, 640
uses to which statement may be put, 644
Real property (See also “Buildings” and “Land”)
definition of, 297
distinction between personalty and, 279
Receipts and disbursements (See “Profit and loss summary”)
Receipts, capital, 87
Receivers, 620-654
accounts, 628
initial statements presented to the court in
bankruptcy proceedings, 627
appointment, 620
deficiency account, 633
Form, 635, 638
in bankruptcy, 620, 621
in equity, 621
accounts of, 623-625
relative standing of creditors, 630
reports of, 623-628
procedure, 622
realization and liquidation account,
cash account, 648
example of balance sheet, 645
illustration of statement, 646
realization and liquidation statement, 644
Forms, 646
reports, 628
“charge and discharge” form, 626
initial statements presented to court in
bankruptcy proceedings, 627
reports to the court, 625
comparative balance sheet, 627
items covered, 626
statement of affairs, 631
Forms, 634-638
basis of valuation, 632
Receivership,
method of liquidating, 501, 503
Records,
Page 685
accounting,
dividends, 442
machinery and tools, 281
asset, 192
bond investments, 267
distinctive, of corporation, 20
dividend book, 20
instalment book, 20
minute book, 20, 24
private (See “Private books”)
register of transfers, 20
special purposes of cost, 50
predetermination of selling price, 51
stock book,
Forms, 22, 23
stock certificate book, 20
stock ledger, 20, 21
Form, 21
stock register, 21
stock transfer book, 20
Forms, 22
subscription book, 20
subscription ledger, 20
time-keeping, 54
Redeemable preferred stock, 6
Redemption,
capital stock, 381
preferred stock, 19, 384
Referee,
in bankruptcy, liquidating dividends, 630
Refunding, inability to secure cash for, 496
Register,
accounts payable, 34
plant, form of, 191
stock, 21
transfer, 20
voucher,
form of, 34, 35
posting of summary totals, 36
proof of distribution, 37
dividends, 442
machinery and tools, 281
asset, 192
bond investments, 267
distinctive, of corporation, 20
dividend book, 20
instalment book, 20
minute book, 20, 24
private (See “Private books”)
register of transfers, 20
special purposes of cost, 50
predetermination of selling price, 51
stock book,
Forms, 22, 23
stock certificate book, 20
stock ledger, 20, 21
Form, 21
stock register, 21
stock transfer book, 20
Forms, 22
subscription book, 20
subscription ledger, 20
time-keeping, 54
Redeemable preferred stock, 6
Redemption,
capital stock, 381
preferred stock, 19, 384
Referee,
in bankruptcy, liquidating dividends, 630
Refunding, inability to secure cash for, 496
Register,
accounts payable, 34
plant, form of, 191
stock, 21
transfer, 20
voucher,
form of, 34, 35
posting of summary totals, 36
proof of distribution, 37
Page 686
purchase discount column, 44
status of when purchase ledger is used, 46
Renewals,
definition of, 89, 90
distinction between, and repairs, 113
methods of handling, 147
of parts, treatment of, 91
recording depreciation on the books, 188
first method, 188
second method, 189
Repairs,
cost of, included in depreciation charge, 148
estimates, 149
definition of, 89, 90
distinction between, and renewals, 113
methods of handling, 147
on second-hand plant, 94
policy, determining depreciation rate, 143, 145
preliminary estimates, 147
reserve for, 148
theory of averages, 147
Replacements,
definition of, 89
distinction between repairs and renewals, 113
financing of, 203
borrowed funds, 203
increase of capital stock, 203
profits of the past reserved in the business, 203
method of calculating depreciation, 169
appraisement of, 183
Interstate Commerce Commission’s instructions, 189
methods, 188
recording depreciation on the books, 188
Reports, (See also “Statements”)
branch,
customers’ accounts collected, 541
examples of, 540
periodic cash summary, 540
receivers (See “Receivers”)
trustees (See “Trustee”)
status of when purchase ledger is used, 46
Renewals,
definition of, 89, 90
distinction between, and repairs, 113
methods of handling, 147
of parts, treatment of, 91
recording depreciation on the books, 188
first method, 188
second method, 189
Repairs,
cost of, included in depreciation charge, 148
estimates, 149
definition of, 89, 90
distinction between, and renewals, 113
methods of handling, 147
on second-hand plant, 94
policy, determining depreciation rate, 143, 145
preliminary estimates, 147
reserve for, 148
theory of averages, 147
Replacements,
definition of, 89
distinction between repairs and renewals, 113
financing of, 203
borrowed funds, 203
increase of capital stock, 203
profits of the past reserved in the business, 203
method of calculating depreciation, 169
appraisement of, 183
Interstate Commerce Commission’s instructions, 189
methods, 188
recording depreciation on the books, 188
Reports, (See also “Statements”)
branch,
customers’ accounts collected, 541
examples of, 540
periodic cash summary, 540
receivers (See “Receivers”)
trustees (See “Trustee”)
Page 687
Requisitions, stores, 53
Reserves, 410-424
bad debts, 411
classification of, 423
proprietorship reserves, 424
valuation reserves, 424
collection costs not under contract, 414
contingent, 416
continuity of policy, 421
covered, 422
“reserve fund,” 422
deferred income, misuse of term, 417
depletion, 413
depreciation,
accounts, 187
decreasing, 200
financing of replacements, 203
increasing, 200
index of financial condition, 199
insufficient charge, 205
methods of financing replacements, 203
not based on cost of replacement, 202
on balance sheet, 199
relation to efficiency, 201
relation to expanding plant, 201
secret, 204
suspense account, 558
different meanings of, 411
distinction between, and accrued items, 415
doubtful accounts as a suspense account, 558
earmarking of, 420
for investment fluctuations, 243
intercompany profits, 610
market fluctuations in merchandise, 228
operating, for accrued costs, 413
estimated sales discounts, 413
proper allocation of taxes, 413
proprietorship, 417
repairs, 148
sales discounts on the balance sheet, 415
Reserves, 410-424
bad debts, 411
classification of, 423
proprietorship reserves, 424
valuation reserves, 424
collection costs not under contract, 414
contingent, 416
continuity of policy, 421
covered, 422
“reserve fund,” 422
deferred income, misuse of term, 417
depletion, 413
depreciation,
accounts, 187
decreasing, 200
financing of replacements, 203
increasing, 200
index of financial condition, 199
insufficient charge, 205
methods of financing replacements, 203
not based on cost of replacement, 202
on balance sheet, 199
relation to efficiency, 201
relation to expanding plant, 201
secret, 204
suspense account, 558
different meanings of, 411
distinction between, and accrued items, 415
doubtful accounts as a suspense account, 558
earmarking of, 420
for investment fluctuations, 243
intercompany profits, 610
market fluctuations in merchandise, 228
operating, for accrued costs, 413
estimated sales discounts, 413
proper allocation of taxes, 413
proprietorship, 417
repairs, 148
sales discounts on the balance sheet, 415
Page 688
secret, 418
argument against, 419
argument for, 419
overvaluation of liabilities, 418
undervaluation of assets, 418
sinking fund, treatment of, 463
under- and over-estimate of, 412
valuation,
handling of, realization and liquidation account, 644
Returns,
purchase, under voucher system, 40
Revaluation,
periodic, of good-will, 337
Revenue expenditures,
defined, 87
distinction between, and capital, 95
Rights,
stock, received while stocks are held for temporary investment, 244
terminable or limited, depreciation, 134
Residual value,
factor in calculating depreciation, 150
Risks, unusual, in connection with estimate for depreciation
and depletion, 313
Royalties, patents, 323
S
Salaries, dividends paid in form of, 435
Sales,
basis of estimate of bad debts, 220
discounts,
on the balance sheet, 415
proper allocation of estimated, 413
instalment basis, valuation of accounts, 222
statistics, 584
to branch house, 534
valuation for purpose of, 83
Salvage account, 188
Schedules,
for special needs, profit and loss summary, 492
selling expense and administration, 491
argument against, 419
argument for, 419
overvaluation of liabilities, 418
undervaluation of assets, 418
sinking fund, treatment of, 463
under- and over-estimate of, 412
valuation,
handling of, realization and liquidation account, 644
Returns,
purchase, under voucher system, 40
Revaluation,
periodic, of good-will, 337
Revenue expenditures,
defined, 87
distinction between, and capital, 95
Rights,
stock, received while stocks are held for temporary investment, 244
terminable or limited, depreciation, 134
Residual value,
factor in calculating depreciation, 150
Risks, unusual, in connection with estimate for depreciation
and depletion, 313
Royalties, patents, 323
S
Salaries, dividends paid in form of, 435
Sales,
basis of estimate of bad debts, 220
discounts,
on the balance sheet, 415
proper allocation of estimated, 413
instalment basis, valuation of accounts, 222
statistics, 584
to branch house, 534
valuation for purpose of, 83
Salvage account, 188
Schedules,
for special needs, profit and loss summary, 492
selling expense and administration, 491
Page 689
supporting,
profit and loss summary, 489
realization and liquidation account, 643
use of, as a means of condensing balance sheet, 79
Scrap,
machinery, 287
valuation of, 236
Scrap value,
factor in calculating depreciation, 150
Scrip, payment of dividends in, 438
Seasoning, appreciation due to, 207
Secret depreciation reserve, 204
Secrets, trade, 325
Selling expense,
schedules, profit and loss summary, 491
Selling price (See “Market value”)
Service,
life, estimated, factor in calculating depreciation, 150
Service output method,
calculating depreciation, 156
appraisement of, 177
Shares (See “Stock”)
Sinking fund, 447-465
accounting for, 456
appear only among assets, 456
balance sheet, 457
booking the trustees’ report, 460
entries, 459
accumulation based on agreement, 451
bond redemption, 458
compound interest method of calculating depreciation,
appraisal schedule, 162
Chart, 162
formula, 161
debts, effect of settlement of, 452
schedule of debit and credit, 452
definitions, 447
final disposition of, 462
mathematical principles on which based, 449
method of calculating depreciation, appraisement of, 181
profit and loss summary, 489
realization and liquidation account, 643
use of, as a means of condensing balance sheet, 79
Scrap,
machinery, 287
valuation of, 236
Scrap value,
factor in calculating depreciation, 150
Scrip, payment of dividends in, 438
Seasoning, appreciation due to, 207
Secret depreciation reserve, 204
Secrets, trade, 325
Selling expense,
schedules, profit and loss summary, 491
Selling price (See “Market value”)
Service,
life, estimated, factor in calculating depreciation, 150
Service output method,
calculating depreciation, 156
appraisement of, 177
Shares (See “Stock”)
Sinking fund, 447-465
accounting for, 456
appear only among assets, 456
balance sheet, 457
booking the trustees’ report, 460
entries, 459
accumulation based on agreement, 451
bond redemption, 458
compound interest method of calculating depreciation,
appraisal schedule, 162
Chart, 162
formula, 161
debts, effect of settlement of, 452
schedule of debit and credit, 452
definitions, 447
final disposition of, 462
mathematical principles on which based, 449
method of calculating depreciation, appraisement of, 181
Page 690
origin and use, 448
policy of investment, 276
outside securities, 276, 277
own bonds, 276, 277
profit and loss summary, 475
relation between depreciation and, 463
relation to profits, 454
treatment of income and expense, 461
treatment of reserve account, 463
valuation of, 276
Solidification, appreciation due to, 207
Stamps, remitted as cash, 212
Standardization, depreciation rates, 142
Standards, machine operation, 285
State,
report to, balance sheet as, 79
Statement,
assets and liabilities, 70
balance sheet, 63, 64
contingent liabilities, 351
financial, 70
of affairs, bankruptcy proceedings, 631
Forms, 634-638
profit and loss (See “Profit and loss summary”)
realization and liquidation
(See “Realization and liquidation account”)
resources and liabilities, 70
surplus, 425
Statistics, 581-589
application of, 584
graphs,
advantages, 586
principles of construction, 587
use of, in presentation, 585
manufacturing, 583
mercantile, 583
railroad, 582
classification, 582
operating details, 582
results of operation, 582
policy of investment, 276
outside securities, 276, 277
own bonds, 276, 277
profit and loss summary, 475
relation between depreciation and, 463
relation to profits, 454
treatment of income and expense, 461
treatment of reserve account, 463
valuation of, 276
Solidification, appreciation due to, 207
Stamps, remitted as cash, 212
Standardization, depreciation rates, 142
Standards, machine operation, 285
State,
report to, balance sheet as, 79
Statement,
assets and liabilities, 70
balance sheet, 63, 64
contingent liabilities, 351
financial, 70
of affairs, bankruptcy proceedings, 631
Forms, 634-638
profit and loss (See “Profit and loss summary”)
realization and liquidation
(See “Realization and liquidation account”)
resources and liabilities, 70
surplus, 425
Statistics, 581-589
application of, 584
graphs,
advantages, 586
principles of construction, 587
use of, in presentation, 585
manufacturing, 583
mercantile, 583
railroad, 582
classification, 582
operating details, 582
results of operation, 582
Page 691
value of, 581
Stock, 372-386
accounting for, 13
bonus stock, 16
discount, 13
forfeited stock, 19
no par value, 20
premium, 14
property exchanged for, 14
redemption of preferred stock, 19
treasury stock donated, 15
treasury stock purchased, 18
assessment, creation of a margin, 409
bonus, 13, 16
capital and treasury stock on the balance sheet, 383
capitalization,
cost, 376
earning capacity, 375
increase in book, 375
capital, showing of, on consolidated balance sheet, 611
certificate book, 20
certificate of, 9, 10
common, 4
no par value, 9
debenture, 4, 8
discount on, 13
dividend book, 20
dividends in, 382, 439
effect of, 382
estate accounting, 440
donated, 11
creation of surplus, 408
exchanged for property, 14
ex-dividend, 442
forfeited, 12, 19
founders’, 4, 7
fully paid and non-assessable, 11
guaranteed, 4, 7
instalment book, 20
issued as a bonus, 383
Stock, 372-386
accounting for, 13
bonus stock, 16
discount, 13
forfeited stock, 19
no par value, 20
premium, 14
property exchanged for, 14
redemption of preferred stock, 19
treasury stock donated, 15
treasury stock purchased, 18
assessment, creation of a margin, 409
bonus, 13, 16
capital and treasury stock on the balance sheet, 383
capitalization,
cost, 376
earning capacity, 375
increase in book, 375
capital, showing of, on consolidated balance sheet, 611
certificate book, 20
certificate of, 9, 10
common, 4
no par value, 9
debenture, 4, 8
discount on, 13
dividend book, 20
dividends in, 382, 439
effect of, 382
estate accounting, 440
donated, 11
creation of surplus, 408
exchanged for property, 14
ex-dividend, 442
forfeited, 12, 19
founders’, 4, 7
fully paid and non-assessable, 11
guaranteed, 4, 7
instalment book, 20
issued as a bonus, 383
Page 692
issue of, bonds versus, 362
kinds of, 372
law and issues of, 377
ledger, 20
Form, 21
no par value, 9, 20 not fully paid, contingent liability, 354
ordinary, 4
preferred, 4, 5
accumulated dividends on, contingent liability, 355
convertible, 6
covered by redemption contract, 384
cumulative, 5
non-cumulative, 5
non-participating, 6
participating, 6
redeemable, 6
redemption of, 19
premium, 14
creation of surplus, 408
property purchases, 14
records, stock book, 22, 23
redemption and reduction of capital stock, 381
at book value, 381
surplus adjustment, 381
register, 20, 21
rights, received while stocks are held for purposes
of temporary investments, 244
sale of, at less than par, 11
sinking fund, 448
subscription book, 20
subscription ledger, 20
transfer book, 20
Form, 22
treasury, 10, 247
balance sheet, 383
bonus, 16
donated, 11, 15
purchased, 18
valuation of, 380
unissued,
kinds of, 372
law and issues of, 377
ledger, 20
Form, 21
no par value, 9, 20 not fully paid, contingent liability, 354
ordinary, 4
preferred, 4, 5
accumulated dividends on, contingent liability, 355
convertible, 6
covered by redemption contract, 384
cumulative, 5
non-cumulative, 5
non-participating, 6
participating, 6
redeemable, 6
redemption of, 19
premium, 14
creation of surplus, 408
property purchases, 14
records, stock book, 22, 23
redemption and reduction of capital stock, 381
at book value, 381
surplus adjustment, 381
register, 20, 21
rights, received while stocks are held for purposes
of temporary investments, 244
sale of, at less than par, 11
sinking fund, 448
subscription book, 20
subscription ledger, 20
transfer book, 20
Form, 22
treasury, 10, 247
balance sheet, 383
bonus, 16
donated, 11, 15
purchased, 18
valuation of, 380
unissued,
Page 693
distinction between treasury stock and, 11
valuation of, 246
used to pay organization expense, 14
valuation,
balance sheet, 374
book value, 373
dependent upon earning capacity, 374
market, 373
of property, 11
par, 373
problems of, 372
real, 373
treasury stock, 380
treatment of discount or premium, 374
when issued for property, 380
watered, 10
Stock corporations (See “Corporations”)
Stockholders,
balance sheet as formal report to, 79
depreciation policy and, 209
rights as to profits, 429
rights to dividends, 431
status of, in liquidation, 504
Stock-in-trade, 225-240
anticipation of profits or losses undesirable, 227
balance sheet, 227
brokerage firms,
valuation of stocks and bonds held, 245
definition and scope of term, 225
depreciation, 119, 229
deterioration, 229
distribution of costs over, 231
fluctuations in market price, 228
reserve for, 228
full costs of, 230
cash discount, 230
drayage, 230
duty, 230
freight, 230
insurance, 230
valuation of, 246
used to pay organization expense, 14
valuation,
balance sheet, 374
book value, 373
dependent upon earning capacity, 374
market, 373
of property, 11
par, 373
problems of, 372
real, 373
treasury stock, 380
treatment of discount or premium, 374
when issued for property, 380
watered, 10
Stock corporations (See “Corporations”)
Stockholders,
balance sheet as formal report to, 79
depreciation policy and, 209
rights as to profits, 429
rights to dividends, 431
status of, in liquidation, 504
Stock-in-trade, 225-240
anticipation of profits or losses undesirable, 227
balance sheet, 227
brokerage firms,
valuation of stocks and bonds held, 245
definition and scope of term, 225
depreciation, 119, 229
deterioration, 229
distribution of costs over, 231
fluctuations in market price, 228
reserve for, 228
full costs of, 230
cash discount, 230
drayage, 230
duty, 230
freight, 230
insurance, 230
Page 694
interest on money invested, 231
seasoning, 230
warehouse charges, 230
inventory-taking, 237
methods, 238
perpetual, 239
rules, 238
land as, 310
method of treatment, 228
objections to valuation at less than cost, 226
pricing of the inventory, 232
weighted average, 232
valuation of, consolidated balance sheet, 607
valuation of, cost or market price, 225
summary arguments, 228
valuation of manufacturing inventory, 233, 234
finished goods, 233
goods in process, 234
raw materials, 234
scrap, 236
Stores department,
accounting for materials, 52
ledger, 53
requisitions, 53
Straight line method,
calculating depreciation, 152
appraisement of, 175
formula, 152
graphic chart, 153
Subscription,
book, 20
ledger, 20
rights, received while stocks are held for temporary investment, 244
Subsidiaries,
advances to,
by holding company, 262
rules for valuation, 263
permanent investments in, by holding company, 261
Subsidiary records, recording depreciation on the books, 190
Supersession, patents, 320
seasoning, 230
warehouse charges, 230
inventory-taking, 237
methods, 238
perpetual, 239
rules, 238
land as, 310
method of treatment, 228
objections to valuation at less than cost, 226
pricing of the inventory, 232
weighted average, 232
valuation of, consolidated balance sheet, 607
valuation of, cost or market price, 225
summary arguments, 228
valuation of manufacturing inventory, 233, 234
finished goods, 233
goods in process, 234
raw materials, 234
scrap, 236
Stores department,
accounting for materials, 52
ledger, 53
requisitions, 53
Straight line method,
calculating depreciation, 152
appraisement of, 175
formula, 152
graphic chart, 153
Subscription,
book, 20
ledger, 20
rights, received while stocks are held for temporary investment, 244
Subsidiaries,
advances to,
by holding company, 262
rules for valuation, 263
permanent investments in, by holding company, 261
Subsidiary records, recording depreciation on the books, 190
Supersession, patents, 320
Page 695
Supplies, factory costs, 51
Surety bond,
signature to, contingent liability, 355
Surplus, 407-410
account, legitimate use of, 424
adjustment of, through redemption or reduction of capital stock, 381
definition, 407
disposition of profits, 410
margin, 407
capital profits and bonuses, 409
capital stock premiums, 408
creation of, 408
stock assessments, 409
stock donation, 408
showing on consolidated balance sheet, 611
statement of, 425
Suspense accounts, 556-563
accounts receivable hypothecated, 560
definition, 556
general purposes, 556
reserve for depreciation, 558
reserve for doubtful accounts, 558
use of suspense ledger, 559
Symbol system applied to accounts
(See “Numbered accounts”)
Symbols, used in calculating depreciation, 151
T
Taxation, valuation for, 83
Taxes, proper allocation of, 413
Time,
idle, factor in depreciation, 139
units of, 139
Time cards, analysis of, 57
Time-keeping,
records, cards, 54
Tools (See “Equipment”)
Trade debtors,
accounts receivable, 216
discounts and collection costs, 221
Surety bond,
signature to, contingent liability, 355
Surplus, 407-410
account, legitimate use of, 424
adjustment of, through redemption or reduction of capital stock, 381
definition, 407
disposition of profits, 410
margin, 407
capital profits and bonuses, 409
capital stock premiums, 408
creation of, 408
stock assessments, 409
stock donation, 408
showing on consolidated balance sheet, 611
statement of, 425
Suspense accounts, 556-563
accounts receivable hypothecated, 560
definition, 556
general purposes, 556
reserve for depreciation, 558
reserve for doubtful accounts, 558
use of suspense ledger, 559
Symbol system applied to accounts
(See “Numbered accounts”)
Symbols, used in calculating depreciation, 151
T
Taxation, valuation for, 83
Taxes, proper allocation of, 413
Time,
idle, factor in depreciation, 139
units of, 139
Time cards, analysis of, 57
Time-keeping,
records, cards, 54
Tools (See “Equipment”)
Trade debtors,
accounts receivable, 216
discounts and collection costs, 221
Page 696
Trade-marks, 326
valuation of, 326
Trade secrets, 325
Trading corporations, 2
Transfer book, stock, 20
Forms, 22
Transfers, register of, 20
Treasury stock (See “Stock”)
Trial balance,
conversion of, foreign branch, example of, 548, 549
relation between balance sheet and, 62, 77
tested as to equality of debits and credits, 695
Trustee, 620-654
accounts, 628
bankruptcy, 502
deficiency account, 633
Form, 635, 638
disposing of bankrupts’ property, 629
liquidating dividends, 629
declaration of, in hands of referee, 630
realization and liquidation account, 639-650
Forms, 642
cash, 643
evolution of, 640
handling of valuation reserves, 644
illustration of, 646
supporting schedules, 643
theory underlying, 640
uses to which statement may be put, 644
records, 629
relative standing of creditors, 630
reports, 628
sinking fund, booking report, 460
statement of affairs, 631
basis of valuation, 632
Forms, 634-638
Turnover, statistics, 584
U
Unearned increment, 209
valuation of, 326
Trade secrets, 325
Trading corporations, 2
Transfer book, stock, 20
Forms, 22
Transfers, register of, 20
Treasury stock (See “Stock”)
Trial balance,
conversion of, foreign branch, example of, 548, 549
relation between balance sheet and, 62, 77
tested as to equality of debits and credits, 695
Trustee, 620-654
accounts, 628
bankruptcy, 502
deficiency account, 633
Form, 635, 638
disposing of bankrupts’ property, 629
liquidating dividends, 629
declaration of, in hands of referee, 630
realization and liquidation account, 639-650
Forms, 642
cash, 643
evolution of, 640
handling of valuation reserves, 644
illustration of, 646
supporting schedules, 643
theory underlying, 640
uses to which statement may be put, 644
records, 629
relative standing of creditors, 630
reports, 628
sinking fund, booking report, 460
statement of affairs, 631
basis of valuation, 632
Forms, 634-638
Turnover, statistics, 584
U
Unearned increment, 209
Page 697
Unissued stock, valuation of, 246
Unit,
cost method, calculating depreciation, 161, 167-169, 182
efficiency, 114
product, 139
time, 139
Utility, public corporations, 2
V
Valuation accounts, showing on the balance sheet, 77
Valuation, principles of, 81-93
accounts receivable, 215
accrued items, 250
advances to subsidiaries, 263
asset subject to depreciation, a deferred charge to operations, 93
authorization for booking capital expenditures, 94
balance sheet concerned with, and content, rather than form, 97
balance sheet, content of, 81
contingent assets, 81
contingent liabilities, 81
buildings, 300
capital stock, 372-386
carriers and containers, 293
cash, 210-214
combinations and consolidations, 512
cost-cutting changes, 92
cost value usual basis, 86
definition,
capital and revenue expenditure, 87
maintenance, 89
renewals, 89
replacement, 89
delivery equipment, 292
depreciation, 99, 101
depreciation and fluctuations in market value, 116, 117
estimates, 97
fire loss adjustments, 83
franchises, 328
furniture and equipment, 291
going concern, 83
Unit,
cost method, calculating depreciation, 161, 167-169, 182
efficiency, 114
product, 139
time, 139
Utility, public corporations, 2
V
Valuation accounts, showing on the balance sheet, 77
Valuation, principles of, 81-93
accounts receivable, 215
accrued items, 250
advances to subsidiaries, 263
asset subject to depreciation, a deferred charge to operations, 93
authorization for booking capital expenditures, 94
balance sheet concerned with, and content, rather than form, 97
balance sheet, content of, 81
contingent assets, 81
contingent liabilities, 81
buildings, 300
capital stock, 372-386
carriers and containers, 293
cash, 210-214
combinations and consolidations, 512
cost-cutting changes, 92
cost value usual basis, 86
definition,
capital and revenue expenditure, 87
maintenance, 89
renewals, 89
replacement, 89
delivery equipment, 292
depreciation, 99, 101
depreciation and fluctuations in market value, 116, 117
estimates, 97
fire loss adjustments, 83
franchises, 328
furniture and equipment, 291
going concern, 83
Page 698
good-will, 333-338
home-made machinery and tools, 289
inventory, 232, 233
kinds of value, 84
land, 303
investments, 307
liability items, 97
liquidation, 83
machinery, 287
main groups of asset items, 95
current assets, 96
deferred charges to operation, 96
fixed assets, 96
mercantile credits, 215-224
necessary to read the balance sheet, 6
notes receivable, 215
organization expenses, 88
over- and undervaluation, 97
patents, 317
patterns, molds, etc., 294
permanent investments, 259
present value of property, 86
profits, 392
purchase, 83
rate regulation, 82
repairs on second-hand plant, 94
sale, 83
sinking funds, 276
source of data as to value, 85
stock-in-trade, 225-240
taxation, 83
temporary investments; accrued and deferred items, 241-257
treatment of renewal of parts, 91
Value,
cost, 85, 86
kinds of, 84
market, 85
depreciation and fluctuations in, 116, 117
no par, stock of, 20
“normal” or “average,” 109
home-made machinery and tools, 289
inventory, 232, 233
kinds of value, 84
land, 303
investments, 307
liability items, 97
liquidation, 83
machinery, 287
main groups of asset items, 95
current assets, 96
deferred charges to operation, 96
fixed assets, 96
mercantile credits, 215-224
necessary to read the balance sheet, 6
notes receivable, 215
organization expenses, 88
over- and undervaluation, 97
patents, 317
patterns, molds, etc., 294
permanent investments, 259
present value of property, 86
profits, 392
purchase, 83
rate regulation, 82
repairs on second-hand plant, 94
sale, 83
sinking funds, 276
source of data as to value, 85
stock-in-trade, 225-240
taxation, 83
temporary investments; accrued and deferred items, 241-257
treatment of renewal of parts, 91
Value,
cost, 85, 86
kinds of, 84
market, 85
depreciation and fluctuations in, 116, 117
no par, stock of, 20
“normal” or “average,” 109
Page 699
par and no par, of stock, 9
present, 86
source of data as to, 85
Variable percentage methods (See “Depreciation”)
Voluntary dissolution, 501
liquidation under, 503
Voucher system, 26-48
“Accounts Payable Register,” 34
advantages, summary of, 47
canceled checks, 32
cash discount on purchases, 44
adjustment of difference between discount columns
in voucher register and cash book, at the close
of fiscal period, 45
customary method, 46
supplementary voucher, 45
checks, given a new series of numbers to facilitate
reconciliation with bank account, 37
control of vouchers payable, 39
definition, 28
description of, 28
development of, 27
disadvantages, summary of, 48
distribution of charges, 31
distribution of vouchers, 34
effect on cash book and bank account, 37
expansion of the purchase journal, 27
form of voucher register, 34
index of creditors, 38
introduction of, 39
journal vouchers, 592-596
Forms, 592, 593
content, 595
index, 594
Forms, 594, 595
method of use, 593
methods of authorizing journal entries, 596
need for, 592
modifications, 46
house vouchers, 47
present, 86
source of data as to, 85
Variable percentage methods (See “Depreciation”)
Voluntary dissolution, 501
liquidation under, 503
Voucher system, 26-48
“Accounts Payable Register,” 34
advantages, summary of, 47
canceled checks, 32
cash discount on purchases, 44
adjustment of difference between discount columns
in voucher register and cash book, at the close
of fiscal period, 45
customary method, 46
supplementary voucher, 45
checks, given a new series of numbers to facilitate
reconciliation with bank account, 37
control of vouchers payable, 39
definition, 28
description of, 28
development of, 27
disadvantages, summary of, 48
distribution of charges, 31
distribution of vouchers, 34
effect on cash book and bank account, 37
expansion of the purchase journal, 27
form of voucher register, 34
index of creditors, 38
introduction of, 39
journal vouchers, 592-596
Forms, 592, 593
content, 595
index, 594
Forms, 594, 595
method of use, 593
methods of authorizing journal entries, 596
need for, 592
modifications, 46
house vouchers, 47
Page 700
purchase ledger sometimes used, 46
notes payable, handling of, 43
operation, 31
summary of, 47
organization of an accounting department of a
manufacturing business, 26
partial payments, 42
payment of vouchers, 37
purchase returns and allowances, 40
purchasing for the manufacturing business, 26
register,
posting of summary totals, 36
proof of distribution, 37
purchase discount column, 44
status of, when purchase ledger is used, 46
voucher check, 32
distribution of charges, 32
folded, 32
Forms, 33
single, 32
Forms, 34
voucher forms, 29, 30
voucher register, 34
Forms, 35
W
Wages, accrued, 57
Warehouse charges, cost of stock-in-trade, 230
Wasting assets (See also “Depletion”)
application of income tax to, 312
basis of depletion charge, 312
characteristics, 311
definition, 311
depreciation on buildings and machinery of, 313
dividends may include return of capital, 311
effect on different kinds of business, 118
leaseholds, 314, 315
unusual risks, 313
water rights, 313
Watered stock, 10
notes payable, handling of, 43
operation, 31
summary of, 47
organization of an accounting department of a
manufacturing business, 26
partial payments, 42
payment of vouchers, 37
purchase returns and allowances, 40
purchasing for the manufacturing business, 26
register,
posting of summary totals, 36
proof of distribution, 37
purchase discount column, 44
status of, when purchase ledger is used, 46
voucher check, 32
distribution of charges, 32
folded, 32
Forms, 33
single, 32
Forms, 34
voucher forms, 29, 30
voucher register, 34
Forms, 35
W
Wages, accrued, 57
Warehouse charges, cost of stock-in-trade, 230
Wasting assets (See also “Depletion”)
application of income tax to, 312
basis of depletion charge, 312
characteristics, 311
definition, 311
depreciation on buildings and machinery of, 313
dividends may include return of capital, 311
effect on different kinds of business, 118
leaseholds, 314, 315
unusual risks, 313
water rights, 313
Watered stock, 10
Page 701
Water pollution, cause of depreciation, 133
Water rights,
acquired along with a wasting asset, 313
Working capital, profit and loss summary, 475
Working hours method,
calculating depreciation, 153
Chart, 155
appraisement of, 176
Workmen’s dwellings, 599
Water rights,
acquired along with a wasting asset, 313
Working capital, profit and loss summary, 475
Working hours method,
calculating depreciation, 153
Chart, 155
appraisement of, 176
Workmen’s dwellings, 599
Page 702
Footnotes:
[1] “Business Finance” by Lough.
[2] “Stocks and Shares” by Hartley Withers.
[3] From “Corporate Organization and Management,” by Thomas Conyngton.
[4] In “Accounting in Theory and Practice.”
[5] In “Accounting Practice and Procedure.”
[6] In “Accounting in Theory and Practice.”
[7] Material in parentheses is author’s.
[8] Material in parentheses is author’s.
[9] In “Auditing, Theory and Practice.”
[10] In “Modern Accounting.”
[11] In “Power for Profit.”
[12] In “Accounting Practice and Procedure.”
[13] “Handbook of Railroad Expenses,” by J. S. Eaton.
[14] In “Power for Profit.”
[15] In “Principles of Depreciation.”
[16] In “Value for Rate-Making.”
[17] Material in parentheses is the author’s.
[18] In “Modern Accounting.”
[19] In “Depreciation and Wasting Assets.”
[20] In “Modern Accounting.”
[21] Chart adapted from “Regulation, Valuation and Depreciation,” by S. S. Wyer.
[22] Leonard Metcalf paper on “Water-works Valuation and Fair Rates” before the
American Society of Civil Engineers, Vol. LXIV, 1909, page 16.
[23] In “Depreciation and Wasting Assets.”
[24] Spring Valley Water Co. v. San Francisco, 165 Fed. Rep. 703.
[25]
A. S. C. E., Vol. 31, page 220, article by R. Montfort.
A. S. C. E., Vol. 40, page 178, article by C. H. Snow.
Association Engineering Societies, Vol. 31, page 49, by F. W. Hodgson.
U. S. Gov’t, Bureau of Entomology Bulletin #94, Pt. 1, by T.E. Snyder.
U. S. Gov’t, Bureau of Plant Industry Bulletin #64, by G.T. More and K.F. Kellerman.
U. S. Gov’t, Bureau of Plant Industry Bulletin #76, by G.T. More and K.F. Kellerman.
U. S. Gov’t., Dep’t of Agriculture, Forest Service, Circular #128 by C. S. Smith.
[26] In “Income Tax Procedure, 1918.”
[27] In “Public Utilities, Their Cost New and Depreciation.”
[1] “Business Finance” by Lough.
[2] “Stocks and Shares” by Hartley Withers.
[3] From “Corporate Organization and Management,” by Thomas Conyngton.
[4] In “Accounting in Theory and Practice.”
[5] In “Accounting Practice and Procedure.”
[6] In “Accounting in Theory and Practice.”
[7] Material in parentheses is author’s.
[8] Material in parentheses is author’s.
[9] In “Auditing, Theory and Practice.”
[10] In “Modern Accounting.”
[11] In “Power for Profit.”
[12] In “Accounting Practice and Procedure.”
[13] “Handbook of Railroad Expenses,” by J. S. Eaton.
[14] In “Power for Profit.”
[15] In “Principles of Depreciation.”
[16] In “Value for Rate-Making.”
[17] Material in parentheses is the author’s.
[18] In “Modern Accounting.”
[19] In “Depreciation and Wasting Assets.”
[20] In “Modern Accounting.”
[21] Chart adapted from “Regulation, Valuation and Depreciation,” by S. S. Wyer.
[22] Leonard Metcalf paper on “Water-works Valuation and Fair Rates” before the
American Society of Civil Engineers, Vol. LXIV, 1909, page 16.
[23] In “Depreciation and Wasting Assets.”
[24] Spring Valley Water Co. v. San Francisco, 165 Fed. Rep. 703.
[25]
A. S. C. E., Vol. 31, page 220, article by R. Montfort.
A. S. C. E., Vol. 40, page 178, article by C. H. Snow.
Association Engineering Societies, Vol. 31, page 49, by F. W. Hodgson.
U. S. Gov’t, Bureau of Entomology Bulletin #94, Pt. 1, by T.E. Snyder.
U. S. Gov’t, Bureau of Plant Industry Bulletin #64, by G.T. More and K.F. Kellerman.
U. S. Gov’t, Bureau of Plant Industry Bulletin #76, by G.T. More and K.F. Kellerman.
U. S. Gov’t., Dep’t of Agriculture, Forest Service, Circular #128 by C. S. Smith.
[26] In “Income Tax Procedure, 1918.”
[27] In “Public Utilities, Their Cost New and Depreciation.”
Page 703
[28] In “Value for Rate-Making,” pp. 255-256.
[29] R. P. Bolton in “Power for Profit.”
[30] In “Value for Rate-Making.”
[31] Inasmuch as by hypothesis the periodic depreciation charges are the same D₁
= D₂ = D₃ etc., hence, D₁ is used to represent the fixed depreciation charge per
period.
[32] Inasmuch as by hypothesis the periodic depreciation charges are the same D₁
= D₂ = D₃ etc., hence, D₁ is used to represent the fixed depreciation charge per
period.
[33] The interested student is referred to Proceedings—American Society of Civil
Engineers—December, 1916, in which will be found the Valuation Committee’s
report, and to Salier’s “Principles of Depreciation,” in both of which the formula is
developed.
[34] D and d may be expressed as the respective periodic amount-multipliers
necessary to create sinking funds of one dollar each under the conditions as to time
and rate for V and V₁. VD and V₁d become, therefore, the periodic amounts of true
depreciation, i.e., decrement in value.
[35] D and d may be expressed as the respective periodic amount-multipliers
necessary to create sinking funds of one dollar each under the conditions as to time
and rate for V and V₁. VD and V₁d become, therefore, the periodic amounts of true
depreciation, i.e., decrement in value.
[36] In “Depreciation and Wasting Assets.”
[37] From “Valuation, Depreciation and the Rate-Base,” by C. E. Grunsky.
[38] That is, cost less salvage.
[39] That is, the number of times renewal of the asset will be required during the
longest life-period of any of the assets.
[40] Dollar-years, column (f), is the product of the total invested values as shown
in column (e), and the life of each group as shown by column (b). Thus, $400,000
invested for 5 years is the equivalent of $2,000,000 invested for 1 year.
[41] (d) = (c) ÷ (b).
[42] See Consolidated Gas Co. v. City of New York, 157 Fed. Rep. 855, and 20 I.
C. C. Rep. 344.
[43] Valuation Committee of the American Society of Civil Engineers.
[44] In “Accounting Practice and Procedure.”
[45] In “Engineering Valuation of Public Utilities and Factories.”
[46] In “Auditing, Theory and Practice.”
[47] In “Accounting in Theory and Practice.”
[48] P. J. Esquerré, in “Applied Theory of Accounts.”
[49] In “Auditing—Theory and Practice.”
[50] “The Principles of Bond Investment,” by Lawrence Chamberlain.
[51] Montgomery’s “Auditing, Theory and Practice.”
[29] R. P. Bolton in “Power for Profit.”
[30] In “Value for Rate-Making.”
[31] Inasmuch as by hypothesis the periodic depreciation charges are the same D₁
= D₂ = D₃ etc., hence, D₁ is used to represent the fixed depreciation charge per
period.
[32] Inasmuch as by hypothesis the periodic depreciation charges are the same D₁
= D₂ = D₃ etc., hence, D₁ is used to represent the fixed depreciation charge per
period.
[33] The interested student is referred to Proceedings—American Society of Civil
Engineers—December, 1916, in which will be found the Valuation Committee’s
report, and to Salier’s “Principles of Depreciation,” in both of which the formula is
developed.
[34] D and d may be expressed as the respective periodic amount-multipliers
necessary to create sinking funds of one dollar each under the conditions as to time
and rate for V and V₁. VD and V₁d become, therefore, the periodic amounts of true
depreciation, i.e., decrement in value.
[35] D and d may be expressed as the respective periodic amount-multipliers
necessary to create sinking funds of one dollar each under the conditions as to time
and rate for V and V₁. VD and V₁d become, therefore, the periodic amounts of true
depreciation, i.e., decrement in value.
[36] In “Depreciation and Wasting Assets.”
[37] From “Valuation, Depreciation and the Rate-Base,” by C. E. Grunsky.
[38] That is, cost less salvage.
[39] That is, the number of times renewal of the asset will be required during the
longest life-period of any of the assets.
[40] Dollar-years, column (f), is the product of the total invested values as shown
in column (e), and the life of each group as shown by column (b). Thus, $400,000
invested for 5 years is the equivalent of $2,000,000 invested for 1 year.
[41] (d) = (c) ÷ (b).
[42] See Consolidated Gas Co. v. City of New York, 157 Fed. Rep. 855, and 20 I.
C. C. Rep. 344.
[43] Valuation Committee of the American Society of Civil Engineers.
[44] In “Accounting Practice and Procedure.”
[45] In “Engineering Valuation of Public Utilities and Factories.”
[46] In “Auditing, Theory and Practice.”
[47] In “Accounting in Theory and Practice.”
[48] P. J. Esquerré, in “Applied Theory of Accounts.”
[49] In “Auditing—Theory and Practice.”
[50] “The Principles of Bond Investment,” by Lawrence Chamberlain.
[51] Montgomery’s “Auditing, Theory and Practice.”
Page 704
[52] In “Principles of Economics.”
[53] In “Political Economy.”
[54] In “Principles of Economics.”
[55] In “Income Tax.”
[56] Badham v. Williams.
[57] In “Auditing, Theory and Practice.”
[58] In “Accounting Practice and Procedure.”
[59] Verner v. General and Commercial Investment Trust, Limited, 2 Ch. 239
(1894).
[60] In “Modern Accounting.”
[61] In “Accounting Practice and Procedure.”
[62] In “Auditing, Theory and Practice.”
[63] In “Applied Theory of Accounts.”
[64] In “Modern Accounting.”
[65] Ch. 59 of the Consolidated Laws (Ch. 61, Laws 1909).
[66] Lee v. Neuchatel Asphalte Co.
[67] George Lisle in “Accounting in Theory and Practice.”
[68] In “Accounting Practice and Procedure.”
[69] Credits in red ink.
[70] This item comprised 5 drafts, of £10,000 each, at 4.75, 4.7575, 4.74875,
4.7625, and 4.78 respectively.
[71] This also may be kept in both currencies if desired and only totals carried in
the London Control account.
[72] “In Symbols.”
[73] Intercompany profit between Z and Y.
[74] Subtraction item, usually shown in red.
[75] From a paper by Herbert C. Freeman, entitled “Accounting for Receivership,”
presented at the annual meeting of the American Institute of Accountants at
Washington, D. C., 1917.
[76] Increments in value.
[77] Increments in value.
[78] Represent capital deficiencies at the time of the 1st and 2nd instalments.
[79] Represent capital deficiencies at the time of the 1st and 2nd instalments.
[80] The account title may be written just as given or, better, the parenthetical part
may be put on the small half-line space immediately below the title line as that is
usually ruled. (See ruling at top of any ledger page.)
[81] The account title may be written just as given or, better, the parenthetical part
may be put on the small half-line space immediately below the title line as that is
usually ruled. (See ruling at top of any ledger page.)
[53] In “Political Economy.”
[54] In “Principles of Economics.”
[55] In “Income Tax.”
[56] Badham v. Williams.
[57] In “Auditing, Theory and Practice.”
[58] In “Accounting Practice and Procedure.”
[59] Verner v. General and Commercial Investment Trust, Limited, 2 Ch. 239
(1894).
[60] In “Modern Accounting.”
[61] In “Accounting Practice and Procedure.”
[62] In “Auditing, Theory and Practice.”
[63] In “Applied Theory of Accounts.”
[64] In “Modern Accounting.”
[65] Ch. 59 of the Consolidated Laws (Ch. 61, Laws 1909).
[66] Lee v. Neuchatel Asphalte Co.
[67] George Lisle in “Accounting in Theory and Practice.”
[68] In “Accounting Practice and Procedure.”
[69] Credits in red ink.
[70] This item comprised 5 drafts, of £10,000 each, at 4.75, 4.7575, 4.74875,
4.7625, and 4.78 respectively.
[71] This also may be kept in both currencies if desired and only totals carried in
the London Control account.
[72] “In Symbols.”
[73] Intercompany profit between Z and Y.
[74] Subtraction item, usually shown in red.
[75] From a paper by Herbert C. Freeman, entitled “Accounting for Receivership,”
presented at the annual meeting of the American Institute of Accountants at
Washington, D. C., 1917.
[76] Increments in value.
[77] Increments in value.
[78] Represent capital deficiencies at the time of the 1st and 2nd instalments.
[79] Represent capital deficiencies at the time of the 1st and 2nd instalments.
[80] The account title may be written just as given or, better, the parenthetical part
may be put on the small half-line space immediately below the title line as that is
usually ruled. (See ruling at top of any ledger page.)
[81] The account title may be written just as given or, better, the parenthetical part
may be put on the small half-line space immediately below the title line as that is
usually ruled. (See ruling at top of any ledger page.)
Page 705
[82] The account title may be written just as given or, better, the parenthetical part
may be put on the small half-line space immediately below the title line as that is
usually ruled. (See ruling at top of any ledger page.)
[83] The finished goods were listed at the factory cost but the policy covered the
selling price which was based on a profit of 60% on the factory cost, with 10% on
sales added for selling expenses.
[84] Most of these problems in Appendix C are C. P. A. problems of various states.
The dates have been changed to recent dates.
Transcriber's Notes:
The cover image was created by the transcriber, and is in the public domain.
The illustrations have been moved so that they do not break up paragraphs and so that
they are next to the text they illustrate.
Typographical errors have been silently corrected.
may be put on the small half-line space immediately below the title line as that is
usually ruled. (See ruling at top of any ledger page.)
[83] The finished goods were listed at the factory cost but the policy covered the
selling price which was based on a profit of 60% on the factory cost, with 10% on
sales added for selling expenses.
[84] Most of these problems in Appendix C are C. P. A. problems of various states.
The dates have been changed to recent dates.
Transcriber's Notes:
The cover image was created by the transcriber, and is in the public domain.
The illustrations have been moved so that they do not break up paragraphs and so that
they are next to the text they illustrate.
Typographical errors have been silently corrected.
Page 706
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