5feui ^atk Hate ajallegc of Agricttltutc At aiar«BU Intnecaitg 3tl)ata. N. f . Sltbrar^ Cornell University Library HF 5625.P4 Principles of accounting, 3 1924 013 824 234 1(1 !)l I Cornell University Library The original of tiiis book is in tine Cornell University Library. There are no known copyright restrictions in the United States on the use of the text. http://www.archive.org/details/cu31924013824234 PRINCIPLES OF ACCOUNTING •Tl >^?>^° THE MACMILLAN COMPANY NEW YORK - BOSTON • CHICAGO • DALLAS ATLAN-fA • SAN FFtANCISCO MACMILLAN & CO., Limited LONDON • BOMBAY • CALCUTTA MELBOURNE THE MACMILLAN CO. QF CANADA, Ltd. TORONTO PRINCIPLES OF ACCOUNTING BY WILLIAM ANDREW PATON, Ph.D. Associate Professor of Economics in the University of Michigan AND RUSSELL ALGER STEVENSON, Ph.D. Associate Professor of Accounting in the University of Iowa TStia gorft THE MACMILLAN COMPANY * ' 1920 A// rights reserved Copyright, 1918, By the MACMILLAN COMPANY. Set up and electrotyped. Published October, igi8. jMotbiaoIr Vnis J. B. Gnshing Go. — Berwick & Smith Go. Norwood, Mass., U.S.A. PREFACE This book is intended primarily as a text for general account- ing courses in colleges and universities. It may also be of interest to other readers than college students who wish to understand the fundamentals of accounting. Although new books are now being rapidly added to the list of general treatises on the subject the authors feel that no apology need be offered for the appear- ance of this volume. There has been a dearth of material avail- able for the student of economics who desires a broad training in accounting principles as a part of a general equipment. The texts available are, for the most part, too highly professional and specialized for this purpose, and are without adequate refer- ence to the background of economic principles underlying all commercial transactions. In other words, although there are many books intended for the business man and professional accountant there are few works on accounting which even pro- fess to be suited to the needs of the student of economics. It is the aim of this book to present the principles of the subject in such a way as to meet the needs of the general student as well as to afford the proper basis for specialized work in professional accountancy. An effort has been made to develop principles without dis- cussing the details of specific systems of bookkeeping and ofl&ce methods. This procedure implies that accounting is a science dealing with logical classifications and embracing a definite body of doctrine which can be developed independently of mere clerical iroutine. Furthermore, since the classroom is not a laboratory capable of reproducing exact business conditions, and since bookkeeping methods are constantly changing, a discussion of clerical details is of minor importance in a treatise on principles. Once a student is thoroughly grounded a mastery of the technical details of any particular system of accounts is easily attained. ' On the other hand, the important general vi PREFACE features of technique have been sufficiently discussed and illus- trated to familiarize the student with the fundamental types of books and working papers used in modern practice. The essential characteristics of modern business organization and finance have received some consideration because of the close relation of these matters to accounting. No attempt has been made, however, to treat these topics elaborately or to refer, for illustration, to specific legal cases. In the first place a too full discussion of such subjects tends to leave the student with a vague impression of the accounting principles involved. In the second place such details as may be desired can be introduced more effectively by means of problems and illustrations from current practice furnished by the instructor. Further, special courses in commercial law, business organization, corporation finance, and similar subjects are generally conceded to be an essential part of the course of study which should be prescribed for the student of economics and accounting. Accordingly, although it should be admitted that the professional accountant requires a rather minute knowledge of these matters, it seems evident that a lengthy study of such topics cannot properly be included in a single course in accounting principles. Although in the exposition of principles in the main part of the book special systems of accounts are not discussed, it has seemed advisable in Part Six to present a brief statement sug- gesting some of the essential features of the more important special fields. The topics considered have been chosen partic- ularly because of the fact that in many institutions the ad- vanced courses in accounting deal with these branches of the subject. Part Six, then, serves to give to the student who wishes to pursue special work a glimpse of the more important fields, and also serves to give to the general student some impression of the scope of accounting. No mention is made, however, of the special systems required by banks, insurance companies, commission merchants, brokerage houses, farm enterprises, construction companies, etc. It would be out of the question to include a study of many special systems in a single volume, and in any case it is doubtful if such material is of much value to the student of general accounting. Certain rather important special features of this book should, PREFACE Vli perhaps, be mentioned in the foreword. In the first place it has seemed to the authors that the importance of the proprietary interest, so-called, is unduly stressed in most textbooks. Indeed, the usual treatment of the subject is so dominated by the doc- trines of proprietorship that it might well be described as "pro- prietary accounting." Although this theory of accounts is not an unreasonable view for the accountant who is dealing with very simple situations, as applied to the complex conditions of modern business organization it becomes practically untenable. Particularly in view of the present and growing importance of the corporate form of organization, with all its complexities of ownership, is it becoming more difficult to define proprietorship on any but a conventional basis. Accordingly, the significance of the concept of proprietorship in the theory of accounts has been minimized in this book (although the accounting importance of this equity has by no means been neglected). The business enterprise in its entirety has been emphasized as the accounting unit of organization, and an attempt has been made to state the theory of accounts in terms of the needs and purposes of all the equities in the enterprise rather than from the standpoint of any particular interest. The adoption of this view has lead to certain important consequences in connection with the dis- cussion of interest transactions and other topics. In the presentation of the theory of valuation this book also diverges somewhat from current treatments of the subject. A logical theory of valuation for accounting purposes has been adopted ; and for the sake of completeness and consistency this view has been introduced even in the discussion of the elementary principles of double-entry. It is possible and even advisable, however, for the instructor to postpone the consideration of the more difficult points implicit in this matter until they are specifically taken up later in the text. Further, it should be emphasized that the authors recognize that there are certain practical difficulties in the way of the actual adoption, at all points, of some of the theories presented. It is felt, however, that the student of accounting should be trained in the logical analysis of business situations, and that such training will pro- mote rather than jeopardize his chances for professional success. The discussion of the interest problem in this volume, partic- viii PREFACE ularly the mathematics of interest, is rather elaborate. It is recognized that the mathematics of interest calculation is a matter somewhat outside the field of accounting proper. Never- theless the importance of this subject, particularly in connection with certain branches of accounting, can hardly be overem- phasized ; and there can be no doubt that it should form a part of the regular course of study taken by the accounting student. Moreover in many cases suitable courses in mathematics are not available to supply this need. Even if such special courses are available some review of (or introduction to) this work in connection with a study of accoimting principles seems advisable. The instructor, however, who for any reason desires to abbre- viate this part of the course may easily do so. Chapter XV is designed to give a general view of the interest problem and might be used, if a short course is desired, without Chapters XVI, XVII, and XVIII. Or Chapter XVI alone might be omitted without seriously impairing the availability of the remaining chapters. Finally, the terminology employed in this text does not con- form to current business and accounting usage at all points. Since this is primarily a book for the student it has seemed legiti- mate for the sake of clearness to employ some terms which differ from those ia common use. Where the expressions used here differ noticeably from current practice, however, the con- ventional terminology is referred to. An attempt has been made to standardize the nomenclature for all important conceptions. A serious cause of confusion in accounting is the loose terminology commonly employed. To some extent the terms adopted by the Interstate Commerce Commission in its prescribed classi- fications (which represent the most logical system of accounting phraseology at present developed) have been used. This book has been planned to suit the needs of the general course in principles as was stated above; and it is believed that it can be used successfully in either one-year or two-year courses. In many institutions a single course (ruiming from three to five hours per week through two semesters) is devoted to the study of principles. In such a course, Part One, supple- mented by laboratory work, will furnish sufficient material for the first semester's work. In the second semester the student PREFACE ix is able to handle larger reading assigiunents in the advanced topics, and the remaining chapters may be conveniently covered. Where a two-year course of from two to three hours per week is given, this text may still be used to advantage if supplemented with considerable practice work in elementary accounting. In any case, of course, practice work is necessary. The authors have prepared a book containing about 500 problems and exer- cises arranged in chapters specifically to accompany this text.^ It is probable that many instructors would consider it unnecessary, if using this exercise book, to introduce other laboratory material. The authors wish, in conclusion, to acknowledge their indebted- ness to their instructors and colleagues (former and present) of the University of Michigan who have furnished, in large meas- ure, the background of economics and accounting which has made possible the preparation of this text. Among these should be mentioned, as having had a particularly important influence, Professor H. C. Adams, Professor F. M. Taylor, and Professor David Friday. A special acknowledgment is due to Professor Friday for suggestions which were used in the preparation of Chapter I, and to Professor W. D. Moriarty of the University of Michigan for reading the manuscript. W. A. P. R. A. S. September l, 1918. ' Published by George Wahr, Ann Arbor, Michigan. CONTENTS INTRODUCTION TtiE Natuee and Scope or Accounting THE BUSINESS ENTERPRISE . THE NEED TOE ACCOUNTING ANALYSIS THE GENERAL PROBLEMS OF ACCOUNTING PAGE 3-13 3 7 10 PART ONE ELEMENTS OF ACCOUNTING II The Theory of Balance Sheet Accounts .... 17-34 THE fundamental CLASSES OF DATA 17 the accountlng equation 20 THE construction OF ACCOUNTS 24 CLASSES OF TRANSACTIONS . . .... 29 DOUBLE-ENTRY — DEBIT AND CE^EDIT 3 1 III Tee Construction of Supplementary Accounts . . . 35-55 current asset accounts 35 expense and eevenue accounts 39 special equity accounts 43 valuation accounts 47 the classification of accounts $0 IV The Analysis and Recording of Transactions THE books of record AND ACCOUNT xi 56-76 S6 xu CONTENTS THE JOURNAL THE LEDGER JOURNALIZING POSTING PAGE 59 62 64 75 Developments in Technique . the special-column journal the cash book .... the sales book .... the purchase book . the vouchers payable register specialized ledgers . 77-102 77 90 92 93 96 VI The Asset Accounts 103-13 1 accounts with pixed tangibles 103 accounts with fixed intangibles iio functional classification of fixed asset accounts . ii7 accounts with current tangible assets . . . i20 accounts with current rights iz6 VII Further Classification of Equity Accounts ACCOUNTS with FIXED EQUITIES . CLASSES OF EXPENSE AND REVENUE ACCOUNTS NET REVENUE AND SURPLUS ACCOUNTS ACCOUNTS WITH CURRENT LIABILITIES 132-150 132 136 147 VIII Closing and Interpreting the Accounts .... 151-191 THE trial balance 151 the necessity for the inventory and appraisal . . 154 closing accounts with fixed assets .... 157 materials, sales and subsidiary accounts . . . 160 CLOSING merchandise ACCOUNTS 167 closing accounts RECEIVABLE 1 74 CLOSING OTHER CURRENT ACCOUNTS 177 SUMMARY ACCOUNTS FOR SUNDRY ASSETS AND LIABILITIES 182 CONTENTS xiii PAGE CLOSING THE EXPENSE AND REVENUE ACCOUNTS -. . 184 CLOSING THE NET REVENUE AND EQUITY ACCOUNTS . . 187 IX The Preparation of Statements 192-119 the expense and revenue statement .... 193 the net revenue and surplus statement . . . i97 the balance sheet 20i the ten-column statement 207 the working sheet 215 X The Determination of Net Revenue 220-243 the significance of net revenue 220 the cash statement 224 deferbed charges and credits 228 wasting assets 232 maintenance and improvement 234 appreclation and depreciation 238 PART TWO THE EQUITY ACCOUNTS XI Proprietorship — Single-Proprietors' and Partners' Ac- counts 247-268 proprietorship 247 the single-proprietor enterprise 250 copartnership proprietary accounts . . . . 255 special problems in partnership accounting . . 260 XII Corporate Proprietorship — Capital Stock corporate proprietorship . . . . the transition from partnership to corporation organization ■ — stock issued for cash . donated and treasury stock subsidiary proprietary records . , . . 269-293 269 276 280 285 290 xiv CONTENTS XIII PAGE CQKPOEATE PROPBIETORSHrP — SUEPLUS ACCOUNTS . . . 294-3 1 2 CAPITAL STJEPLUS AND DEFICIT 294 ACCUMULATED PROFIT AND LOSS 297 DIVIDEND APPROPRIATIONS 3P0 SINKING FUND APPROPRIATIONS 305 MISCELLANEOUS SURPLUS TRANSACTIONS AND APPRO- PRIATIONS 308 XIV The Liabilities 313-327 ACCOUNTS AND notes PAYABLE 313 ACCRUED, DEFERRED AND CONTINGENT LIABILITIES . , 3 18 MORTGAGES AND BONDS , 322 PART THREE THE INTEREST PROBLEM XV A General Analysis of the Interest Problem . . 331-348 THE INTEREST PHENOMENON 33 1 commercial INTEREST 334 LONG-TERM SECURITIES 339 INTEREST IN VALUATIONS 344 XVI Interest Calculations 349-386 the accumulation of principal 349 the present value of a future sum . . . . 355 the accumulation of an annuity 360 present worth of an annuity . . . . 365 sinking fund contributions 372 the annuity which a principal will purchase . . 374 the apportionment of annuity payments , . . 376 the valuation of bonds 378 accumulation and amortization 38 1 determining the interest rate 383 CONTENTS XV XVII Interest Transactions — Equity Accounts LONG-TEEM NON-INTEKEST BEARING NOTES ANNUITIES .... BONDS ISSUED AT PAR . BONDS ISSUED AT A DISCOUNT BONDS ISSUED AT A PREMIUM THE REEUNDING OE SECURITIES PAGE 387-411 387 391 395 401 40s 409 xvni Interest Transactions — Asset Accounts .... 412-429 investments in securities 412 interest in fiduciary ACCOUNTING 42 1 SINKING EUNDS 425 PART FOUR THE VALUATION OF ASSETS XIX Organization and Construction 433-45° organization costs 433 depreciation DURING CONSTRUCTION 436 INTEREST, DIVIDEND AND TAX ACCRUALS DURING CON- STRUCTION 438 THE CONSTRUCTION PERIOD — ILLEGITIMATE COSTS . . 446 DISCOUNTS ON SECURITIES 448 XX The Basis eor Revaluation 451-469 THE general SIGNIEICANCE OF VALUE CHANGES . 451 VALUATION AND MANAGEMENT 45 S THE MEASUREMENT OE INVESTMENT OR SACRIFICE . . 46 1 SPECIAL OBJECTIONS TO THE RECOGNITION OF APPRECI- ATION 463 XXI The Valuation of Special Assets 470-481 CASH AND receivables ...*.... 470 XVI CONTENTS PAGE MERCHANDISE AND GOODS IN PROCESS 474 MACHINERY, BinLDINGS AND LAND 477 XXII The Depreciation Accounts 482-505 THE depreciation PROBLEM 482 REPAIRS AND RENEWALS 485 THE REPLACEMENT POLICY 488 FORMAL DEPRECIATION ACCOUNTS 49 1 THE DEPRECIATION FUND ... ... 496 DEPRECIATION FUND RETURNED TO INVESTORS . . . 500 THE POLICY OF REINVESTING THE FUND IN THE BUSINESS 503 XXIII Methods of Measuring Depreciation 506-527 the basis for measurement 506 straight line method 51i the sinking fund method 515 the compound interest method 517 present value of future revenue method . ' . . 520 miscellaneous methods 524 XXIV The Intangible Assets 528-541 the nature of goodwill 5-38 the valuation of goodwill 530 going value 535 miscellaneous intangibles 53s PART FIVE THE CONSTRUCTION AND ANALYSIS OF FINANCIAL STATEMENTS XXV The Income Sheet 545-571 purposes of income sheets 546 summary income sheets* 549 CONTENTS xvu PAGE THE COMPARATIVE INCOME SHEET 555 SOME SPECIAL EOEMS OF INCOME SHEETS .... 558 FURTHER CLASSIFICATION OF OPERATING ACCOUNTS . . 563 THE CONSOLIDATED INCOME SHEET 567 XXVI The General Balance Sheet 572-586 GENERAL balance SHEET CAPTIONS . . 572 illustrative BALANCE SHEETS 576 CLASSIFICATION OF ASSET ACCOUNTS 584 XXVII Comparative and Consolidated Balance Sheets . . 587-598 THE comparative BALANCE SHEET 587 THE consolidated BALANCE SHEET 592 XXVIII Statements of Insolvency 599-605 statement of affairs 599 deficiency STATEMENT 603 PART SIX SPECIAL FIELDS OF ACCOUNTING XXIX Cost Accounting .... ... the problems of management . the classification and distribution of expense . 609-619 609 61S XXX Municipal Accounting 620-628 THE municipal BALANCE SHEET 62 1 THE MUNICIPAL INCOME SHEET . .... 623 THE MUNICIPAL BUDGET 626 xvui CONTENTS XXXI PAGE Railroad Accounting 629-641 the i. c. c. classifications 629 eate eegtjlation and accounting 638 xxxn Auditing 642-649 the purposes of audits 642 the essentials of auditing 646 APPENDICES A The Treatment of Cash Discounts 653-656 B Interest Tables „ . . . 657-667 C Railway Statements 668-674 D Selected Bibliography 675-676 INDEX 677-685 INTRODUCTION PRINCIPLES OF ACCOUNTING The Nature and Scope of Accounting Accounting, in a bioad sense, is the science which attempts to present and classify the statistics of the properties and property rights in the business enterprise. All valuable considerations coming into the possession of a business concern should be ac- counted for, and the rights which various individuals and interests have in the business must be protected. To accomplish this, more or less elaborate statistical records are usually neces- sary. Since accounting has to do primarily with the private business enterprise, the gaining of a general conception of the enterprise as the accountiag unit of organization is an essential preliminary step in the study of this subject. In the following section the nature of the business enterprise will accordingly be briefly discussed. THE BUSINESS ENTERPRISE A business enterprise involves the investment of capital funds, often by more than one individual, in some commercial project. Such a venture, supposedly, contemplates the pro- duction of some commodity or service which commands a price on the market. The owners of the capital invested in any case naturally expect to realize a gross income from the sales of the product which will not only maintain the original investment but will yield a net income as well. It is the function of account- 3 4 PRINCIPLES OF ACCOUNTING ing to follow the investment, as it takes shape in various com- modities and services, and to inform the investor as to the amount and rate of net income and the subsidiary facts which will enable him to make a rational disposition of his resources. The familiar types of business organization in the United States are the single-proprietorship, the partnership, and the corporation. The joint stock company, a kind of halfway house between the partnership and the corporation, is no longer common in this country, having been almost entirely superseded by the corporation. A brief statement of the nature of these three common types of business units will be given at this point. The single-proprietorship is a business enterprise conducted by a single individual. Actual ownership of the property used commonly resides largely in the hands of the proprietor, so- called. The proprietor is usually the active manager of the business and may furnish a considerable part of the ordinary labor services required. In a strict sense any capitalist, however humble, who is utilizing his resources in an independent commercial venture, is a pro- prietor, and his business is a single-proprietorship. The majority of retail stores are of this type, many wholesale and manufactur- ing businesses are single-proprietorships, and farm estabhsh- ments are almost always in this class. Such enterprises range in importance from the fruit stand on the corner to the private banking house or other large business having an investment of many thousands of dollars. Very large aggregates of capital, however, are seldom brought together under the single-proprie- torship form. Although the single-proprietorship is legally only a kind of personal enterprise, and no formal steps of organization are usually required for its initiation, still it is useful for the accountant to conceive of such a business as a commercial unit of organization. The personification of the business enterprise, a figure so much deplored by some writers, is one of the funda- mental ideas of accounting, and it may well be applied to all kinds of businesses, the simple as well as the complex. In gen- eral this view conforms to commercial and legal practice and no apologies need be made for such a conception. The most im- portant financial statement, the balance sheet, can always be NATURE AND SCOPE 5 conveniently conceived as representing the financial condition of a distinct business entity. Probably the great majority of single-proprietors make but an imperfect use of accounts ; but something in the way of statistical records is essential in nearly all such cases, and efficiency in the management of even the small concern would generally be much advanced by an extension of the use of systematic accounting methods. Certainly the . accountant should be familiar with the general nature of the single-pro- prietorship and the accounting problems arising in such cases. The partnership is an association of two or more persons by contractual agreement in a business undertaking. Partnerships are usually composed of but two, three, or four members, but there may be any number of partners. The partnership associa- tion is usually based upon a written agreement called the articles of copartnership. This agreement commonly contains stipula- tions in regard to investments, withdrawals of principal or in- come, management, division of income, dissolution, etc. It is fairly evident that careful accounting is much more im- portant in the case of the partnership than in the case of the single-proprietorship. Where more than one individual or interest is involved in an enterprise questions of equity commonly arise. The failure to keep a careful record of all business transactions in such a case may result in the exploitation of one equity to the advantage of another ; and at any rate if the business is of con- siderable size and complexity the partners will be very much in the dark as to the actual situation. The importance of proper accounting is the more clearly seen when it is noted that the rights of the partners in control, income, investment, etc., may differ widely. The characteristics of the partnership and the peculiarities of partnership accounting will be specifically dis- cussed later in the text. The corporation is in many respects the most important form of business organization. In point of aggregate capital controlled, number of employees, quantity of output, financial influence, etc., the corporation easily leads in many important lines of industry ; and the development of this form of organization does not yet appear to have reached its limit. The corporation is marvelously well adapted to the exigencies of large scale pro- 6 PRINCIPLES OF ACCOUNTING duction. By this device the capital of the investor, great and small, is brought together and welded into a unit for purposes of carrying on economic production under modern conditions. By means of a great variet}^ of securities the corporation form per- mits of the division of the important elements of ownership in such a way as to attract all classes of investors. The corporation like the partnership is an association of indi- viduals and interests who have combined their funds in a busi- ness undertaking with the hope of ultimate profit. A very important feature of the corporation lies in the fact that the fiction of the business enterprise is supported in this case by the attitude of the law which views a corporation as an entity sep- arate and distinct from the personnel of its members. Limited liability and other important consequences follow from this view. The members proper of a corporation are its shareholders. The interests of the shareholders in the joint investment are evidenced by formal instruments known as stock certificates. The total of the capital stock outstanding constitutes the formal expression of the stockholders' equity in the business. Outside interests, known as the creditors, also furnish capital. The bondholder is the most important investor of this class. The modern business corporation with its vast aggregate of property and its complexity of property rights, furnishes the more difficult problems of accounting analysis. In the next section some features of the large scale enterprise will be further emphasized. In all of these forms of business organization the interests of the private owners are uppermost. It is the private investors who largely control operation. It is the owners or their em- ployees who keep the accounts. Consequently the influence of the private equities upon accounting concepts and methods is predominating. The ownership of economic goods is not restricted to what may properly be called the business enterprise. The owner of a residence and other consumption goods, for example, may have a considerable estate. Semi-business associations with a con- siderable capital investment which have as a purpose the further- ing of some philanthropic or similar end are also common. The NATURE AND SCOPE 7 municipality or state often owns large aggregates of property. A communistic community may own property devoted to both consumptive and productive purposes. In these cases, however, while it is possible and usually necessary to make use of ac- counting records, the typical problems of accounting do not pre- sent themselves. The private business enterprise, organized for pecuniary profit, is the typical accounting unit, and the dis- cussion of accounting principles in this text will be restricted primarily to a consideration of the problems arising in connec- tion with such enterprises. THE NEED FOR ACCOUNTING ANALYSIS It is the function of accounting, then, to present a record of the various properties owned by the business enterprise and a show- ing of the equities in the enterprise. The importance of account- ing and related branches of statistical science in modern business can be emphasized by a brief consideration of some general characteristics of large scale production and certain other aspects of the present industrial situation. In the first place the mere size of the modern business unit should be stressed. To-day the large scale enterprise, operating a huge plant and selling goods in a world market, is a familiar fact. One of the most important influences making possible this concentration of capital has been the tremendous improvement in transportation facilities and the consequent extension of the market. The development of the corporate form of organization mentioned above is another important factor contributing to (or at least accompanying) the growth of large scale production. This form of business organization makes possible the bringing together of vast aggregates of capital. Some large corporations have many thousands of stockholders. Evidently mere size and complexity of organization contribute to the need for ex- tensive statistical records. Closely connected with the large size of the modern business unit is the great variety of property types used in production. The production of transportation service, for example, involves the use of many kinds of property such as, land, bridges, tunnels, rails, ties, buildings, rolling stock, various kinds of services, etc. 8 PRINCIPLES OF ACCOUNTING Similarly in manufacturing and other industries (in fact wherever large scale production is developed) a complex equipment is necessary. This complexity of property bears an important re- lation to the problem of financial accounting. The heteroge- neous character of property is one of the factors which necessitate the use of value units ; e.g., it is impossible to add railroad tracks, buildings, bridges, etc., without reducing all of these items to a common denominator. Further, the problem of ascertaining the amount of property expired in any given period is compli- cated by the great variety of property used. The problem of valuation is rendered still more difficult by the fluctuations in price to which the modern market is sus- ceptible. In a static economic society the problem of ascertain- ing the status of property is largely physical. Physical units in such a case could be converted directly into value terms ; for value can be measured in terms of the item itself. The medieval shepherd, for example, could count his wealth and his income in sheep. But the continual fluctuations in the level of prices, which constitute changes in the measuring unit itself, complicate the process of valuation, and may require recognition in the statistical records. Indeed, it is prices under the present system that "render possible the rational direction of economic activity by accounting, for accounting is based upon the principle of rep- resenting aU the heterogeneous commodities, services, and rights with which a business enterprise is concerned in terms of money price." ^ The point should be emphasized that account- ing in modern times deals directly and primarily with the value representations of things; the use of physical facts in ac- counting statistics is entirely subordinate. Another characteristic of modern business which has con- tributed to the present emphasis upon accounting is the special- ization of securities which has been made possible by the develop- ment of the corporate form of organization as was stated in the preceding section. Not only do many individuals contribute capital to this type of enterprise, but their rights to income and property vary according to the class of security held. To- day one is familiar with common stock, preferred stock, mort- gage bonds, debenture bonds, income bonds, collateral trust ' Mitchell, Business Cycles, pp. 31-32. NATURE AND SCOPE 9 notes, etc. ; and some of these classes may be subdivided almost indefinitely. The task of preserving the rights between the different classes of security- holders is a difficult one, and cannot be satisfactorily accomplished without the aid of information based upon extensive statistical data. A striking phenomenon of the modern industrial process is its susceptibihty to trade disturbances. While the severity of the business cycle has been due in a measure to unsound banking and credit institutions, it should be recognized that reforms in this direction can never be more than palliatives. The essential cause of the business cycle is the difficulty experienced by the entrepreneur and the business world generally in accurately forecasting the market situation. It is coming to be recognized that extensive dissemination of complete and reliable information concerning the entire industrial process is the most promising remedy for alleviating this condition. The data concerning the financial situation furnished by the accounts form an important part of the information necessary for the construction of a trade barometer. The present tendency toward public control and regulation of industry is another factor which emphasizes the need for accounting analysis. The public has awakened to the need for controlling the activities of the'entrepreneur when the interests of the individual conflict with those of society. Further, the complexity of the private equities involved renders more em- phatic the need for government interference. The public can pass soujid judgments on the complex situations that arise only on the basis of reliable statistical information. Much emphasis is being placed at present upon the necessity for internal economy of organization in industrial enterprises. There are several causes for this situation. First may be men- tioned the fact that the opportunities to increase revenues through the exploitation of undeveloped natural resources is largely past. In addition to this, the technique of industry, which has under- gone tremendous development in the past century and a half, is becoming standardized ; this means that the opportunities for building large fortunes through the development of inventions are more restricted than formerly. As the country grows older, as population increases, as competition becomes keener, the lo PRINCIPLES OF ACCOUNTING need of efficiency in production is emphasized. The problem of improving the utilization of our economic resources is one of the most important of modern questions. The solution of this problem requires a very extensive statistical analysis of the productive process. THE GENERAL PROBLEMS OF ACCOUNTING From the standpoint of the equities involved the accounting records of a business enterprise should furnish two kinds of state- ments : (i) a history of the operation of the enterprise during the fiscal or accounting period ; (2) a statement of the financial status of the business at the end of the period.^ These statements, the income sheet and the balance sheet, present the results of the entire accounting process. The income sheet shows a summary of all the outlays necessary to the operation of the business and all revenues accrued. The balance sheet presents a statement of all the property items at a given moment, and shows the distribution of the ownership in the same. The income sheet may be used for managerial purposes, and it is of general importance in deciding questions of equity. If the entire property is owned outright by one person, inaccuracies in this information or an entire* absence of such data cause no injustice between individuals. If the number of investors is large and if their equities vary considerably in character, however, the problem of ascertaining these facts is at once more difficult and more important. In the corporation, for example, the personnel of the investors is continually changing, due to the ease with which securities can be transferred from one individual to another. Thus if an error in stating net revenue is made in one period it is probable that the rights of some of the individuals whose equities have been misstated cannot be restored by the correction of the error in a later period. Further, there is the added difficulty of apportioning the annual net revenue among the various classes of security-holders. This may be illustrated by the case of a certain company which has outstanding, among other equities, six per cent non-cumulative preferred stock. Through an error in accounting analysis in the annual income ' Cf. Hatfield, Modern Accounting, p. 5. NATURE AND SCOPE ii sheet for one year, net revenue as shown was not sufficient to pay the regular six per cent dividend. The loss of this dividend by the preferred stockholders cannot be regained in later periods. In fact, this loss will inure to the benefit of the common stock- holders. Assuming that it is possible to expand the business and increase net earnings through the retention of profits in the enterprise, it would be to the advantage of the common stock- holders, who have the larger element of control, to adopt a policy which would lead to an understatement of net revenue. The accountant is called upon to pass judgment upon accounting procedure which affects net revenue, and hence the relations between the various equities. Similarly the status of the equities represented in the enter- prise must be determined at various moments of time. Not only must net revenue be apportioned between the different classes of investors, but the status of each equity must be shown after this division is made. The determination of net revenue and hence the condition of the equities involves the problem of valuation ; i.e., the ascertaining of property expirations and property balances. Only from such information in regard to the condition of property can the financial condition of the equities in the enterprise be ascertained. These data must be furnished to the present investor if he is to know the status of his investment. The prospective creditor or investor must also have this information if he is to proceed rationally in the use of his capital. Further, if the state is to do justice to all parties concerned in the adjudication of disputes, such statistics must be available. Ordinarily only the individuals who furnish capital to an enterprise are considered as having equities in the property. Under certain conditions, however, the pubHc interest approaches the nature of an equity. The state always reserves the right to appropriate a portion of investment or revenue by taxation. Further, in so far as the state assumes control of prices and methods of financing, it has an interest which carries with it more control than the equity of the private investor. In the case of the municipal enterprise already mentioned the public exercises complete ownership, and here the public interest con- stitutes a distinct equity. The continued recognition of the 12 PRINCIPLES OF ACCOUNTING rights of private property still insisted upon by the courts, how- ever, makes it imperative that action tending toward public regulation shall not injure the private equities. Consider the regulation of railroad rates, for example. It is recognized that railway transportation is a quasi-monopolistic industry and that the proper rates cannot be fixed by competition. The pubHc has determined that the rates shall not be exorbitant. The courts, having in mind the rights of private property, insist on the other hand that the rates fixed by the state shall be high enough to jdeld a "reasonable return on the fair value of the property." The point should be emphasized that the viewpoint of the pri- vate equities is still dominant in accounting. Even the rights of the laborer represent an equity in the busi- ness enterprise when the term equity is broadly interpreted. The wage-earner's right to a portion of the earnings of an enter- prise has a definite legal status. Especially in certain indus- tries is the laborer coming to have an authoritative voice in the control of operation. Although the interests of the laborer and the public are not recognized in the accounting records as equi- ties per se, still the accountant must recognize the influence of both of these interests upon accounting problems. It is possible that in time a more definite recognition will be given these equi- ties in the accounts. Although the statistics of management are closely connected with the problems of the equities, and are in a sense subsidiary to them, nevertheless this branch of accounting requires the use of other information than that furnished by the purely financial records. A further analysis of both physical and value facts is necessary for efficient management. The manager must have the information necessary to base rational judgments as to the effective utilization of the resources at his disposal. The re- lation of this question to financial success, and the tendency to emphasize this phase of accounting, can be illustrated from the railroad industry. Twenty-five years ago the attention of the operating officials was centered upon the gross revenue figure, rather than upon costs. The conquest of new territory through the extension of main lines, and the development of branch lines and feeders, characterized the railroad industry and made pos- sible the constant and rapid growth in gross revenues. Economy NATURE AND SCOPE 13 of organization was entirely overlooked in the scramble for traffic. To-day gross revenue has reached a more stable position. No longer is it possible to cover up gross inefl&ciency in management with revenue from -constantly increasing traffic. In view of the rise in wages and other expenses the only possibility of preserving the margin of profit is through an increase in efficiency. This situation is reflected in the building of new roads. In late years the increase in mileage has been comparatively insignificant, although a considerable extension of trackage has been made; that is, lines are not being extended, but already existing fines are being double-tracked and otherwise improved. This situation is duplicated in all lines of industry. To pre- vent costs from encroaching upon the profit margin, managerial efliciency is necessary. The manager is called upon to pass judgments as to the most effective utiHzation of the economic factors available. What are the most effective combinations of factors ? What are the most efficient processes ? What are the best methods of organizing and paying labor to secure efficiency in production? These and similar questions the managers must answer. It is the function of cost accounting, so-called, to furnish the statistical information necessary to aid the manager in making these judgments. PART ONE ELEMENTS OF ACCOUNTING II The Theory of Balance Sheet Accounts The first step in the study of accounting is the mastery of the main principles underlying the construction of modern financial accoimts. The details of bookkeeping procedure can be more readily grasped, and the significance of specific questions of ac- counting analysis can be more fully appreciated, if the student is able to refer these matters, as they arise, to a background of general principles. It is the purpose of the present chapter and the next to furnish this background by explaiaing the structure of the principal types of accounts in terms of the important facts and concepts with which accounting is concerned. the fundamental classes of data As was emphasized in the preceding chapter, the important imit of organization with which accounting deals is the specific business enterprise. The fundamental concepts of accounting can be defined, and the nature of the system of accounts neces- sary to record the various happenings which may occur can be adequately expressed, only in terms of the needs and purposes of a particular business concern. It will be convenient, therefore, to take a hypothetical business, the A. B. Co., at its inception, and to classify the facts which its accounts must show, both at the outset and after operation has begun. The structure of the accounts will be explained in terms of this classification. The A. B. Co., it may be supposed, is a small manufacturing enterprise, completely organized and ready to begin operation. What are the data necessary to a statement of the firm's financial status? What fundamental classes of value facts can be dis- covered? Clearly one important category embraces all the c 17 i8 PRINCIPLES OF ACCOUNTING property or asset items to which the A. B. Co. has title. If any conclusions are to be drawn as to the financial condition of this company, a complete statement of property must be available. This property might consist not only in many different kinds of tangible goods, but also in valuable rights, securities, etc. Mate- riahty is no satisfactory test as to what is or what is not an asset, and this is one of the important facts which must be kept in mind if one is to appreciate the significance of the term. An asset can be defined as any consideration, material or otherwise, owned by a specific business enterprise and of value to that enterprise. Thus an asset is essentially an economic fact, and in the strict accounting sense must be connected with some particular busi- ness establishment. In preparing a statement of the financial condition of an enterprise the various kinds of assets can be listed or classified very minutely, or they can be stated under a few heads. How far these items shall be subdivided is purely a matter of con- venience, depending upon the character of the enterprise in question and the particular purpose which the classification is intended to serve. A small mercantile establishment may re- quire but a few classes of property ; a railroad corporation may make use of hundreds of distinct assets. The property of the A. B. Co., it will be assumed, consists in the following assets: land, $40,000 ; building, $70,000 ; equipment, $20,000 ; mate- rials, $80,000; cash, $15,000. Then the financial statement of the firm must show this list of assets ; and the items may be ar- ranged in any intelhgible way. A convenient method of presenta- tion is the listing of the assets in a column, one below another, thus: Assets Land $40,000 Building 70,000 Equipment 20,000 Materials . 80,000 Cash 15,000 Total $225,000 Does this list of facts present a satisfactory statement of the financial condition of the company ? Does a statement of assets cover all of the logical classes of data involved in the enterprise ? THEORY OF BALANCE SHEET ACCOUNTS 19 No, such a statement is clearly inadequate, either from the stand- point of the interests of the A. B. Co., a probable purchaser of — or investor in — the business, or any other party concerned. The situs of the title to this property must be determined. What are the claims against or rights in this property? Where is the distribution of ownership? Or more concisely : what are the equities in these assets? The equities like the asset items may have a variety of forms. The particular interest which has immediate control of opera- tion may own all the assets clear, or it may have only a small net interest in the property and the greater part of the ownership may be vested in outside parties whose claims may consist in contractual Kens and rights represented by bonds, mortgages, promissory notes, accounts payable, etc. In this case it will be assumed that the rights in the assets, or equities, consist in the following items: the proprietors' equity, $170,000; mortgages, $35,000 ; notes payable, $20,000. The first of these items — • often called proprietorship — rep- resents the owners in the narrow sense ; it is the equity of those who have the large element of direct control of business opera- tion and financial policies. In a single-proprietor enterprise the "capital" and "personal" accounts of the individual pro- prietor furnish a record of this equity ; and in a partnership the capital and personal accounts of the individual partners are used to represent proprietorship. In the case of an incorporated enterprise proprietorship is represented by the capital stock outstanding less the discount or deficit if any item of this nature is present, or capital stock plus surplus if any such item exists. For the time being it will be advisable to postpone further dis- cussion of the general nature of this equity or its peculiarities imder different forms of organization; and in the case of the A. B. Co. this item can be designated simply by the name of the firm. Because of the fact that the proprietors' equity represents the parties in immediate control, and because this equity is often — although not always — much the largest in amount, proprie- torship is the most important equity from the standpoint of ac- counting; and in later chapters it will be necessary to discuss in some detail its accounting significance. These equity facts may be listed in a column, as was done in 20 PRINCIPLES OF ACCOUNTING the case of the asset items. The two columns may now be grouped in any convenient way. The following arrangement is a conventional form : Assets Equities Land $40,000 A. B. Co $170,000 Building 70,000 Mortgages 35,ooo Equipment 20,000 Notes Payable .... 20,000 Materials 80,000 Cash 15,000 Total $225,000 Total $225,000 This balance sheet form of presenting a statement of a firm's financial condition at a given moment is a lucid and concise way of showing the necessary facts, although it is not the only possible method. The essential thing is to have all of the facts presented and arranged in the most intelligible form ; and from every point of view it appears desirable to separate in some way the two distinct categories, assets and equities. One writer has observed that the balance sheet is the "groundwork of accountancy."^ Certainly the balance sheet as conceived in the above table rep- resents a classification of facts which is the basis of the funda- mental accounting concepts and the technical structure of the accounts. THE ACCOUNTING EQUATION It is apparent that these two classes of facts will in every case be numerically equal, for they are, in a sense, merely different aspects of the same thing. The asset class constitutes a list of objective property items ; the equity class represents the legal relationships between this same property and certain individuals or interests. That is, one class represents the valuable com- modities and rights of a given enterprise, the other class repre- sents the distribution of ownership, or the claims against assets, or, more exactly, the equities in assets.^ And since the same 1 Sprague, The Philosophy of Accounts, p. 26. ' To observe strictly the legal fiction in the case of an incorporated enterprise one should say, not "equities in assets," but equities in the enterprise. A stock- holder, for example, has no claim or title to any specific asset. From the stand-, point of accounting, however, it is no serious error to say that an equity, in every case, is virtually a right in assets. THEORY OF BALANCE SHEET ACCOUNTS 21 measuring unit, the dollar, is used in stating both classes of fact?, the totals are always numerically equal. One or two simple illustrations may serve to make clear the nature and necessity of this fundamental equation. A certain individual has $100 in cash in his pocket. This represents his entire capital, and he has no obligations. What are the facts necessary for a complete representation of his financial status? There are two essential facts present. The cash in his possession has two aspects : one is its significance as an objective bit of property; the other is the fact of the ownership of this asset. Looking upon the individual as an enterprise, then, his balance sheet would appear as follows : Assets Equities Cash $icx3 An Individual, Capital . . $100 Both classes of facts — property and the ownership of that prop- erty — are present, whether expressed or not. In a simple situa- tion such as this, it might well be that the owner of the cash would take his ownership for granted, and if asked to prepare a state- ment of his financial condition he would probably present, simply : An IndividuAi,, Financial Statement Cash $100 This does not mean that both classes of facts are not present — inevitably ; but in this case the actual classification is not made. On a student's desk ten books are scattered, worth, it may be assumed, one dollar apiece. The student owns seven of these books, and three are borrowed from his next-door neighbor. A balance sheet representing these books and their ownership as an enterprise would then appear as follows : Assets Equities Books $10 Student, Ownership .... $ 7 Neighbor, Ownership ... 3 Total $10 Total $10 It would seem fairly obvious, then, that assets and equities are always equal, no matter how simple or complex may be the situa- 22 PRINCIPLES OF ACCOUNTING tion or enterprise under consideration. Assets and equities are distinct but interdependent classes of facts. One class cannot exist without the other, and the totals in each case are equal. This classification, and its equality, is at the foundation of every system of modern accounts. Business transactions consist essentially in the alteration of one or both members of this equa- tion ; but the equahty of totals — as will be shown a little later — is continuously maintained. Certain apparent exceptions in accounting practice to this fundamental equation should be briefly noted at this point. A feature of the structure of modern accounts which will be ex- plained in detail in the next section of this chapter is the sub- stitution of addition for subtraction wherever possible. This procedure secures neatness, and economy of clerical effort ; and there are in many cases special reasons for maintaining original figures. It is convenient, for example, to hst securities in the accounts at par. If, then, a company secures its capital through the issue of securities at a discount this will mean that the nominal (par) value of the securities outstanding is greater than the amount of cash and other assets actually invested. Then if this par value is recorded as an equity, instead of the actual amount of the equity, the extent to which this item is overstated may be indicated by including the amount of the discount among the asset items. • • A corporation, for example, issues capital stock to the amount of $50,000 (par value) although the actual investment made by the stockholders is but $45,000. In other words, the stock is issued at a discount of ten per cent. The balance sheet represent- ing this condition would appear, in smnmary form, as follows : Assets Equities Cash and Other Assets . $45,000 Capital Stock .... $50,000 Discount on Stock . . . 5,000 Total $50,000 Total $50,000 The item of discount is not an asset but a deduction from an equity, capital stock, which is maintained in the records at nomi- nal figures. Actual assets amount to but $45,000, and therefore the amount of actual ownership is also but $45,000. The funda- THEORY OF BALANCE SHEET ACCOUNTS 23 mental equation exists in this case as in all others, although there is an apparent discrepancy equal to the amount of the discount. Similarly, whenever the assets of an enterprise are being dis- sipated through losses, and the equities are maintained at the old amounts, there is an apparent discrepancy. But the use of original figures for the equities when assets have disappeared is purely conventional. In the case of insolvency equities nomi- nally exceed assets, but virtually the equation is maintained — the insolvent firm pays less than one hundred cents "on the dollar." Further, asset items are sometimes left at original figures for various reasons and deductions are listed among the equities. It will be sufficient at this point to say that the substitution of addition on the opposite side of the equation instead of actual subtraction, or, as it is sometimes put, the use of valuation items (see Chapter III) explains all apparent exceptions to the equation, assets equal equities. It is customary to denominate the right-hand member of the equation liabilities. It might be urged that this is improper terminology, since this term has the connotation of debts or outside obligations and this meaning clearly does not apply to the proprietor's equity. If the term equities — which covers all elements of ownership — were used instead, there would be less danger of misunderstanding. For it must be recognized that there are important distinctions between proprietorship and the liabiHties proper. The liabilities are contractual in character ; proprietorship is residual. The liabilities carry less control and risk and have contractual rights to income; the proprietor's equity carries the large element of control and risk and has resid- ual rights to income. These distinctions can be more sharply drawn in the case of the small single-proprietor enterprise or partnership than in the large incorporated enterprise. In the typical modern corporation the important aspects of ownership — control, risk and income — have been so subdivided and com- bined through the speciahzation of securities that it is difficult, in many cases, to define proprietorship clearly. Nevertheless the general distinction exists, and to include proprietorship and contractual obligations under the caption, liabihties, is very confusing. To avoid this confusion the term equities will be 24 PRINCIPLES OF ACCOUNTING used throughout the text to designate the right-hand member of the balance sheet equation. The financial statistics of any business enterprise can thus be listed in two fundamentally distinct and numerically equal classes, assets and equities; and, as was stated above, the es- sence of any complete system of accounts consists in the separa- tion of the members of this equation and the maintenance of this classification. With this equation as a basis a convenient and intelligible system of ordering and presenting the necessary facts is built up ; and — as will appear later — an important characteristic of this system is the test for arithmetical accuracy afforded by this continuous equation. The explanation as to how the accounts are constructed from this basic classification will now be undertaken. THE CONSTRUCTION OF ACCOUNTS The hypothetical A. B. Co. begins operations. It will be necessary at this point to consider briefly just what the opera- tion of a business enterprise means in terms of the effect upon the asset and equity classes. An equipment of commodities such as land, buildings, tools, raw materials, etc., together with services such as ordinary labor, management, advertising, insurance, etc., is incorporated with the services of the owners ^ themselves and results in a flow of product — either commodities or services — which is sold to the consuming public. The continued produc- tion of this commodity or service can be secured only at the expense of constant decay, replacement and change among the asset elements involved. In other words there will always be a continual shifting among the asset items as business operation proceeds. Similarly as respects the facts of ownership a process of transposition and general change will normally be taking place : the amoimts anJl character of the equities will be altered from time to time. It is evident that the accounts of an enterprise should be so constructed that record may conveniently be made of these ^ The individuals and interests represented by the equities furnish the capital invested in the enterprise and have ultimate control of operation. The proprietors, particularly in small enterprises, often furnish labor services as well as capital. THEORY OF BALANCE SHEET ACCOUNTS 25 changes which occur on both sides of the fundamental equation. It would be possible to follow these changes simply by altering in the proper amount and direction the asset and equity items as they appear on a tabular financial statement such as was given above, and when new types of assets are secured, or when new equities appear, these new headings could be listed in the same way. An obvious objection to this procedure is its inconvenience for any but the simplest cases. The fundamental objection is that accoimting statements so constructed would throw little light upon the business process, and, as was emphasized in the preceding chapter, the data of the historical as well as the synoptic situation are necessary to meet the needs of the different in- terests involved. It will be necessary, then, to extend or stretch out the above financial statement of the A. B. Co. so that space will be avail- able for the recording of the transactions which may affect the original amounts. This virtually means the opening of an ac- count for each kind of asset and for each equity, thus : Land A. B. Co. $40,000 $170,000 Building Mortga.ges $70,000 $3S.°°o Equipment Notes Payable $20,000 $20,000 Materials $80,000 Cash $15,000 Now what, in the first place, will be the effect upon asset amoimts of the various transactions which may occur ? Clearly asset items may be altered in two directions : an asset balance may be either increased or decreased — ■ there may be additions to assets or there may be subtractions or withdrawals from assets. 26 PRINCIPLES OF ACCOUNTING It is evident that all possible change can be summed up in this numerical manner when one realizes that it is not the building or machine which is recorded in the accounts but rather its value representation. That is, immediately speaking an asset is an amount, and although changes in this amount may be due to various causes they can occur in but two directions — the posi- tive and negative. Accordingly it will be desirable to have two separate columns under each asset heading, one for additions or positive items and one for subtractions or negative items. Now how shall these columns be arranged ? Shall the positive items be preserved at the left and the subtractions at the right or vice versa? The answer to this question is not at all a matter of principle ; either arrangement will serve as well as the other. In the tabular statement of assets and equities given above the asset items were set at the left and the equity balances at the right. This is the conventional arrangement followed in this country although the English practice is just the reverse. The essential thing is a separation of the two fundamental classes of facts; the ar- rangement of data after the classification is made is a matter of comparatively little importance. But if it is decided to have left stand for asset balances and right for equity balances in the accounts, then it will be necessary in the positive and negative columns under each asset heading to use the left-hand column for additions and the right-hand column for subtractions, in order to preserve positive balances at the left. This gives the essential nature of any modern account : two columns, one for additions and one for subtractions ; and custom decrees that in asset accounts the left-hand column shall be used for additions, the right-hand for subtractions. Similarly, transactions affecting the equity items may result in either increasing or decreasing an equity balance. Conse- quently each equity account has need of two columns, a positive column for additions and a negative column for subtractions. What shall be the arrangement of these columns? Again the answer is that the arrangement is an arbitrary matter, the only essential consideration in constructing the accounts being the preservation of the fundamental classification, assets and equi- ties. But, since it was decided to keep positive asset balances THEORY OF BALANCE SHEET ACCOUNTS 27 at the left and equity balances at the right, it will be necessary in the positive and negative columns under each equity heading to use the right-hand column for additions and the left-hand column for subtractions. It is important to note that the definition of the account in terms of parallel columns, as given above, is somewhat arbitrary. A balance sheet account, in a broad sense, consists in a record of plus and minus happenings in connection with some specific asset or equity item. The parallel-column arrangement is only one of many possible devices for presenting such a record. Vari- ous symbolic schemes as well as other methods of spatial arrange- ment could be readily suggested. Plus and minus signs, for example, might be used to designate additions and subtractions respectively, or inks of different colors. An actual physical separation of plus and minus items is very desirable, however, from the standpoint of clerical efficiency ; and because it makes such a separation the parallel-column arrangement is a highly practicable device. Hereafter in speaking of an account the conventional form will be understood. The scheme of the construction of the balance sheet accounts in their relation to the fundamental classes can be represented thus : ^ 1 These accounts — since each is a distinct unit — might be arranged in any order whatever without disturbing the equality of left-hand and right-hand balances. Thus, in practice, the accounts of an enterprise are often kept in a bound volume, arranged, not in asset and equity groups, but alphabetically. 28 PRINCIPLES OF ACCOUNTING The a. B. Co. Assets Equities Additions SUBTEACTIONS Subtractions Additions Land A. B. Co. $40,000 Building $70,000 Equipment $20,000 Materials Cash |iS,ooo $170,000 Mortgages $3S,ooo Notes Payable $20,000 THEORY OF BALANCE SHEET ACCOUNTS 29 Thus far, then, it appears that all asset balances are arbitrarily listed on the left-hand side of the asset accounts, and all equity balances on the right-hand side of the equity accounts ; and the fact should be emphasized again that the most important con- sideration controlling the construction of these accounts is the maintenance of the classification represented by the equation, assets equal equities. CLASSES OF TRANSACTIONS To illustrate the way in which business transactions are re- corded in the accounts a few typical occurrences will be analyzed and their effect upon the fundamental equation noted. a. Raw material is purchased by the A. B. Co. for cash, $600. This illustrates a very common type of transaction. One asset (usually cash) is paid out and another kind of asset of equal value is received in exchange ; this means a subtraction from one asset and an equal addition to another. Proceeding in the manner outHned in the preceding section an entry of $600 must be made in the right-hand column of the Cash account and an equal entry in the left-hand column of the Materials account. This gives two equal entries in opposite columns, and the original equality between asset balances and equity balances is undisturbed. The purchase of any commodity or service for cash or an equiva- lent gives a transaction which comes under this head. Such occurrences obviously affect only one member of the balance sheet equation, the assets ; and the total of the assets is unchanged. Such transactions involve simply plus and minus occurrences among the various assets — transpositions of assets. They are all recorded in this way. b. The A. B. Co. is planning some heavy purchases of mate- rials and other supplies and borrows $5,000 from a bank on a ninety-day note. Here an asset is increased and at the same time an equity, notes payable, is increased a like amount — an addition to cash and an equal addition to notes payable. This transaction would be recorded by a left-hand entry of $5,000 in the Cash account and an equal right-hand entry in the Notes Payable account. Again the result is two equal entries in op- posite columns, and the equation, assets equal equities, is main- 30 PRINCIPLES OF ACCOUNTING tained. This transaction affects both members of the equation but clearly does not disturb the separation of the two kinds of facts or their equality. A note of the A. B. Co. falls due and is retired with cash, $i,ooo. This illustrates the reverse of the pre- ceding transaction. In this case there is a decrease in assets, cash, and an equal reduction in an equity, notes payable. Hence it would be recorded by a right-hand eiitry in the Cash account of $i,ooo and an equal left-hand entry in the Notes Payable ac- count. All transactions of the type which involve an addition to assets and an equal addition to equities, or a subtraction from assets and an equal subtraction from equities, are recorded in this way. c. A transaction may involve a transposition of equities — an exchange of one kind of equity for another. The A. B. Co., for example, issues a first mortgage on land and building for $5,000 in exchange for $5,000 of outstanding notes payable. This transaction involves a subtraction from one equity, notes payable, and an equal addition to another equity, mortgages. It would be recorded by a right-hand entry of $5,000 in the Mortgages account and an equal left-hand entry in the Notes Payable ac- count. All such transactions clearly affect the equities only, and not the total of this class. And again the result is equal entries in opposite columns, leaving the equality of classes un- disturbed. • d. A transaction may involve some combination of the above fundamental types. The A. B. Co., for example, buys addi- tional equipment amounting to $4,000, paying cash, $2,000, and giving a ninety-day note for the balance. This transaction in- volves an increase in one asset, equipment, a decrease in another asset, cash, and an increase in an equity, notes payable. It would be recorded by a left-hand entry of $4,000 in the Equip- ment account, a right-hand entry of $2,000 in the Cash account, and a right-hand entry of $2,000 in the Notes Payable accpunt. All such transactions are simply combinations of the other t3^es illustrated above, and give equal entries in opposite columns in every case. Although there may be a great variety of combinations and examples of the above cases, these illustrations cover the funda- mental types of transactions possible in any business enterprise. THEORY OF BALANCE SHEET ACCOUNTS 31 An increase or decrease in an asset must be accompanied by an equal decrease or increase in another asset or an increase or de- crease in an equity. And, reversing the order of statement, any change in an equity can only be explained by an equal and op- posite change in another equity, or an equal change in an asset in the same direction. Further, any combination of these changes is possible. It appears, then, that every transaction is two- sided, that is, there is always an equal right-hand entry (or entries) for every left-hand entry (or entries) and vice versa; hence the original equahty between the sum of the left-hand (asset) balances and the sum of the right-hand (equity) balances is continuously maintained. DOUBLE-ENTRY — DEBIT AND CREDIT The asset and equity classification arranged in parallel-column accounts is the basis of the device known as double-entry book- keeping. The term double-entry originates in connection with the equality of opposite entries just explained. Conceived in this way the double-entry system is not an arbitrary construc- tion depending upon a particular arrangement of data. It is rather a highly rational and logical system founded in terms of the fundamental classes of accounting data and constructed so as to record conveniently all changes in these classes. The system is thus more rational than is often appreciated. Any system is double-entry which represents all of the facts in the asset-equity classification. Any system of accounts which does not give all of this information is inadequate. Single-entry is the term applied to a number of methods of keeping accounts which do not represent all of the facts. In the case of very simple situations it may be possible to deduce all unstated facts from an incomplete set of accounts ; but anything short of the complete double-entry system is usually more complex in the end. In this text the discussion of bookkeeping methods will be confined to the double-entry system. In practice the left-hand side of all accounts is called the debit side and the right-hand dolumn is called the credit side. In many explanations of double-entry bookkeeping an attempt is made to attach the significance of the words debtor and creditor to the 32 PRINCIPLES OF ACCOUNTING terms debit and credit as used in modern accounts. As used in personal accounts these meanings can with some reason be ap- plied, for example: A, Customer I (In account with the A. B. Co.) Dr. Cr. $500 $100 Here the debit and credit headings of the opposite columns may be thought of as having real meanings. A, Customer is debtor to the A. B. Co. for the sums listed in the debit column and creditor to the A. B. Co. for the sums Hsted on the credit side. But the terms debit and credit are applied to the left- and right- hand columns, respectively, of all accounts in the double-entry system, and it is impossible, rationally, to attach such meanings to debit and credit elsewhere than in personal accounts. Ety- mologically these terms are doubtless related to the words debtor and creditor, but as now used they are merely conven- tional signs employed to designate left-hand and right-hand columns in the accounts. These expressions will be used only with this significance throughout the text. A brief summary of the chapter will serve to emphasize some of the important points discussed. The system of accounts for a business enterprise is founded logically in the nature of the facts with which accounting deals. These data cbnsist funda- mentally in the two classes, assets and equities (rights in assets). The asset class includes all valuable items regardless of their material or immaterial character. Any commodity or service owned by a business enterprise and of value to that enterprise is an asset. The equities represent the distribution of ownership. These items can be roughly grouped as proprietorship and lia- bilities. This grouping is based upon the differentiation of owner- THEORY OF BALANCE SHEET ACCOUNTS 33 ship into its principal elements. Assets always equal equities numerically for one class consists in the objective asset items, the other class represents the situs of the ownership of these same assets, and the same measuring unit, the dollar, is used in both cases. Business operation means a constant process of shifting in both asset and equity items. Assets expire, are replaced, are exchanged. Any asset item may be increased or reduced. Similarly the process of change will mean increases and decreases in specific equity items. Accounts with the various items of assets and equities are built up to record these changes. The important characteristic of the conventional accoimt is : two columns, one for additions, the other for subtractions. Arbitrarily it is decided to maintain asset balances in the left-hand column and equity balances in the right-hand column. Therefore, in asset accounts, the left-hand column is used for additions and the right-hand column for subtractions ; and in equity accounts just the reverse is true. The only important consideration con- trolKng this arrangement is the maintenance of the original equation. All possible transactions can be classified under four heads : (i) an asset is exchanged for another asset of equal value ; (2) an increase or decrease in assets takes place through an equal in- crease or decrease in equities ; (3) an equity is exchanged for an equal amount in another equity ; (4) a transaction may involve some combination of the above cases. In any of these cases equal entries in opposite columns are made for every transaction. Consequently the original equality between left-hand balances and right-hand balances is continuously maintained. This con- stant equality is an important clerical advantage because of the test for numerical accuracy which it furnishes. The essence of the double-entry system of accounts consists in the separation of the members of the equation, assets = equities, and the maintenance of this classification and its equality. Thus the double-entry method is more than an arbitrary device for recording facts. The first step in the interpretation of ac- counting data is made in forming the two fundamental classes. In the double-entry system the left-hand side of all accounts is called the debit side, the 'right-hand is called the credit side. 34 PRINCIPLES OF ACCOUNTING The simplest rule for debit and credit is based directly upon the fundamental equation. Debit indicates additions to assets and subtractions from equities; credit indicates additions to equities and subtractions from assets. The terms debit and credit have no other important significance as used in modern accounts. In the next chapter will be explained the construction of the special types of accounts necessary to record certain classes and phases of the assets and equities which appear in the process of business operation. Ill The Construction of Sxipplementary Accounts It was noted in Chapter I that an adequate system of ac- counts for a business enterprise should furnish a record of the history of operation as well as the facts necessary to a statement of the concern's momentary financial status. The balance sheet accounts, which were explained in the last chapter, show the condition of the enterprise at the beginning of any given period of operation ; but because of the complexity of the business pro- cess many additional accounts are necessary in which to record systematically the various transactions of the operating period which may affect the original equation. Not only are there some accounts necessary which are not in the first balance sheet but which become incorporated in succeeding financial statements, but special groups of accounts are needed which never appear in a statement of assets and equities. In the present chapter the construction of the important types of these supplementary accounts will be explained. CURRENT ASSET ACCOUNTS It was stated in the last chapter that the operation of a business enterprise may be conceived as the combination of a more or less considerable variety of purchased commodities and services with the services of the owners themselves for the purpose of produc- ing some other conunodity or service for sale. Now it is obvious that, in the case of the A. B. Co. (referring again to this supposi- titious concern) or any other enterprise, there will necessarily be involved in production other types of commodities and serv- ices than those the firm has on hand at the moment operation begins. The assets of the A. B. Co. listed in the preceding chap- 35 36 PRINCIPLES OF ACCOUNTING ter were land, building, equipment, materials and cash. The first three of these items axe fixed assets, representing the more or less permanent equipment of the enterprise. The only current assets on hand, then, are raw materials and cash. If this is a tjrpical manufacturing enterprise, other kinds of current commod- ities and services will be necessary in the process of producing the finished article. Labor services are necessary in practically all productive processes; and certainly the A. B. Co. will be obliged to purchase labor from time to time if operation is to proceed. The services of insurance and advertising will doubtless be secured ; it will be necessary to buy stationery, fuel and other supplies. The number of classes of such commodities and services required in any case will, of course, depend upon the needs of the particular enterprise under consideration. The question arises as to how accounts with supplies, fuel, insurance, etc. , will fit into the scheme of asset and equity accounts thus far outUned. What is the nature of these items? As the student easily becomes confused at this point it is desirable to answer these questions with considerable care. These items at the moment of purchase fall into the category, assets. This is fairly obvious in the case of such tangible items as coal, stationery, etc. Coal in the bin is clearly just as much an asset as show cases and other store fixtures. Further, as was noted early in Chapter II, the asset concept may apply with equal propriety to material and immaterial items. All things for which one must pay are assets at the moment of purchase, whether the thing secured be a commodity or a right to services. Hence, services such as insurance, advertising, etc., in so far as such items represent future goods, are assets. They are all economic goods and are so considered by the business man. When a proprietor buys insurance service, for example, and pays cash, he expects to receive a value' equivalent for his expenditure, just as in the case of buying a machine, a building, or any other item of physical property. Valuable services are to him just as truly asset items as aje valuable commodities. If one approached the owner of some business with the idea of buying him out, what would the prospective seller include in a statement of his property ? Certainly he would include fuel, stationery and other supplies on hand, as well as building, fixtures and merchandise. CONSTRUCTION OF SUPPLEMENTARY ACCOUNTS 37 And further, if there are any insurance services, advertising serv- ices, or any other valuable services or rights which have been purchased but are not yet consumed, or from which the entire benefit has not yet been exhausted, the balances of such items would be listed as assets. There are important reasons for distinguishing the current assets from the more permanent forms of property, and it is not intended here to minimize or obliterate the distinction between the two groups. Nevertheless it should be recognized that the general class, assets, covers all these current items as purchased. It cannot be too emphatically urged that as far as the structure of the accounts is concerned there is no distinction whatever between the accounts used to record current assets and the balance sheet asset accounts described in Chapter II. The purchase of coal can be conceived as exactly analogous to the purchase of real estate, and the entries representing such a pur- chase are made according to the same rules in either case. The difference between buildings and fuel is not that one is an asset and the other an expense (see the following section) or asset con- sumed ; the only Hne that can be drawn is the relative permanence of the former as compared with the latter item. A shipment of coal may be largely consumed in a month ; a building may last twenty years. The distinction made in economic theory between circulating and fixed capital follows much the same line of de- marcation as this distinction between current and fixed assets. How far the classification of current assets should be carried in the accounts in any given case is purely a matter of conven- ience, depending upon the nature of the particular enterprise under consideration and the needs and purposes of the manage- ment. In some cases these items may be grouped under a few heads ; in others a long Hst of accounts is necessary. For pur- poses of illustration it will be assumed that the A. B. Co. has four accounts in which to record the purchases of current assets : Supplies, Fuel, Insurance, and Miscellaneous Assets. This would in most cases be a very inadequate Hst of such accounts for a manufacturing enterprise, and it must be understood that these accounts are given, not as a proper classification for an actual business, but merely to make the discussion more con- crete. According to the above analysis these accounts should 38 PRINCIPLES OF ACCOUNTING be opened in exactly the same way as the asset accounts described in the preceding chapter — the left-hand column being used for additions, the right-hand column for subtractions, thus : Additions Subtractions Supplies Fuel Insurance Miscellaneous Assets Then if coal were purchased for cash, $60, the transaction would be recorded by a left-hand — or debit — entry of $60 in CONSTRUCTION OF SUPPLEMENTARY ACCOUNTS 39 the Fuel account (representing the addition to an asset) and a right-hand — or credit — entry of the same amount in the Cash account (representing the subtraction from an asset). All pur- chases of current assets, whether commodities or services, would be similarly recorded in the debit columns of the proper accounts. EXPENSE AND REVENUE ACCOUNTS The point was made in Chapter I that one important purpose of the financial records is to show the increase or decrease in the equities in a given period, and the process whereby this change is attained. Because of the complexity of the actual business process it is impossible to record the changes in ownership directly in the equity accounts as they occur. Special groups of accounts are necessary in which certain phases of the assets and equities are recorded as the facts are ascertained, and later the informa- tion shown by these special accounts is gathered together and its net result incorporated in the balance sheet equity accounts. The positive phase of the equities which arises during business operation is revenue. Revenue represents the sale of product, or, more exactly, the additions to the equities which occur through the sale of the owners' services embodied in the finished product. Whether the product of the firm in question be a commodity or a service, the sale of the commodity or service gives rise to rev- enue. It is impossible in practice, however, to determine all expirations of assets which have occurred in the process of pro- duction concurrently with the additions to assets made from the sale of product. Such expirations are those which are due to business operation and the passage of time, for example : the consumption of coal in the furnace ; the depredation of buildings. Consequently revenue from the sale of product usually repre- sents gross rather than net additions to the equities. It becomes necessary, then, at certain intervals to subtract from the revenues the decreases in assets not previously recognized in the accounts. This can be done by making subtractions from the revenue ac- counts directly, or these subtractions may be listed in distinct expense accounts, in which case the net change in the equities may be determined by combining the amounts listed in both of these groups of accounts. 40 PRINCIPLES OF ACCOUNTING If the necessary commodities and services which a firm acquires were imperishable (in the economic as well as the physical sense), then the sale of product would give rise to a net increase in ownership, for no deductions would be necessary. Although it is difficult indeed to discover an actual enterprise which even approximates this condition, a consideration of such a case will serve to throw some light upon the nature of the important con- cepts of revenue, expense and net revenue. A certain individual has $5,000 on deposit in a savings bank. His business, it might be said, consists in furnishing the use of capital. A balance sheet for the enterprise would appear as follows : Assets Equities Cash $S)°°o An Individual, Ownership . $5,000 The bank, it will be assumed, pays four per cent interest on de- posits. At the end of a year $200 in interest has been earned. The balance sheet would now appear : Assets Equities Original Cash $S,ooo An Individual, Original New Cash .... . 200 Ownership $S,ooo An Individual, New Ownership 200 Total $S,2oo Total fS,2oo In this case the increase in assets, $200, means an increase in equities of an equal amount. Revenue, then, is net, for no ex- pirations of original capital are involved. The entire amount, $200, constitutes a payment for capital service (the pure 'service of the proprietor) ; and since the investment remains intact this amount constitutes at once a net increase in assets and a net increase in equities. The typical business enterprise, however, is not at all repre- sented by such a case. Even a firm engaged primarily in loaning capital will usually have certain costs, such as rent, labor, station- ery, etc., incident to operation. And in a manufacturing or retail business from eighty to ninety per cent of the assets received from the sale of product may be necessary to replace the outlays CONSTRUCTION OF SUPPLEMENTARY ACCOUNTS 41 required in the production of that product. This means, in other words, that large deductions must be made from gross revenue, through the expense accounts, before the net return to ownership is determined. Expense and revenue accounts, therefore, may properly be considered as subsidiary equity accounts, recording gross addi- tions to and gross subtractions from the equities ; and the con- struction of such accounts is analogous to that of the equity accounts described in the preceding chapter. Items of revenue, which constitute gross additions to the equities, are listed in the right-hand column of the revenue accounts. Items of expense are listed in the left-hand column of the expense accounts because these amounts constitute subtractions from revenue. It is important to note that the concept of expense can be most adequately defined in relation to revenue. Revenue represents gross additions to equities; expense represents subtractions from revenue. This relation can be shown graphically, thus : Subtractions Additions Revenue Expense Then, in applying the rule for debit and credit entries given in Chapter II, it should be recognized that a debit entry in an ex- pense account is a subtraction from equities in the sense that it is first a subtraction froni revenue, which in turn represents gross additions to equities. It will doubtless occur to the student that all expense and revenue items might be grouped logically under one account, the expense items being listed in the left-hand column, the revenue items in the right-hand column. That is, expense and revenue accounts are really one-column accounts, minus equity items appearing in one case, and plus equity items in the other. The 42 PRINCIPLES OF ACCOUNTING net balance of such a composite account would represent the net change in the equities. The use of such an account will be dis- cussed in a later chapter. When expense and revenue items are segregated in special accounts, however, the two-column arrange- ment is preserved in each distinct account for clerical convenience in making transfer entries. The expense and revenue accounts may be subdivided for statistical purposes almost indefinitely. This is one of the points at which a system of accounts is capable of great extension. Each particular type of expense may be listed in a distinct account, and these accounts may be grouped under several main heads. Similarly the special revenue accounts in an enterprise like a railroad company, for example, may be very numerous. The classification of expense and revenue accounts is one of the most important questions arising in the construction of a system of accounts for some specific enterprise. For the present, however, it will be sufficient for the student to grasp the general principles underlying the construction of such accounts; and hence the detail questions of classification will not be discussed at this point. The A. B. Co., it will be assumed, uses but two such accounts, one for the expense items and one for revenues. This would be an inadequate system in practice for any but very simple situations. An analysis of a few transactions involving expense and revenue items will show concretely the nature of such accounts and the method of making the entries. The A. B. Co., for example, sells goods for $1,500, cash. This is an illustration of a revenue trans- action. It would be recorded by a debit entry of $1,500 in the Cash account — an addition to assets, and a credit entry of $1,500 in the Revenue account — a gross addition to equities. If now it were possible to discover immediately the expenses involved in producing this item of revenue these expenses might be at once recorded and the amount oi net revenue shown. Right-hand — or credit — entries would be made in the various asset accounts affected to Represent the subtractions from assets, and left-hand — or debit — entries for the same amounts in the Expense ac- count to represent the subtractions from revenue. If, for ex- ample, it is discovered that coal has been consumed to the amount of $10, this situation would be recorded by a credit entry of $10 CONSTRUCTION OF SUPPLEMENTARY ACCOUNTS 43 in the Fuel account and a debit entry of $10 in the Expense ac- count. In many cases a service or commodity purchased becomes an expense before it appears as an asset in the accounts. A purchase of postage stamps, for example, may be utilized entirely on the day of purchase and hence never exist in the accounts as an asset. If the amount w;ere $5 the transaction would then be recorded by a debit entry of $5 directly in the Expense account, and a credit entry of the same amount in the Cash account. The item has passed on in the operation of the business and cannot now be considered an asset. In strict logic, however, these entries are really a summary of two independent happenings : (i) an exchange of assets — cash for stamps ; (2) an expiration of an asset and a subtraction from revenue. If a complete record of this situation were made the entries would be as follows : (i) a debit entry in the Miscellaneous Assets account and a credit entry in the Cash account ; and (2) a credit entry in the Mis- cellaneous Assets account and a debit entry in the Expense account. In practice, however, it would not be expedient to carry this analysis into the accounts. Similarly, if the A. B. Co. hires laborers for a week and pays them $150 in cash at the end of this period, these services do not exist as independent assets but have passed on in the business process before payment is made. Hence the transaction in practice would be recorded by a debit entry of $150 in the Ex- pense account and a credit entry of the same amount in the Cash account. But if wages or salaries are prepaid in any case for a. considerable interval it should be recognized that the debit entries involved represent, not subtractions from revenue but additions to assets. The problem of classifying the accounts involved in these and similar situations will be further co;nsidered in a later section of this chapter. SPECIAL EQUITY ACCOUNTS In addition to the expense and revenue accounts several other types of supplementary equity accounts may be necessary, in the case of the typical enterprise, if the financial records are to show a reasonably complete statement of the changes in ownership due 44 PRINCIPLES OF ACCOUNTING to business operation. The net balance of the expense and revenue accounts is, as already noted, net revenue — or, if the enterprise has been unsuccessful, net loss. It is desirable in some cases to record this amount, after it is once determined, in a special account. Such an account, in the case of net revenue, represents the net increase in ownership during the period of operation under consideration ; in the case of net loss such an account shows the decrease in the equities for the period. En- tries in these accounts are made in exactly the same manner as are the entries in the balance sheet equity accounts already de- scribed. Items of net revenue are transferred to the credit column of the Net Revenue account; items of net loss are entered in the debit column of this account (or in the debit column of a distinct loss account). It should be noticed that in addition to the balance from the expense and revenue accounts certain items of net loss and net gain may arise which require entries directly in special equity accounts. Suppose some unforeseen calamity results in the de- struction of a portion of the assets of an enterprise. Such a happening constitutes a net subtraction from assets and hence a net subtraction from ownership. If, for statistical purposes, such items are set up under a special head the resulting account is a negative equity account, recording certain subtractions from the equities which for the time being are not deducted from the amounts appearing in the main equity accounts. Suppose, for example, coal to the value of fioo is stolen. This transaction could be recorded by a credit entry of $ioo in the Fuel account and an equal debit entry in a special loss account. It is evident that such a subtraction from equities is quite distinct from an expense item — a subtraction from revenue. The ton af coal burned in the manufactory's furnace gives rise to an expense ; although in a broad sense it is an exchange of one asset for an- other, for normally the proceeds from the sale of product will recoup the firm for all such expirations. But the ton of coal stolen is an actual loss, no valuable consideration being received in exchange ; and hence such an item constitutes a net subtrac- tion from the equities. It is not intended to elaborate at this point the importance of the distinction between a loss and an expense. For the present it is sufficient to note that the accounts CONSTRUCTION OF SUPPLEMENTARY ACCOUNTS 45 in either case are constructed as subsidiary equity accounts, and the entries are made according to the same rules. Similarly, a donation, or any other accidental or extraordinary increase in assets, gives rise to an immediate net increase in equi- ties ; no expense deductions are involved in such an increase. If, for example, a factory site were donated to the A. B. Co. by an interested municipahty, the transaction would be recorded by a debit entry in the Land account, as in the case of any asset increase, and a credit entry either in the A. B. Co. account or in some special proprietary account (for example. Surplus from Donations). Since proprietorship is the residual equity all special accounts in which actual losses or gains are recorded can be classed as subsidiary proprietary accounts. Another occasion for the use of special equity accounts arises in connection with the distribution of net revenue among the various equities. In a partnership the partners' "personal" or "drawing" accounts are commonly used to record withdrawals from either income or original investment. If, for example. A, a partner in a certain enterprise, withdraws in cash net revenue amounting to $500, the transaction would be recorded by a credit entry of $500 in the Cash account and a debit entry of $500 in the A, Personal account. In the incorporated enterprise, where such withdrawals take the form of interest and dividends, special accounts are necessary to record the pajmaents — sub- tractions from equities — made to the various classes of security- holders. It will be assumed that the A. B. Co. makes use of two such accounts, Interest and A. B. Co., Current. The Interest account is to be used to record all accruals to the contractual equities — in this case represented by mortgages and notes ; and it is the function of the A. B. Co., Current account to show all proprietary earnings and withdrawals. The relation between these special accounts and the Net Revenue account is shown in the exhibit at top of page 46. If, then, $1,050 (interest for six months) were paid to the holders of mortgages against the assets of the enterprise the transaction would be recorded by a credit entry of $1,050 in the Cash account (a subtraction from an asset) and a debit entry of $1,050 in the Interest account (a subtraction from an equity — net revenue). Similarly, if the proprietors decided to withdraw earnings amount- 46 PRINCIPLES OF ACCOUNTING Subtractions Addotons Net Revenue Interest A. B. Co., Current ing to $3,000 the transaction would be recorded by a credit entry of $3,000 in the Cash account and a debit entry of the same amount in the A. B. Co., Current account. A great variety of simple •and complex transactions involving additions to or subtractions from net revenue and its subsidiary heads may occur in business practice. Nevertheless the rules for making debit and credit entries as explained in Chapter II apply logically to all cases. Special accounts are commonly used to show the accumula- tions of net proprietary revenue invested in the business. The Surplus account is used for this purpose. Such an account is simply a special proprietary account and is constructed in the same way as any other equity account. The term deficit is used to designate accumulated net loss, and the account in which such items are recorded is the Deficit account. The relation between the original proprietorship. Surplus and Deficit accounts can be shown thus : SUBTEHCTIONS ADDmONS A. B. Co. Deficit Surplus CONSTRUCTION OF SUPPLEMENTARY ACCOUNTS 47 The Surplus account in practice may have a number of important subdivisions. The special loss and gain accounts mentioned above can be considered as examples of subsidiary deficit and surplus accounts, provided the amounts involved are treated as adjustments of original proprietorship rather than of net revenue. In Chapter XIII the various surplus accounts will be discussed in some detail. One other group of equity accounts — those recording current liabilities — should be mentioned. In addition to liabilities such as ordinary accounts payable — which arise through the purchase of raw materials and other assets on credit — accrued items of wages, interest and taxes are sometimes set up in special accounts. All of these accounts are constructed as are the bal- ance sheet equity accounts — the right-hand column being used for additions, the left-hand column for subtractions. Any firm which does not adopt a strictly cash basis for its business rela- tions will require several such accounts. Specific examples will not be considered at this point, however, for the use of such ac- counts can be more conveniently explained in later chapters. VALUATION ACCOUNTS Almost any asset or equity account may have a subsidiary account. Whenever it is desired for some reason to take special cases of subtractions from either an asset or an equity item and place such subtractions under a special head, the new account simply represents a part of the main account, or is, in other words, subsidiary to the main account. Such accounts are usually called valuation accounts. There are several reasons for the use of valuation accounts. In the case of a fixed asset, such as a building, it may be thought desirable to preserve in one account the original cost figures and to use a special account to show the subtractions from this asset which are due to business operation and the passage of time. Such an account may be called. Allowance for Depreciation of Building.^ If, for example, it were discovered that the building of the A. B. Co. had declined in value during a certain period of ' Cf. Cole, Accounts, Their Construction and Interpretation. 48 PRINCIPLES OF ACCOUNTING operation, $600, this transaction would be recorded by a right- hand entry of $600 in the Allowance for Depreciation of Building account and a left-hand entry in the Expense account. The first entry represents the subtraction from the asset, but instead of being recorded directly in the Building account this sub- traction is set up in a subsidiary valuation account ; or, in other words, a credit entry in a valuation account is substituted for a credit in the asset account. The second entry represents the subtraction from revenue due to the expiration of this asset in business operation. The relation between the Building account and its subsidiary can be suggested thus : Additions Subtractions Building Allowance for Depreciation of Building Many cases of asset valuation accounts are met with in ac- counting practice. Since such accounts show credit balances they are sometimes confused with the equities. The importance of avoiding such a confusion can hardly be overemphasized, for there is clearly no relation between a positive equity balance and a subtraction from an asset. The use of such accounts and their significance in the accounting statements wiU be further dis- cussed later in the text. In connection with equity accounts which represent the secu- rities of incorporated companies valuation accounts are fre- quently used. Securities are commonly maintained in the ac- counts at par — the nominal value. Since the actual amount of ownership represented by a security very often is more or less than the stated par value, subsidiary accounts are necessary to show the difference. Thus, capital stock may be issued at $75 per share although the formal capitalization is $100 per share. CONSTRUCTION OF SUPPLEMENTARY ACCOUNTS 49 If the Capital Stock account is used to record the par value, a valuation account, Discount on Stock, must be opened, in which is shown the amount of the discount. Such an account simply shows an offset to an overstated equity. The Deficit account mentioned in the preceding section is really a valuation accoimt, its function being to show the accimiulated net decrease in the proprietor's equity. There is nothing about valuation accounts that invalidates the explanation of the double-entry system thus far outlined. Each valuation account is so constructed as to preserve the balance of the main account, be it an asset or an equity account, in the proper column. Such accounts are further illustration of the general scheme of using additional colimins for minus items rather than making the actual subtractions ; though in this case entirely distinct accounts are used for the negative items. The need in particular cases for preserving original figures in the ac- counts is the legitimate excuse for such a procedure. In this section, as in the preceding, it is not feasible to do more than mention these special subsidiary accounts. Yet although an endeavor has been made to reduce the discussion to its simplest terms it has been impossible to avoid introducing certain expres- sions and concepts with which the student will not be entirely familiar until much later ; as in many other subjects the student's mastery of ideas which are necessarily brought in at the beginning is not complete until the entire field has been covered. The way in which such special accounts fit into the general structure of the double-entry system has, however, been suggested; and it should appear fairly evident at this point that the general rules involved in the construction of a whole system of accounts — those representing the historical situation as well as those showing the financial condition of an enterprise at given moments of time — are essentially those stated in Chapter II. The fundamental consideration controlling the construction of the historical as well as the balance sheet accounts is the preservation of the clas- sification, assets and equities. In all valuation and other sub- sidiary accounts, then, debit and credit entries have essentially the same possible meanings as in the main asset and equity ac- counts. 50 PRINCIPLES OF ACCOUNTING THE CLASSIFICATION OF ACCOUNTS The classification of accounts that has been presented thus far in the text has recognized only pure accounts — accounts, that is, which show in each case but one of the important classes of the balance sheet, or some phase, positive or negative, of one of these classes. In other words, each of the important accounting concepts — asset, equity, expense, revenue, etc. — has been at- tached to a distinct group of accounts. While this classification is of primary importance in that it furnishes a rational basis for the explanation of the essential nature of a system of double- entry accounts, it should now be recognized that no set of ac- counts in actual practice can be expected to follow such a grouping exactly. Brief consideration will be given at this point to some of the principal difficulties involved in account classification.^ As already noted, the current assets merge with the expense items at certain points ; or, in other words, some outlays in busi- ness practice are of such a nature that they may be classed, with almost equal propriety, as either asset or expense items. Some commodities and services are so transitory in character as to con- stitute expense almost at the moment of purchase ; that is, al- though any valuable item is logically an asset as purchased, it may become an expense shortly after — or even before — it is convenient to record it in the accounts. The cash purchase of advertising services, for example, may be conceived in the first instance as an exchange of assets ; hence the entries involved may be said to represent an addition to one asset and a sub- traction from another. If, then, the accounts affected are de- fined in terms of the logical classes involved in the transaction at the moment of purchase, it can be affirmed, with reason, that both accounts are asset accounts. On the other hand, if the pay- ment made is for services covering a very short period, the trans- action may logically be viewed, not from the moment of purchase but from the moment of expiration ; and from this standpoint it can be said that the debit entry represents an expense — a deduction from revenue. If the accounts involved are now defined in terms of the logical classes existing at the moment ^ "Account classification" means liere, not detail classification for managerial purposes, but general classification in terras of fundamental concepts. CONSTRUCTION OF SUPPLEMENTARY ACCOUNTS 51 the item has expired, it may with reason be said that the account in which the left-hand item is recorded is an expense account. Or if payment is made concurrently with the expiration of the service — or later, then clearly the left-hand entry records an expense item, and the account affected is an expense account. In accounting practice the accounts designated in this chapter as current asset accounts are often called expense accounts. This is no very serious error if it is recognized that all the items in- volved in such accounts are logically assets as purchased, and give rise to expense items only as consumed. As to whether or not such a practice is justified is largely a question as to the normal condition of such accounts during operation. If the Fuel account of the A. B. Co. at a given moment of time, for example, shows total debit entries of $400, and an examination of the coal bins reveals the fact that of this total, fuel to the amount of $350 has been consumed, then it is evident that of the $400, but $50 rep- resents an asset, the balance being at this moment an expense. Both items belong logically in the left-hand column, but one is a positive asset figure, the other a deduction from revenue. If this situation represents a normal condition, the Fuel account may be defined from the standpoint of coal consimaed rather than coal purchased. A distinction, then, must sometimes be recognized between the logical nature of the items involved in a business transaction and the nature of the accounts which are used to record the trans- action. An account may be defined or classified in terms of its predominating element, or, in other words, from the standpoint of the destination at the end of the accounting period of the principal sum involved in the account. Thus the purchase of assets may be recorded in an "expense" account, because at any given moment a very large proportion of the total amount shown in the account represents expense. Even in such a case, however, it is more rational to conceive of the account as a current asset account, and a debit entry as an addition to an asset, when the purpose of the classification is an explanation of the structure of a system of accounts and the logical rules for making debit and credit entries. In a lesser degree the accounts which represent the more per- manent assets of an enterprise present the same difl&culties of 52 PRINCIPLES OF ACCOUNTING classification. The Building account, for example, may show at a particular moment a debit balance of $70,000 ; but if an ap- praisal of the building reveals the fact that the present value is but $69,000, the account at the moment of appraisal does not represent an asset alone. An element of expense is involved. And, since the depreciation of the building occurs continuously, it is not feasible to represent this fact continuously in the ac- counts. Hence, due to the unpossibiHty of subtracting all ex- pirations from the asset accounts as they occur, nearly all asset accounts, in practice, fail to represent continuously a single class of facts. Just as the Fuel account at a particular moment of time may represent coal consumed as well as coal on hand, so the Building account may show, not simply an asset item, but an item of expense as well. Some accounts in practice become "mixed" in the sense that more than one element is specifically recorded in each account. Thus the Merchandise account as sometimes kept in the retail business is an asset, expense and revenue account combined. The left-hand column is used to record purchases of merchandise (the raw material of the enterprise) ; the -right-hand column shows the sale of the finished product (in this case retailed mer- chandise). That is, one column represents an asset, and the other revenue — a gross addition to equities. As the raw mate- rial is consumed in operation the asset expires and becomes an expense. Similarly, in some cases the Rent account is used to record asset, equity, expense and revenue items. The practice of listing several elements in a single account can be carried very far ; even the balance sheet itself can be conceived as an account showing all the assets and equities of the business. As long as the items involved are grouped in the proper columns, however, such mixed accounts can be used without confusion; and the rules for making debit and credit entries are the same for all such accounts as for pure accounts. The important cases of such involved accounts will be considered in some detail in later chap- ters, particularly in connection with the discussion of the closing of accounts. The discussion has now been carried far enough to suggest the logical problems that arise in classifjang accounts in actual prac- tice. In conclusion it should be emphasized that no classifica- CONSTRUCTION OF SUPPLEMENTARY ACCOUNTS 53 tions of facts in any field of knowledge follow exact lines of cleavage. There are always connecting links, grounds of dubiety, points at which one class shades into another. But these diffi- culties do not destroy the value of classifications. Classifications are primarily for purposes of convenience ; a particular grouping is adequate if it satisfactorily serves the purpose in hand. For some purposes distinctions may well be observed, for others similarities. Controversies concerning the legitimacy of this or that particular classification usually arise because one or more of the contending parties fail to appreciate the conflicting purposes involved. The importance of the purpose served in any case, however, determines the importance of the classification. In Chapter II and the present chapter, to repeat, accounts have been classified in terms of the important logical concepts with which accounting deals in order to furnish a rational basis to the inter- pretation of all possible business happenings for the purpose of making debit and credit entries. The explanation of the nature of the principal types of sup- plementary accounts may be conveniently summarized by pre- senting the complete scheme of accounts for the A. B. Co. in its relation to the fundamental equation, thus : The a. B. Co.'s Accounts * Assets Equities Additions Subtractions Subtractions ADDmONS Land A. B. Co. $40,000 Deficit $170,000 Surplus 1 It must be remembered that this illustration is not intended as an exhaustive classification of the accounts likely to be used by any actual enterprise ; it is rather designed merely to suggest the structure of the important types of accounts required by the typical enterprise. The illustrative transactions given in Chapter II as well as in the present chapter, in so far as these transactions affect the accounts of the A. B. Co., are recorded in the proper columns. No net revenue amounts 54 PRINCIPLES OF ACCOUNTING The a. B. Co.'s Accounts (Continued) Assets Equities Additions Subtractions Subtractions Additions Building Mortgages $70,000 Allowance for Depreciation of BuUdings $35, 000 S,ooo I600 Equip ment Notes Payable $20,000 $1,000 $20,000 4,000 t S,ooo 5,000 2,000 Mate rials Re^ irenue $80,000 600 Expense $1,500 $ 10 S ISO 600 Ca sh NetR jvenue $15,000 $ 600 5,000 1,000 2,000 60 Interest 1,500 $1,050 S ISO 1,050 A. B. Co., Current 3,000 $3,000 were assumed ; hence there are no credit entries in the Net Revenue account although distributions of net revenue are shown, CONSTRUCTION' OF SUPPLEMENTARY ACCOUNTS 55 The a. B. Co.'s Accounts {Continued) Assets Equities Additions Subtractions Supplies Fuel $60 Insurance Miscellaneous $S Subtractions IV The Analysis and Recording of Transactions In Chapters II and III the general principles underlying the structure of a system of double-entry accounts were explained, and the effect of the important types of transactions upon the individual accounts and the fundamental equation was shown. In this exposition, however, little reference was made to either the details or general features of bookkeeping procedure. It is the purpose of the present chapter to describe briefly the more significant forms of "books" which are used in double-entry bookkeeping, and to explain — with reference to these books — the main characteristics of the technical process of analyzing and recording accounting transactions. THE BOOKS OE RECORD AND ACCOUNT As a preliminary to a description of the principal books of record and account some further explanation of the term trans- action should be made. Any happening which affects an asset or an equity item (or some phase of an asset or equity), or, in other words, any situation which gives rise to entries in the ac- counts of an enterprise, constitutes an accounting transaction.^ The recording of transactions representing actual purchase and sale exchanges and the like usually constitutes the main part of the bookkeeper's routine work ; and the forms and records em- ployed in practice are specially constructed to facilitate the process of analyzing and recording "business" transactions. Nevertheless it should be remembered that changes in the assets ' Thus, "closing" and adjusting entries made at the end of an accounting period (see Chapter VIII), and transfer entries such as those covering the appropriations of the directors of an incorporated enterprise, can be said to represent transactions. 56 ANALYSIS AND RECORDING OF TRANSACTIONS 57 and equities of an enterprise which arise because of the condi- tions of operation itself must also be recorded in the accounts ; the consumption of coal must be taken into consideration as well as the purchase of coal.^ But, as was noted in the preceding chap- ter, such occurrences are usually recorded only at intervals — usually at the time of closing the accounts. For the purpose of describing bookkeeping forms and procedure it will therefore be convenient, at this stage, to depend for illustrative transactions largely upon actual business happenings. As soon as a transaction is recognized as taking place an in- formal record, or memorandum, of the occurrence is usually made. In many cases some document or form — such as a bill, check or receipt — is made out in connection with the transaction. Such documents, collected in files, may be thought of as con- stituting — in the absence of a formal book — the book of origi- nal record. Or the original narrative of the various happenings may be jotted down in a bound or loose-leaf book ; in which case such a book can be considered as representing the first formal record. The name daybook is often applied to the original record, particularly if a bound volume is used for this purpose. A daybook, in its simplest form, contains merely a rough narra- tive of events — often written in pencil — with no specific ref- erence to accounts or to debit and credit entries. In such a case a section of a daybook page would appear somewhat as follows : January 2 Bought for cash 10 tons soft coal from Keck & Son @ $6. Amount, f 60. For immediate delivery. Hardware supplies — as per itemized biU of this date — were received from the Essex Mfg. Co. Total amount, $600. A check for this amount was made out and mailed. 3 Borrowed $5,000 from the First National Bank on our 60-day note at 6 %. This amount was deposited to the credit of our checking account. ' Strictly speaking, transactions which occur in time, such as the expiration of a fixed asset due to deterioration and other factors, are infinite in number. Since it is impracticable and even impossible to make a record of these transactions as they occur, transactions as recognized in the accounts can be conceived as including, in many cases, innumerable subsidiary happenings. S8 PRINCIPLES OF ACCOUNTING It is evident that the details of each transaction as recorded in such a book can be made as exhaustive or as meagre as may be desired in any case. Accounting analysis and record proper, however, do not begin with the daybook as it has just been described. In the double- entry system the two books of fundamental importance used in recording business transactions are the journal and the ledger. A daybook and many other supplementary forms and auxiliary records may be necessary — particularly in the case of an enter- prise with a complex organization and a long and involved pro- ductive process ; but in any case the fim.damental books of the double-entry system are the two just mentioned. The account- ing analysis and recording of transactions can best be described in terms of these books. The first essential step is the classification of each transaction as it occurs into debit and credit items. This process of analysis is commonly spoken of as "journaUzing" because of the practice of recording the debit and credit classification of data first in the journal. In this sense the journal is the book of " original entry." The journal may be a bound volimie with the simple page form shown in the following section, or it may be a complex book, or series of books and forms, as will be explained in Chapter V. The particular form of the journal is not an essential element in its definition ; the journal is the book, form, or forms in which are first recorded the debit and credit items involved in the trans- actions that occur. Where the daybook, so called, is used to designate debit and credit entries, it virtually becomes a journal. Further, the debit and credit items, once ascertained, must be listed in compact form in the left-hand and right-hand columns of the proper accounts. The ledger is the book of the accounts. The simple form of the ledger is also the bound volume, but other forms are possible. The ledger also may be a series of books or forms as will be shown in the following chapter. The use of two fundamental books in recording business trans- actions is somewhat arbitrary. Each transaction must be ana- lyzed into debit and credit items and these items must be entered in accounts, as explained in Chapter II, if the double-entry de- vice is to be employed. The use of two books in this process instead of one, however, is largely a matter of clerical conven- ANALYSIS AND RECORDING OF TRANSACTIONS 59 ience, and there is some tendency in bookkeeping technique to reduce the financial books proper to simply the books of account. Yet however technique may develop the essentials of the process must remain the same : (i) each transaction must be classified into debit and credit items ; (2) these debits and credits must be actually carried to the accounts affected. If but one book is used this book constitutes both journal and ledger. Throughout the text the separation of the two steps will be maintained, and the device of the simple journal entry will be used as a representa- tion of the process of debit and credit analysis. A more detailed description of these important books will now be given. THE JOURNAL The journal, as stated above, is the book of original entry. As ordinarily used it can be said to have two functions : first, it furnishes a record of the classification of transactions into debit and credit items ; second, it gives brief details in connection with each transaction. No other formal book for recording the origi- nal narrative is then necessary, although the journal record is usually transcribed at regular intervals -from rough memoranda, underlying papers, or a daybook. The simple journal is a bound volume with numbered pages. A section of a page from such a journal would appear somewhat as the table at top of page 60. The left of the two columns at the right of the page is the col- umn in which are listed the debit amounts ; the right-hand col- umn is for credit items. The name of each account is given a single line ; in this way the details or explanations are not likely to be confused with the account titles in the process of trans- ferring the amounts to the ledger. The debit accounts are first stated in each case. This is the conventional arrangement. The name of the account which is to be credited is indented to the right. Where several debit or credit accounts are involved in a single transaction it is desirable to follow the conventional form, listing first all debit accounts — a separate line for each account — and then all credit accounts. In the column at the left of the page are given the ledger page numbers of the various accounts involved. These ledger page numbers should always be given in the journal to facilitate the comparison of the two 6o PRINCIPLES OF ACCOUNTING L. F. January 2 28 Materials 1 600 7 Cash Bought for cash from the Essex Mfg. Co. materials as per itemized bill of this date. $ 600 7 Cash S,ooo 32 Notes Payable Borrowed Is, 000 from the First National Bank on our 60-day note at 6%. 5,000 II 3 Equipment 4,000 7 Cash 2,000 32 Notes Payable Additional equipment was purchased from the Bur- gan Supply Co.for cash and note. 2,000 IS Fuel 60 7 Cash Bought for cash 10 tons soft coal @ $ 6. 60 7 Cash 1,000 46 Revenue Finished goods sold for cash to H. J. Harvey as per invoice of this date. 1,000 books whenever need for such comparison arises ; and these numbers also serve as a check on the accuracy of the bookkeeper's work in transferring items from the journal to the ledger. The process of entering a debit item in the journal is usually called "charging" : to debit an account is to charge an account. Entering credit or right-hand items is called "crediting." In making journal entries the words to or hy are often used, thus : Fuel $60 to Cash $60 The use of the preposition serves no purpose except to indicate further which item is a debit and which a credit. Indeed such terms are Ukely to be more confusing than helpful. There is no time or other sequence between the debit and credit items in- ANALYSIS AND RECORDING OF TRANSACTIONS 6l volved in a transaction. The conventional method of indenting the credit accounts to the right, as shown above, suggests the spatial arrangement of debits and credits and is probably the most satisfactory of all devices. If this is done there is no need of further explanation. The importance of the journal when considered as representing the primary debit and credit analysis of the transactions is evi- dent. The structure of the double-entry system depends upon a debit and credit classification of items. Such a classification is the first essential step in interpreting accounting data, and the use of parallel-column accounts, as shown in Chapter II, is im- possible without this analysis. Further, an orderly statement of the important details connected with each transaction is very necessary for future reference in case of misunderstandings, audits, legal complications or other contingencies. For this reason it is desirable that the journal narrative give a rather full explanation of each transaction, instead of a very much abbre- viated statement. As stated above, many of the original details may be recorded in other books and forms than the journal proper. Notes pay- able and notes receivable registers may be kept, for example, in which are recorded the details in connection with these types of commercial paper. Various other kinds of memoranda are used in keeping the record of original data ; and, of course, original documents such as receipts, vouchers, bills of lading, etc., are to a great extent preserved and kept on file to supplement the books proper. From the standpoint of authenticity in legal and other disputes these underlying papers naturally carry more weight than the journal. As far as the formal books are concerned, however, the journal, as stated above, is the book of original entry. The journal itself is often subdivided into a number of special books. The cash book, the purchase book and the sales book are the common examples of such special journals. The names of these books suggest their nature. The use of these additional books is of advantage in economizing clerical effort; and they also serve to isolate in the accounts each department or phase of the business. These and other modifications of the simple journal will be described in Chapter V. 62 PRINCIPLES OF ACCOUNTING THE LEDGER The ledger, as explained above, is the book of final account. It is the book of the accounts proper, representing the organiza- tion of the debits and credits of the journal into compact form and allocated to the various accounts affected by the transactions. The difference between the journal and ledger in regard to the organization of data may be expressed in this way : in the jour- nal the unit is the transaction; in the ledger the unit is the ac- count. The simple form of the ledger is also a bound volume, although innumerable variations are possible. Each account may be given a single page, or more or less than a page according as it is expected that there will be a large or small number of trans- actions affecting the account. The accounts are commonly arranged alphabetically rather than in logical groups, because this arrangement can be more readily used for reference purposes. The conventional ledger account has, roughly, the following form : Cash I9I8 1918 Jan. 2 Ji $15,000 Jan. 2 J3 $ 600 4 J4 500 3 J4 1,000 S Js 1,250 3 4 S 5 J4 J4 Js Js 2,000 60 s ISO Usually, as in the above case, the ledger contains simply the heading or name of the account, the date of each entry, the journal page on which may be found the original entry, and the amount. Sometimes the name of the account that contains the concurrent opposite entry is written in. There are not many cases in which this is necessary, for if the journal page is given the details of the transaction giving rise to a particular ledger ANALYSIS AND RECORDING OF TRANSACTIONS 63 entry can be readily ascertained. It is the particular function of the ledger to summarize the transactions in connection with each account so that conclusions concerning the status of each account may be drawn. Or, in other words, it is the function of the ledger to show under each account heading all plus and minus items — opposite tendencies — pertaining to that account, so that a balance can readily be taken. The ledger, like the Journal, may be divided into a number of special books, and the extent to which it is expedient to carry this subdivision depends upon the nature of the enterprise in any case. The most common examples of such speciahzed ledgers are : the expense ledger, often containing current asset accounts as well as pure expense accounts ; the creditors' ledger, contain- ing the "accounts payable" (a separate account for each person or firm); and the customers' ledger, embracing the "accounts receivable" (a separate account with each individual or firm). The cash book, which, as stated in the preceding section, is pri- marily a Journal of transactions involving cash, may also be used as a ledger containing the single account, Cash. The general ledger includes all the accounts not contained in the special ledgers and controlling or summary accounts of the special ledgers as well. The accounts payable of the creditors' ledger represent current obligations of the firm — usually obligations incurred through the purchase of raw materials, merchandise and other suppUes on credit. Because credit purchases are the usual thing in many lines of business, the number of transactions to be recorded in these accounts is often very large. Such accounts, evidently, represetit current equities in the enterprise. The time allowed on credit purchases is usually either thirty or sixty days. The goods so purchased represent assets as received, and should be recorded as such. Since payment for these assets is postponed, current equities for the same amounts (represented usually by the names of the firms from whom the purchases are made) must also appear in the records. Similarly, the accounts receivable of the customers' ledger represent current claims which the enterprise has against other firms and individuals — claims usually arising from the sale of finished product on credit. Illustrative transactions affecting 64 PRINCIPLES OF ACCOUNTING these accounts and the accounts payable as well will be given in the following section. The possibihty of using controlHng accounts for the special ledgers was mentioned above. A controlling account is of ad- vantage in cases where detailed information is necessary for one purpose and simimary information for another. For example, the sales manager may desire to determine at a glance the amount of outstanding customers' accounts. Hence the general ledger should iaclude an Accounts Receivable, which is a controlling or sumrnary account of the customers' ledger. Similarly, there should be a controlUng account, Accounts Payable, for the credi- tors' ledger. The use of controlHng accounts makes it possible to have in the general ledger a complete representation of the business. Conclusions concerning the status of the enterprise at any time can then be drawn from one book. The controlHng account device may be carried very far in practice. In some cases each general ledger account "controls" several subsidiary accounts. The nature and use of the special ledgers will be further ex- plained in a later chapter. The clerical advantage of such books, and of controlHng accounts, depends largely upon the device of the special-column journal, which will be described in some detail in Chapter V. JOURNALIZING As has been stated, it is one function of the journal to present a classification of transactions in debit and credit, or left-hand and right-hand, entries. Thus it is apparent that journalizing in- volves more than the mere recording of facts. The first* and a very important, step in interpretation is taken in the process of grouping debits and credits. Whenever both balance sheet classes are involved this classification makes the fundamental distinction between asset and equity items. If the bookkeeper is handed a memorandum on which are given the details of the transaction and the names of the accounts involved, and on which it is already indicated for him which entries are debits and which are credits, then journaUzing from that point is mere copying or recording, for the important process has already been completed. ANALYSIS AND RECORDING OF TRANSACTIONS 65 The fundamentals of journalizing have already been brought out' in explaining the structure of the accounts and the under- lying principles for making debit and credit entries. This clas- sifying of transactions into debit and credit accounts is of primary importance, and is a matter which presents considerable diffi- culty to the beginner. The classification of transactions given in Chapter II will therefore be repeated, and some additional il- lustrative cases will be analyzed. Although the second function of the journal mentioned above — the showing of the impor- tant details in connection with each transaction — is of impor- tance, it presents no difficulty and will be ignored in the following discussion of journal entries. a. Transactions occur which involve the exchange of valuable commodities or services for other commodities or services of equal value. In such cases a debit entry always means an addition to an asset, and a credit entry always indicates a subtraction from an asset. Examples 1. The A. B. Co. loans $500 to A (one of the proprietors) in exchange for his sixty-day note at six per cent. What would be the journal entries in this case? One asset, cash, has been de- creased to the amount of $500, and another asset, notes receivable (a right against A in this case), has been increased a Uke amount. The journal entries would therefore be : Notes Receivable $500 Cash Isoo 2. Materials to the amount of $2,000 are bought for cash from Rankin & Co. This means a subtraction from cash of $2,000 and an addition to another asset, materials, of the same amount. The transaction would accordingly be journalized by a debit, or charge, to Materials and a credit to Cash, thus : Materials $2,000 Cash $2,000 3. The equipment is insured for $24,000 for three years. The premium of $240 is paid in cash. This transaction represents the purchase of a service for cash. Protection from certain pos- 66 PRINCIPLES OF ACCOUNTING sible losses is secured for a period of three years, and payment is made in advance. The insurance premium in this case rep- resents an asset charge ; a right — covering a period of three years — is secured. As this right expires, it will constitute ex- pense. The situation is analogous to the purchase of a machine for $240, which, it is expected, will last three years. At the moment of purchase the entire amount is an asset charge; as the machine depreciates the amount should be transferred to an expense account. This transaction would therefore be journalized by a left-hand or debit entry to Insurance and a right-hand or credit entry to Cash: Insurance $240 Cash $240 Many similar transactions involving the purchase of services and rights covering a considerable period are met with in business practice. All such transactions should be analyzed in the same manner as this case. 4. The A. B. Co. agrees to purchase delivery equipment amounting to $300 from Rankin & Co. provided the latter firm will accept in payment a return of unused raw material amount- ing to $300 (cost price). This agreement is carried out. The journal entries would be : Equipment $300 Materials S300 Such barter transactions — particularly those which do not in- volve either expense or revenue items — are very exceptional under modern business conditions. 5. It is estimated that raw material to the amount of $700 has been taken from the store room and is now in the factory in the form of semi-finished goods. This situation may be recognized in the accounts by the following entries : Goods in Process S700 Materials $700 Such transactions are of common occurrence in the accounts of manufacturing enterprises. Three accounts — or groups of ANALYSIS AND RECORDING OF TRANSACTIONS 67 accounts — corresponding to the important stages in the manu- facturing process are usually adopted. These accounts are : Materials ; Goods in Process ; Finished Goods. At intervals the changes in form which some of the assets are undergoing are recorded in these accounts. All such transactions may be con- ceived as internal transpositions of assets ; in each case there is no connection with any outside firm or individual. 6. The Y. Co. settles an open account for $1,000 in favor of the A. B. Co. with its sixty-day note at six per cent. This trans- action involves — on the books of the A. B. Co. — a subtraction from accounts receivable and an equal addition to notes receiv- able. The journal entries would therefore be : Notes Receivable Si, 000 Accounts Receivable $1,000 (The Y. Co.) This accounting procedure recognizes the legal and commercial distinction between open book accounts and promissory notes. The accounts now show that the Y. Co. no longer owes the A. B. Co. on the basis of a bill of goods, but on a promissory note ; the open account is cancelled, and is replaced by a new asset — a new right against the Y. Co. Such transactions are of quite common occurrence. 7. Another illustration of the transposition of assets is found in the case where an' enterprise sets aside cash, or other liquid assets, as a fund to be used for some special purpose. The term "sinking fund" is often applied in this connection. The A. B. Co., for example, decides to deposit $1,000 each year with a trus- tee, in order to accumulate a fund of liquid assets sufficient to meet a certain mortgage at maturity. The journal entries cover- ing such a deposit would appear as follows : Sinking Fund Assets $1,000 Cash $1,000 The intricacies of the sinking fund cannot be discussed at this point, but it should be clear to the student that such a transaction as this represents an exchange of assets. All transactions which involve simply asset exchanges are entered in the journal according to the same principles of analysis 68 PRINCIPLES OF ACCOUNTING that govern the treatment of the above cases. Such transactions affect only one member of the fundamental equation, as was pointed out in Chapter II. ^ence the problem of interpretation involved in making journal entries for these cases is simply that of distinguishing between additions to and subtractions from assets, and selecting the accounts affected. It is worth noticing that the Cash account is involved in the majority of such cases. Cash, being the only legal tender, is the only asset possessed by a given enterprise which it can readily exchange for other assets. b. Transactions frequently occur which represent an increase or decrease in assets and an equal increase or decrease in equities. The complete rule for making debit and credit entries is necessary to cover all such cases : debit indicates an addition to assets or a subtraction from equities; credit indicates a subtraction from assets or an addition to equities. Further, it must be remem- bered that an addition to equities may be a net addition or a gross addition (revenue), and that a subtraction from equities may be made directly through some equity account, or as a sub- traction from revenue — an expense charge. Examples 1. Notesof the A. B. Co. are retired with cash, $5,000. In this case an equity is reduced $5,000 and there is a corresponding re- duction in an asset, cash. The transaction would be journalized by a debit to Notes Payable and a credit to Cash, thus : Notes Payable fs,ooo Cash $5,000 2. Materials are bought on account from Rankin & Co. to the amount of $1,200. An asset, materials, has been increased, and a liability, accounts payable, has been increased an equal amount. The entries would then be : Materials $1,200 Accounts Payable $1,200 (Rankin & Co.)' If these materials had been purchased with a note, the only dif- ference in the entries would be that another equity account, Notes Payable^ would be credited instead of Accounts Payable. ANALYSIS AND RECORDING OF TRANSACTIONS 69 3. It is decided that $150 represents a month's accrued de- preciation on the A. B. Co.'s building, and the bookkeeper is asked to recognize this fact in the accounts. This transaction involves a subtraction from an asset, building, of $150, and an equal subtraction from revenue through the Expense account. The journal entries would appear as follows : Expense $150 Building 1 $150 4. The A. B. Co. needs additional capital; and a new mort- gage on real estate is issued, $5,000. Thii transaction means an addition to an asset, cash, and an equal addition to an equity, mortgages. Accordingly the entries would be : Cash $S,ooo Mortgages $S)°°° 5. The month's consumption of coal is $100. This transaction would be recorded by a credit to Fuel (indicating the subtraction from an asset) and an equal debit to Expense (indicating the subtraction from revenue), thus: Expense $100 Fuel $100 All transactions involving expirations of assets in operation are journalized according to this analysis. 6. The weekly payroll is met with cash, $500. The journal entries would be as follows : Expense Ssoo Cash $500 This transaction illustrates the use of a direct charge to Expense for services purchased instead of to an asset account. If a special expense account. Labor, were used, the entries would be : Labor $5°° Cash $500 1 The valuation account, Allowance for Depreciation of Buildings, would often be credited instead of Building. 70 PRINCIPLES OF ACCOUNTING 7. The following bills are received : light, $12; telephone, $8 ; freight and cartage, $50. Checks are drawn and mailed for the amount of these bills. This transaction would be journaHzed : Expense $70 Cash $70 A special expense account might also be used for each of these items. Nearly all small amounts of this kind are charged di- rectly to an expense account even if payment is made before the receipt of the commodity or service involved. Such items are transitory in character and are' usually viewed from the stand- point of their destination in the accounts. 8. Finished goods are sold for cash, $500. An asset, cash, is increased, and revenue is increased a like amount. The trans- action would therefore be journalized as follows : Cash $500 Revenue ISoo In practice the Revenue account is often called the "Sales" ac- count. 9. The A. B. Co. rents a portion of its building for $50 per month. A month's rent is received. This transaction also represents an addition to an asset and an equal addition to rev- enue. In this case the revenue arises in connection with the performance of an ancillary service. The entries for this trans- action would appear as follows : Cash $5° Revenue $50 For statistical purposes a special revenue account. Rent, might be used. 10. The firm is credited with interest on its bank balance, $40. This is another revenue transaction. Since the item of revenue is net in this case, however, the Net Revenue account should be credited, thus : Cash $40 Net Revenue $40 ANALYSIS AND RECORDING OF TRANSACTIONS 71 Or a special account, Interest Received, may be credited, thus : Cash I40 Interest Received $40 11. The firm pays interest on outstanding mortgages, $400. This transaction is essentially the reverse of the preceding illus- tration; it represents a subtraction from an asset, cash, and an equal subtraction from an equity, net revenue. The Journal entries would be : Net Revenue $400 Cash $400 Or a special account. Interest Paid, may be debited, thus : Interest Paid $400 Cash $400 12. The firm sells goods on account to H. A. Wilcox, $150. This transaction represents an increase in an asset and an equal increase in revenue. Accordingly the entries would be : Accounts Receivable $150 (H. A. Wilcox) Sales $150 According to the terms of the sale, it will be assumed, the buyer is to be allowed a two per cent discount if the bill is paid within ten days. The bill is paid and the discount is allowed. This transaction would be JournaUzed as follows : Cash $147 Sales Discounts ' . . 3 Accounts Receivable $150 (H. A. WUcox) This transaction illustrates the general practice of allowing cash and trade discounts, and other rebates and allowances, in com- mercial transactions. The usual bill of purchase or sale contains alternative terms of settlement. If cash is paid within a certain specified time it is customary to allow a discount on the gross price. In this case the amount of the discount is $3. This item represents a subtraction from the amount credited to the 72 PRINCIPLES OF ACCOUNTING Sales account in the preceding entry. Sales Discounts is there- fore a valuation account, showing subtractions from an overstated revenue. The amoxuit of the discount might logically have been charged directly to Sales. 13. To illustrate transactions involving purchase discounts it might be assumed that Rankin & Co. offer a discount of two per cent on the bill mentioned in (2) above. If the discount is accepted by the buyer the entries when the account is paid would appear as follows : Accounts Payable $1,200 (Rankin & Co.) Cash $1,176 Purchase Discounts 24 Purchase Discounts is another valuation account and the amount shown by such an account is a deduction from the cost of mate- rials and suppHes which have been entered at the gross rather than the actual price. A discount accepted on goods purchased and ent'ered at a gross price might therefore be logically credited directly to the asset account in question. Valuation accounts of this kind are very common in account- ing practice, and some difficult problems of analysis arise in con- nection with such accounts.^ A further discussion of transactions involving adjustments of costs and revenues will be given in a later chapter. 14. An actual loss or gain represents a transaction which af- fects both members of the fundamental equation directly. An officer of the A. B. Co. embezzles cash amounting to $1,500. The following entries would be a recognition of ttiis occurrence in the accounts : Surplus $1,500 Cash $1,500 Since this defalcation represents a net decrease in assets with no compensating advantages it also constitutes a net subtraction from proprietorship. If there be no Surplus account in a given case, a charge should be made to the original proprietorship account, or to some valuation account such as Deficit. ' See Appendix A. ANALYSIS AND RECORDING OF TRANSACTIONS 73 The opposite of this transaction would be an extraordinary gain, such as a gift. Transactions involving actual loss and gain are not of very conunon occurrence in the typical business enter- prise. The above cases are typical of the situations which give rise to entries affecting both the asset and equity classes. In inter- preting transactions of this type it should be constantly kept in mind that the expense and revenue and other supplementary accounts involved can only be understood in view of their rela,- tion to the balance sheet accounts. The Revenue account is credited with all sales of product, for revenue represents gross additions to the balance sheet equities. Expense accounts are charged with all commodities and services consumed because these expirations constitute subtractions from revenue. c. Transactions may occur which affect only the equities — the right-hand member of the fundamental equation. One equity may be increased and another decreased a like amount. The exchange of notes and accounts payable gives a simple illustration. The A. B. Co. gives its sixty-day note at six per cent for $1,000 to cover an open account in favor of Rankin & Co. of the same amount. The entries would accordingly be : Accounts Payable $1,000 (Rankin & Co.) Notes Payable |i,ooo This transaction involves a subtraction from one equity, accounts payable, of $1,000, and an equal addition to another equity, notes payable. In each case it is Rankin & Co. that has the claim against the A. B. Co., but this claim now is represented by a promissory note instead of by a book account. Such transactions are of quite common occurrence — par- ticularly in the case of incorporated enterprises.^ A large number of the transfer entries made in the process of closing the accounts fall under this head. It will be desirable to postpone 1 The refunding of securities ; the division of surplus into a variety of forms (such as the declaration of dividends) ; the exchange of securities for other equities {e.g. the funding of a floating debt of general creditors' accounts into bonds or other securities) : all these operations involve merely the exchange of equities, and do not affect the asset accounts. 74 PRINCIPLES OF ACCOUNTING the discussion of further illustrations until later chapters, how- ever, since such transactions are largely restricted to the period of closing and to the corporate form of organization. d. A great many business happenings represent combinations of the above types of transactions. Examples 1. A machine which cost $200, and has been carried on the books at that figure, is sold for $150. This transaction involves an addition to assets of $150, a subtraction from revenue of $50 and a reduction in assets of $200. The entries, therefore, would be as follows : Cash $150 Expense 50 Equipment $2cx3 2. The firm buys supplies from Rankin & Co. amounting to $400. In making payment the firm transfers to Rankin & Co. an account which it holds against H. A. Wilcox, $50, gives its thirty-day note at six per cent for $100, and pays the balance in cash. In this transaction one asset, cash, is decreased $250, another asset, accounts receivable, is reduced by $50, an equity, notes payable, is increased $100, and an asset, suppHes, is re- ceived amounting to $400. The entries would be : Supplies $400 Cash $250 Notes Payable 100 Accounts Receivable 50 (H. A. Wilcox) Although such transactions may be quite complex no new prin- ciples of analysis are required for such cases. All possible transactions are covered by the above classifica- tion. An appUcation of this analysis to other transactions will be made in succeeding chapters. It should be emphasized again that journalizing represents a highly important step in interpre- tation, for this is the process which classifies transactions into debit and credit entries. ANALYSIS AND RECORDING OF TRANSACTIONS 75 POSTING The process of transferring items from the journal to the ledger is known as posting. It is purely a clerical matter. Once a transaction has been journalized the debit and credit classifica- tion is made. Posting, then, consists simply in the allocation of all debits as indicated by the journal to the left-hand column of the proper ledger accounts and all credits to the right-hand column of the proper accounts. For an illustration of the process of posting it will be conven- ient to refer to the Cash account shown on page 62. The first credit entry, $600, under date of January 2, was posted from page 3 of the journal (as indicated by the J3). The original entry which, it may be assumed, corresponds to this posting is shown in the section of a journal page on page 60. The figure 7 ap- pearing in the column at the left of the journal page indicates the ledger page on which is found the Cash account. The $600 item in the debit journal column is posted to the debit side of the Mate- rials account which is found on ledger page 28. The ledger pages noted in the journal and the journal pages listed concur- rently in the ledger accounts serve as a check for the bookkeeper to indicate which transactions have been posted and to correlate the two books for future reference. In connection with controlling accounts such as Accounts Payable and Accounts Receivable the amounts affected must be posted twice — first to the controlling account, and second to the special creditor's or customer's account as the case may be. In the last transaction shown above, for example. Accounts Receivable was credited with I50. In posting this transaction it would be necessary not only to enter an item of $50 in the right-hand column of Accounts Receivable — the controlling account, but to carry the same amount to the credit of the H. A. Wilcox account. This is an apparent exception to the prin- ciple that in every transaction the debit entries involved equal the credit entries. In reality it is no such exception ; for this situation simply means that certain information is posted in dupli- cate. The labor of posting in such cases is very much reduced by the use of the special-column journal. • If all the transactions are correctly posted the ledger columns 76 PRINCIPLES OF ACCOUNTING exactly represent the debit and credit classification of the journal, and the total of all debit items equals the total of all credit en- tries. In other words the opposite columns of the ledger are in balance. This applies only to the general ledger, for obviously if any journal item is posted to two ledgers the equality of col- umns — including both books — is not maintained. Where the journal is of the simple form described in this chap- ter — having but two columns', one for debits and one for credits — posting is obviously a tedious process. Each entry must be taken separately ; for every debit in the journal there must be a debit item posted to some ledger account, and for every credit journal entry there must be a separate credit posting. And where controlling accounts are used there are two debits or two credits as the case may be. To reduce the clerical work involved in this process is one of the main reasons for the development of the technique of bookkeeping, and some very ingenious special forms have been devised to eliminate a part of this clerical labor. In the following chapter the way in which the process of posting can be abridged by the use of special forms will be explained. V Developments in Technique The simple forms of journal and ledger described in the last chapter have been supplemented in large measure by improved types of records. These "books are not sufficiently specialized to cover the various phases of a large business and to allow a large staff of bookkeepers to work on them. Further, the process of posting from the simple journal is laborious and much time and effort may be saved by the newer forms. These develop- ments in the technique of double-entry do not in any way change the principles of debit and credit already explained. All trans- actions must be recorded in some form of record and analyzed into d6bit and credit items, and a tabulation must finally be made of the debits and credits by ledger accounts. The detail process of effecting these purposes, however, may vary according to the conditions within the enterprise. Some of the more common of the modern forms will be described in this chapter. the special-column journal A very simple modification of the older type of journal, but one which effects a great saving in the labor of posting, is the special- column journal. In such a journal the debit and credit columns of the simple journal are subdivided and headed with the names of special accounts. The items in these special columns are posted in total rather than individually. Cash, for example, is an account which is debited and credited frequently in connec- tion with current transactions. The posting process may be abridged through the use of two special colunms for this account — ■ one for debit entries, and one for credit entries. Two post- ings will then serve to transfer all the cash entries to the ledger. This in brief is the principle of the special-column journal. The following illustration of one type of special-column journal shows the method of entry and of posting.'^ ' Explanations follow the entries for the first two transactions but are omitted thereafter. The student can readily assume transactions which might give rise to the remaining entries. 77 78 PRINCIPLES OF ACCOUNTING W 3 u ^; < "i5 , H c a u ;zf M >-) <; p u m o U U2 Q Ocd B^ti S T3 O 3 ^ I — » [« So M 3 PL, o O '^ F-i a s (-1 3 .a In > ■a o o a tn ►^ O a o >> >> >> o n H Q . b ^ H tj S M ri DEVELOPMENTS IN TECHNIQUE 79 i-l o O AX 1 s, Ac- counts Receiv- able 00 \0 CO -^ lO HI H M LO S lo O O >-. to do z 1 o o O O s IS ^ Si J f rg^i s^ h U hS J? % O Ot^ U H U fiH OTjfa 00 MD vo vO M CO |J(^ >> ^-^^ '^> » >> >>> >°o »^ >> §3 in Q O lo O O Kl lO M IN oo" CO CO CO CO n o O o o ro "O CO O lo O M O M d" "o" VO H S s 8 8 Ac- counts Receiv- able i^ o to H ?0 ^ o o o_ 8o PRINCIPLES OF ACCOUNTING 1^ o o ill O « o >o t^ N d Ac- counts Receiv- able O lo v^ s M in H >o •^ O. IT, H oo M en q n n ^ lO m m lO 8 8 M oooooooo OOUOOOOO ^;sS ^o 1 1 - -^S P^f^-^ 3 3 111 e^-d ^^i 1 |-i -S^sl -ajis ^|m ^^o \0 lO O C^ IN oO CO lO lo ^ CO Th 8 M < "o o s O O in Ac- counts Receiv- able 41 8 a o O DEVELOPMENTS IN TECHNIQUE 8i Special debit columns are maintained in this illustration for Cash, Merchandise, Accounts Receivable and Accounts Payable, and special credit columns for Cash, Sales, Accounts Re- ceivable and Accounts Payable. Whenever a transaction re- quires an entry to one of these accounts, the amount is entered in the appropriate special column. When entries must be made to other accounts, the amount is entered in the "sundries" debit, or " sundries " credit column as the case may be. These columns are posted item by item in the manner described in the preceding chapter. An explanation of a few of the illustrative entries shown above will serve to explain the nature and use of this journal. The first pair of entries shows the investment of $40,000 cash in a business by the proprietor ; consequently there is a debit to Cash and a credit to the proprietor's account. The debit item is en- tered in the cash column. A check mark is immediately placed in the ledger-folio column to serve as a reminder to the book- keeper that this item will not be posted separately. A special column is not maintained for credits to the proprietor's account ; therefore the entry for this part of the transaction is made in the sundries credit column and no check mark is placed in the ledger- folio column. This entry will be posted separately and the ledger page on which is found the proprietor's account will be entered in the folio column. In the second transaction debits are made to two accounts for which special columns are not maintained. The debit amounts involved, real estate $15,000 and building $20,000, are placed in the sundries debit column and are posted to the ledger accounts affected separately. The credit to Cash, $35,000, is entered in the special credit column for Cash and a check mark is placed in the ledger-folio column as before. The third entry records the purchase of merchandise amount- ing to $6,000 on account. Both the debit and credit items for this transaction are entered in special columns and check marks are placed in the ledger-folio columns. Had this purchase been made for cash the debit item would have been handled in the same way but the credit entry would have been listed in the cash credit column. All entries are made according to the method shown in these 82 PRINCIPLES OF ACCOUNTING transactions. The columns reserved for sundries are used for making entries affecting accounts for which special columns are not maintained and the items in these columns are posted sepa- rately. All other entries are listed in the appropriate special columns. The total of each special column is carried forward to the end of the period covered by each posting — a month in this case, it may be assumed. For example, the total of the ' cash debit column, $47,485, is brought over to the sundries column and from there is posted to the ledger just as is any other sundry item. This one posting carries all of the items in the column for cash debits to the ledger in one sum. The operation of posting the remaining special columns is similar. That this form of journal effects a great saving in posting is evident even from the above simple illustration. The total num- ber of entries made in special columns is thirty-nine, while the number of postings from these columns is eight, making a saving of thirty-one postings. Since the ledger accounts show just as much information as they would if the simple journal were used, this may be considered a net saving. In the case of an enterprise where the entries run into the hundreds per day, the cost of keep- ing books would be very materially reduced by such a method. The extent to which the special-column principle may be carried is practically unlimited. There could be special columns in the journal for each ledger account. In this case the postings would be made in totals to all accounts. Such a procedure would be inadvisable, however, as there are some accounts in which only one or two entries at the most are made in a single period. The use of special columns for such accounts would not only fail to save work in posting but would make necessary the use of an unduly large book, which in the end would actually increase the work of the bookkeeper. The possibility for labor saving is often dependent upon the use of controlling accounts and subsidiary ledgers. The general significance of the controlling account was explained in the last chapter and in the journal above this principle is illustrated for Accounts Receivable and Accounts Payable. The total amount receivable on customers' accounts constitutes one distinct asset item for balance sheet purposes. The amount due from an DEVELOPMENTS IN TECHNIQUE 83 individual customer is of little importance in the presentation of a statement showing a firm's financial condition. It is the sum- mary of all the customers' accounts that is significant. It is obvious that for other purposes, however, a knowledge of the amounts due from individual customers must be available. In order to serve both of these purposes the controlling account is used. That is, an account is kept in the general ledger called "Accounts Receivable" in which the debits and credits to all customers are entered. In addition to this a special ledger called the customers' or sales ledger is used in which a separate account with each customer is kept. The general ledger account is used for obtaining the information for financial statements while the customers' ledger is used for the detailed information concerning each customer's account. This procedure necessitates the enter- ing of tne same information in duplicate. A saving is effected by placing all debits and credits to the controlling account in special columns in the journal and posting in total from these columns to the general ledger account. Two postings to the controlling account are all that are required for each accounting period. The separate amounts must be posted to the customers' ledger in order that each individual's account will always show the balance due. There are various methods used in practice in making these postings. In the illustration given, two ledger- folio columns are employed, one for general ledger postings, the other for subsidiary ledger postings. Take, for example, the entries under date of January 5th. On this date J. R. Kerwin purchased goods amounting to $50 on account. This transaction requires a debit to Accounts Receivable in the general ledger and an item of $50 is entered in the accounts receivable debit column. An entry of $50 must also be made to J. R. Kerwin's account in the customer's ledger. J. R. Kerwin's name is entered on the line used for the name of the account to be debited. At the time for posting, the $50 item is posted to his account in the customers' ledger and the ledger page is entered in the ledger- folio column reserved for subsidiary ledger entries. A great many improvements have been made in the customers' ledger which have simplified the process of posting to that book. In fact systems have been devised which eliminate this work altogether. 84 PRINCIPLES OF ACCOUNTING A discussion of these methods will be deferred to a later section of this chapter, however. What has been said with regard to customers' accounts may be appHed in principle to the creditors' accounts. In this case the general ledger account is called " Accounts Payable" ; the subsidiary ledger is called the creditors' or purchase ledger. In fact the controlUng account device may be used wherever sum- mary information is desired for one purpose and detailed infor- mation for another. In a complex system of accounts for a large enterprise practically every general ledger account controls a subsidiary ledger. In the special-column journal of the above illustration the entries were made in the conventional form described in Chapter IV. That is, the debit account was written on one line and the credit account was placed on the next hne sUghtly indented to the right. The entries for cash sales, for example, were made in this form : so Cash Sales SO In actual practice a bookkeeper shortens the entry, writing it as follows : so Cash Sales 50 The $50 item at the left is entered in the cash debit column ; that at the right is listed in the sales column. Since both en- tries are recorded in special columns, one line may be used as just explained without causing confusion. Many bookkeepers who have become adept in the use of special-column journals find it convenient to place all special-column entries for one day's business on a single Hne. One case is known in which a book- keeper made all the journal entries for a month on one page. He had made a wise choice of special columns and had been able to place most of his entries for each day on a single line. Of course when this policy is pursued it is essential that all original documents such as sales memoranda should be kept in a con- venient file for reference. DEVELOPMENTS IN TECHNIQUE 85 THE CASH BOOK Another device for simplifying the work of the bookkeeper consists in the use of specialized journals. Each special journal is used for the recording of entries resulting from a single type of transaction such as cash receipts and disbursements, sales, and purchases. The cash book, as is suggested by its title, is used for recording all entries affecting cash. Transactions for which either a debit or credit to Cash is required are entered in this journal, and no other. This book may be used in a system of journals consisting of an old style journal and cash book, a special-coliman journal and cash book, or several books of original entry such as purchase book, sales book, ordinary jour- nal, etc., including the cash book. The construction of the cash book is not primarily dependent upon the types of journals used for other original entries and may therefore be discussed inde- pendently. The illustration on pages 86 and 87 will serve as a basis for this discussion. The left-hand page is a complete journal for all transactions recognizing the receipt of cash, while the right-hand page is a complete journal for all transactions involving disbursements. Except for the fact that only cash transactions are entered, the cash book is the same in principle as the special-column journal. The entries are made in much the same manner and the process of posting is essentially the same. For example, whenever cash is received, the amount received is entered in the cash debit column on the left-hand page and the credit item is entered in the appropriate credit column on the same page. If the credit entry is to some account for which a special column is kept, for example. Accounts Receivable or Sales, the amount involved is entered in the column headed by the name of the appropriate account and a check mark is placed in the ledger-foho column opposite the entry. If the credit is to an account such as Capital Stock the amount is entered in the sundries credit column. The items in this column are posted separately. The same things may be said of the right-hand page, except that this side is used for recording cash payments. Credits to the Cash account are en- tered in the cash column and the corresponding debits are placed either in one of the special columns or in the sundries debit column. 86 PRINCIPLES OF ACCOUNTING O O O "N OS o o o w °- 9, 0 U-J LO ^o P (S U-) ffl g 1 ^" \0 C30 0\ lO M \0 1 COh-llJ^ M CS hJfi4 ">>>">>»'^ "'>>>> ■*'"° > Mco'J ■<^ M N W C-l 00 Id 10 10 c^ -^ M W lr> < CO M vO COUNTS YABLE Dr. 00 00 00 00 >o 00 lO <^ 8 85 II 00 00 \0 ro « tn B . tjr 0000>oi^000(N0000000 Ov M ,1" 10 10 10 ^ c^ t^vo OcoOOOOOHOO M H cicf c^u^M.* -N MC>l^fOH(OOlO c^ M cO>>>>>>^ ^>>>>>>> (N Tf-OO M (N _^ 1 M M H CN rO ^ 1 WfO u-)^OCOC3nO'n rO'OO ■^'OOO H MW MM(N INWW 1 xi 1 r^ tXH 88 PRINCIPLES OF ACCOUNTING It will be noticed that a discount debit column appears on the left-hand page and a discount credit column on the right-hand page. These columns are used to simplify the recording of cash discounts on customers' and creditors' accounts respectively. The transactions which give rise to the cash discount accounts were explained in Chapter IV. An illustration, however, will be needed at this point to make clear the necessity for the special discount columns in the cash book. A bill of goods is sold on February loth at an invoice price of $300, with an allowance of two per cent if settled in ten days. The firm making the sale would charge the customer with the amount of invoice on Feb- ruary loth, making the following entries : Accounts Receivable $300 Sales $300 If the customer takes his discount on February 20th the actual cash received is $294, and this amount is accepted in full settle- ment of the amount originally charged to Accounts Receivable. The necessary journal entries to recognize this situation on the books would be : Cash $294 Sales Discounts 6 Accounts Receivable $300 Since these entries represent essentially a cash transaction, pro- vision should be made in the cash book for the complete entry. This is accomplished by the use of a special column on the re- ceipts side headed " Sales Discounts Dr. " The actual amount of cash received is entered in the cash debit column, the discount in the discount column and the credit to Accounts Receivable in the accounts receivable column, and since all items are entered in special columns, a check mark is placed in the ledger-folio column opposite the entry. The discount column on the disbursements side is for purchase discounts. The entry on February 15th illustrates the use of this column. It may be assumed that on January isth the firm purchased materials at an invoice price of $1,000 with an allow- ance of two per cent for payment within thirty days. The entries would be : DEVELOPMENTS IN TECHNIQUE 89 Materials $1,000 Accounts Payable |i,ooo Then on February 15 th when payment is made, the journal entries would be : Accounts Payable $1,000 Cash $980 Purchase Discounts 20 These latter entries must be made on the disbursements side of the cash book, and a special column should be provided for the credit to Purchase Discounts. If the cash book were used, how- ever, entries covering this case would be made by placing the cash payment in the cash credit column, the discount in the dis- counts credit colimm, and the sum of the two in the accounts payable debit column. One line is usually suflEicient for recording a complete trans- action in the cash book. On the receipts side all debit entries are placed in special columns ; no occasion arises for the use of a sundries debit column ; and hence there is no need of naming the accounts to be debited as the fact that the transaction is entered in the receipts side means that Cash (or Cash and Sales Discounts) is debited. The name of the account to be credited must be stated, however, and this is placed in the colunm headed " Accounts to be credited." On February ist, for example, the name Capi- tal Stock was entered in this column, and an item of $20,000 on the same line in the sundries credit column. This means that $20,000 must be posted to the credit of Capital Stock. The same amount is, of course, also entered in the cash debit column. Thus the entries for the complete transaction are made on a single line. The same thing is true of the disbursements side except that here the credit entries are always made in the cash credit column (and discount credit column where necessary), and the name of the account to be debited is placed in the proper coltunn on the same line. The column totals are posted in a manner similar to the process described for the special-column journal. Postings to subsidiary ledgers are also made in much the same manner. The name of the customer's account to be credited for a cash receipt, for ex- 90 PRINCIPLES OF ACCOUNTING ample, is enteredin thecolumn headed "Accounts to be credited." A check mark is placed in the general ledger-folio column, as the posting to the controlling account will be made in column total. When the proper amount is posted to the credit of the individual customer's account the number of the ledger page is placed in the subsidiary ledger-folio column. As a final consideration, mention should be made of the possi- bility of using the cash columns in place of a cash account in the general ledger. It will readily be seen that, since all cash receipts are entered in the cash debit column and all cash payments in the cash credit column, these two columns contain all the infor- mation usually given in a cash account except the opening bal- ance. This figure may be placed on the receipts side on the first day of each period following the closing of the accounts and the closing balance on the disbursements side immediately preceding the closing of the accounts. When this is done, no cash account is kept in the general ledger. The process of closing accounts will be fully discussed in a later chapter. THE SALES BOOK Sales transactions constitute another distinct phase of the business and therefore usually form the basis for another special- ized journal. Like the cash book, this journal as generally con- structed is in the nature of a special-column journal, the entries in this case being limited to credit sale transactions. The table on page 91 is an illustration of a typical sales book page. There are two debit and three credit columns in this sales book. The debits for sales transactions will generally be made to Ac- counts Receivable since most sales are on open book account. One debit column is therefore maintained for Accounts Receiv- able. A sundries debit column is used for debits to the accounts involved when the sale is not made on open book account. The sales on February 15th and 20th, for example, were made for promissory notes. The debit in each case was to Notes Re- ceivable and was entered in the sundries column. The items in the sundries column are posted separately, the other columns are posted in total. DEVELOPMENTS IN TECHNIQUE 91 Feb. V 36 Name of Account TO v~i Debited J. B. Crane A. B. Woods J. E. Parker A. M. Spencer Bennet and Co. McGuire Supply Co. Notes Receivable L. M. Hayes Notes Receivable Fred J. Jevons Kane Webster & Co. J. B. Crane L. N. Keller Carter and Watt A. K. Rawlins Ellis Baker & Co. K. V. Harvey Albert Peters Co. Accounts Receivable Dr. Sales Dept. A Cr. Sales Dept. B Cr. Sales Dept. C Cr. Explanation Inv. I Terras 5-30 Inv. 2 Terms 2-10 Inv. 3 Terms 1-30 Inv. 4 Terms 2-10 Inv. 5 Terms 1-30 Chicago Inv. 6 n-60 R. M.Jones & Co. for Inv. 7 Inv. 8 Terms n-30 M. A. Pierson on Inv. 9 Inv. 10 Terms 2-10 Inv. II Terms 2-30 Inv. 12 Terms 3-30 Inv. 13 Terms 2-10 Inv. 14 Terms 1-30 Inv. 15 Terras n-30 Inv. 16 Terms 2-30 Inv. 17 Terms 1-30 Inv. 18 Terms n-30 Total of column Total of column Total of column Total of column Ac Sun- COUNTS Sales Sales Sales dries Receiv- Dept. A Dept. I Dept. C Dr. able Dr. Cr. Cr. Cr. 240 130 no ISO 120 30 21S 35 180 7S 30 45 2IS 100 75 40 I7S 17s 235 125 70 IS 35 10 130 100 1 8s 38s 2S6 195 360 160 22s 7S 215 135 no 210 I2S 75 25 IIS IS 25 76 50 120 31 I2C 45 35 100 60 95 25 55 100 31S 100 10 95 59 3.201 1,241 966 = = 1. 414 Cash sale transactions are not recorded in this book. Such transactions must be entered in the cash book an}rway if the cash columns are used for a cash account. A sales column (or col- umns) on the receipts side of the cash book makes the posting of the credit sales entries very simple. To enter such transactions in the sales book also would entail needless duplication. It is sometimes urged that the sales book should include cash sales so that the total of all sales may be in one place. This information can be readily ascertained, however, by adding the cash book and sales book figures together or by reference to the Sales account after both journals have been posted. The three credit columns are for the sales accounts for the three h3^othetical departments of this business. Departmental sales accounts are of importance for comparative purposes. Often a separate sales organization is maintained for each of the different departments and in such cases these accounts serve to inform the manager of results attained by the departmental heads. In any case a knowledge of the sales by departments is of importance for managerial purposes. 92 PRINCIPLES OF ACCOUNTING The posting process is the same as for the other journals al- ready described. Special columns are posted in total with ledger pages entered in the appropriate column. The customers' ledger pages are entered in the second ledger-folio column. THE PURCHASE BOOK This book is kept for the purpose of recording the same kind of information in regard to purchases as the sales book shows for sales. The form of a purchase book is essentially the same as that of a sales book except that the debits are to materials or merchandise accounts and the credits mainly to Accounts Payable instead of Accounts Receivable and Sales respectively as for the latter. A page from a purchase book might appear somewhat as follows : — Ac- Mer- Mer- Mer- Date L F s L F Name or Account TO BE Credited Explanation Sun- dries Ch. counts Pay- able chan- dise Deft. chan- dise Dept. chan- dise Dept. V 6 Cr. A. Dr. B. Dr. C. Dr. Feb. I The Davenport Inv. I Terms 2-10 215 100 IS 100 Mfg. Co. 3 V 8 The Iowa SupplyCo. Inv. 2 Terms 2-10 36s 31S so 1 4 V lo The Detroit Ma- chine Co. Inv. 3 i-3o/n-6o 22s 200 25 / S V 5 Grand Rapids Furn. Co. Inv. 4 Terms 1-30 19s 95 2S 75 9 V 17 Barnes Desk Co. Inv. 5 Terms 2-30 3,200 1,980 20 1,200 12 V 32 Muskegon Furniture Co. . Inv. 6 1-30 1.295 89s 400 IS V 19 Marshall Table Mfg. Co. Inv. 7 Terms 2-10 98s 36s 20 600 19 V 45 Smith and Black Inv. 8 Terms 5-30 876 676 I2S 75 21 V 66 Fetter Lamp Co. Inv. 9 Terms 2-10 72s 72s 22 V 71 Grand Haven Piano Co. Inv. 10 Terms 1-30 350 300 15 35 23 12 V Notes Payable Rochester Glass Co. 6% note 250 SO 75 125 24 V 6 Davenport Mfg. Co. Inv. 12 Terms 1-30 225 75 IS 135 25 V 25 Mallock Hastings & Co. Inv. 13 Terms n-30 3SO 350 28 V 23 Shaw Supply Co. Inv. 14 Terms 2-10 215 100 10 105 V 32 Electric Iron Co. Inv. IS Terms 2-10 160 80 40 40 25 35 Marshall and Field Accounts Payable Cr. Merchandise Dept. Inv. 16 Terms 1-30 Total of column 75 15 60 - 9,4S6 i6 Total of column 5,971 A Dr. 19 Merchandise Dept. B Dr. Total of column 1,220 21 Merchandise Dept. C Dr. Total of column 2,515 DEVELOPMENTS IN TECHNIQUE 93 All purchases of merchandise except those for which cash is im- mediately paid, are entered in this book. Cash purchases like cash sales are entered in the cash book, and to enter these transactions again in the purchase book would in- volve needless duplication. The form of entry is the same as for the sales book. There are two ledger-foHo columns, one for general ledger pages and one for the creditors' ledger pages. The first money column is for sundry items and is used to show the amounts credited to accounts for which no special credit columns are kept. In this case the only special credit column is for Accounts Payable, and, as most purchases are made on open book account, most of the entries are made in this column. The only sundries column entry in the illustration was for the transaction on February 23rd when a note was given for the purchase of $250 worth of merchandise. This amount was credited to Notes Payable through the sundries column. The remaining three columns are for debits to the merchandise accounts. Three merchandise accounts are shown for the three departments of the business corresponding to the sales ac- counts as shown above. It is customary to limit the purchase book to entries recording the purchases of merchandise (or of materials in the case of a manufacturing enterprise) but other items such as labor and suppUes could be charged here if special columns were kept for that purpose. The process of posting is essentially the same as from the sales book. THE VOUCHERS PAYABLE REGISTER The charters or by-laws of a great many corporations provide for the incurring of liabiUties and the payment of the same only on written authorizations of certain officers. When this provi- sion obtains, it means that payments may be made only to cancel obligations which have already been recognized as liabilities. Stated in another way it means that all purchases — from the viewpoint of the bookkeeper — are made on open account. Furthermore it is customary for corporations to make settle- ments of creditors' accounts within the allowed discount period for each invoice. These facts make the purchase book of ex- ceptional importance and make possible its use for other pur- 94 PRINCIPLES OF ACCOUNTING poses than those mentioned in the preceding section. This is usually accomplished through the substitution of what is called a vouchers payable register for the purchase book. A detailed description of a vouchers payable register can best be made on the basis of the illustration of a page from such a book shown on page 95. The first column after the date in this book is headed "Voucher No." This refers to the number of the voucher on which the authorization of the proper official is placed. Immediately upon receipt of an invoice from any creditor, the bookkeeper makes out a voucher covering the invoice and sends it to the proper official for his signature. As soon as the voucher is signed, it is entered in the vouchers payable register. Each voucher is given a num- ber. The voucher itself is then placed in a file for unpaid vouch- ers where it is kept until paid. On the date of payment it is removed from this file ; the treasurer is instructed to draw a check for the amount ; after which the voucher is placed in another file for vouchers paid. This same routine is followed no matter how short the time between receiving the bill and the making of pay- ment. Even the entries for so-called cash transactions are handled according to this procedure. In the series of columns which follow the voucher number column, the name of the party to whom the voucher is payable, the address and a statement of the purpose are entered to further describe the voucher. Entries are made in the columns headed "When and How Paid" at the date of payment. The unpaid voucher file constitutes the creditors' ledger and no other credi- tors' accounts are kept. This saves all the posting to the credi- tors' ledger usually required from the ordinary purchase book. All of the remaining columns are for journal purposes. The first money column is headed "Vouchers Payable Cr." The total amount of every voucher is entered in this column. This recognizes the indebtedness of the corporation on each voucher at the time it is properly signed. It might be called the accounts payable credit column. The series of columns immediately following this one are for the accounts to be debited. Special columns are kept in this case for three departments of merchan- dise, and for Labor, Advertising, Fuel, Freight, and General Ad- ministrative Expense. The " Sundry Accounts Dr." column is DEVELOPMENTS IN TECHNIQUE 95 ►Jfc< 1 \o 00 m en Rent Notes Payable Furniture and Fixtures ijunoray K 1 8 sasNadxa aAixvBx -simwav iv^aNao 2 8 IHOlaHJ g f- r^ ^ Fuel Dr. O «3 ro I>- ONISIiHSACIV Q 8 8 "^ Hoav-i g :- 8 8 a co' ^ 3 -ijaa «■ 8 8 J^ sg a -Maa « •asoM n lo o O u^ O r,-^ •asQH O " ! 1- 00_ 00 aiavAVj pj saaHOQOA O >o vo O lo Q Q M CO H 00 t^ « 5 o (^00 H lo 3 OVCOt^M_C1CO •* W 00' ■t II dl \0 « -o »o « t^ t- M « lOO t- OO Ov O 1 00 OO OO 00 00 00 00 2-12-18 2-18-18 2-20-18 2-19-18 3- 4-18 2-26-18 ^-26-18 fa Rent Merchandise Coal Week's Payroll Note Pay. # 8 Merchandise Furniture and Fix- tures Merchandise Merchandise Merchandise Week's Payroll Adv. BooUets Week's Payroll Freight Fuel Stationery Week's Payroll Gen'l Office Ex. i < City Davenport, la. City City City Imlay City Muskegon, Mich. Redville, Ind. Richland, N. Y. Chicago, 111. New York City Detroit, Mich. City City § 5 G. H. Langley The Davenport Mfg.Co. Ajax Coal Co. Paymaster First National Bank Imlay Utilities Co. Muskegon Furniture Co. Marshall Iron Co. Smith and Black F. E. Caimes Paymaster Economy Advertiser Paymaster M. C. R. R. Ajax Coal Co. Bartlett Supply Co. Paymaster Cashier •ON HaHOQOA ! M w (O .d- V)0 t^ 00 a* w M ro -+ mo t^oO 1 M cn lOCO OV .£1 W I- 0> fO 00 96 PRINCIPLES OF ACCOUNTING placed at the extreme right of the page. Here there is one space for the amount, one for the name of the account to be debited, and one for the ledger folio. A slightly different method of posting the column totals is shown here. Instead of carrying the total of each special column over to the sundry column for posting so that the ledger page can be entered in the ledger-f oUo column, the posting is made directly from the column total and the ledger page is placed just below the total in parentheses, thus, (41) . This procedure has the advan- tage of economizing space especially when several special columns are used. When the vouchers payable register is used, the disbursements side of the cash book can be very greatly simplified. Since every payment must be made on an authorized voucher, the debit for every payment must be to the Vouchers Payable account. Three columns then are sufficient, vouchers payable debit, discount credit, and cash credit. SPECIALIZED LEDGERS So far the illustrations of technical improvements have been concerned primarily with journal rulings. More progress has been made in simplifying the books of original entry than those of account, but some of the modifications in the ledger are of suffi- cient importance to bear mention in this connection. In prac- tice the general ledger accounts are usually kept in the form shown in the last chapter. Sometimes, however, the arrangement of the columns is changed so that the debit and credit money col- umns are adjacent and a third column is added for the purpose of showing the balance continuously. Again, the ledger is often kept in a loose-leaf binder in order to keep the active accounts in compact form without carrying the dead or inactive accounts. The general ledger usually contains a great many controlling ac- counts supported by subsidiary ledgers. In fact in the case of a large corporation nearly every general ledger account controls some subsidiary ledger. In the case of a manufacturing company, for instance, the Buildings and Equipment accounts are supported by building and equiprtient ledgers having detailed records of separate buildings, units of machinery, and equipment. The DEVELOPMENTS IN TECHNIQUE 97 manufacturing and sales expense accounts are supported by factory cost ledgers, etc. These are detail questions which pre- sent themselves more particularly in the designing of systems of records for specific firms and generahzations of importance cannot well be made. The customers' ledger is common to most enter- prises, however, and a brief discussion of modern developments in this book is given here. In the retail merchandise business one form of customers' ledger has been almost universally adopted. This may be called the slip system, although the specific system in any case usually bears the name of the manufacturer who produces the ledger forms. The salesman makes out a detail sKp in duplicate or triplicate at the time of making a sale for credit. This sHp gives the name of the customer and specifies the articles sold and the amount of the bill. One copy is given to the customer and one is kept for ledger purposes. All of these credit sales slips are added up at the end of each day and one journal entry is made covering all credit sales. This entry of course would be made either in the special-column journal or sales book (whichever is used). The slips are then filed by customers' names, and the file constitutes the customers' ledger. This procedure saves all the time required to post from the sales book to customers' ac- counts. When the customer pays his account he is given a receipt which is also made out in duplicate. The duplicate, after being used for making the cash book entry, is filed with the sales slips. This makes the record with each customer complete in the file . The same method in principle is often used by manufacturers. Here the invoice covering a sale of goods is made out in duplicate, ■the original being sent to the customer as an invoice and the duplicate retained for his account. These duplicate invoice sheets are first used for sales book entries and are then filed alpha- betically by customers' names. This file constitutes the custom- ers' ledger. The form of file depends on the form of invoice. In some cases the invoices are prepared to fit a loose-leaf binder. Again the dupHcate might be made on a card of convenient size for placing in a card file. Even the standard letter file might be used, although the looseness of such a system makes possible a great many errors which would not occur as frequently under one of the other methods. gS PRINCIPLES OF ACCOUNTING Local public utiKties such as gas, electric, water and telephone companies which bill their customers but once a month often have the sales book arranged in such form that it may also be used for a customers' ledger. The table on page 99 is an illustration of a page from such a combination sales book and customers' ledger for a gas company. This book is arranged in such a form that considerable statis- tical information in addition to sales and customers' accounts is available. In the first place the names of all customers are ar- ranged in a convenient order usually according to the meter readers' routes. This is done so that the index readings obtained from the meter readers' bbok may be copied in consecutive order. The reading from the previous month in each case is set down in the first index column and the reading for the current month is placed in the next column, and the difference between these two columns is Hsted in the column headed "Amount Consumed Cu. Ft." The total of the amount consumed column shows the total amount of gas actually sold. This figure is of considerable impor- tance to the plant manager. A meter at the plant registers the total amount produced and by comparing that figure with the amount registered by the customers' meters, he can determine the amount lost and unaccounted for. This figure of course he tries to keep as low as possible. The gross amount of each bill is shown in the next column. This is found by multiplying the rate by the amount consumed. The discount allowed for prompt payment of the bill is listed in the following column. The difference between the gross bill and the allowed discount is placed in the column headed "Net." The total of this column represents the total net sales for the- month and can be used for making the proper entries in the ledger — a debit to Accounts Receivable and a credit to Sales. This is the extent to which the book can be used for Journal pur- poses, the remaining columns being exclusively for ledger purposes. Any unpaid balances from the preceding month are carried to the column to the right of the net figure. The second customer in the illustration, John B. Campbell, failed to pay his December bill as shown by the fact that $3.10 is Hsted opposite his name in the column headed "Brought forward from December." The sum of the figures in the net and brought forward columns DEVELOPMENTS IN TECHNIQUE 99 i < Q >4 O o lo o o ro « ro OO 1 1 OOOO loiooo Qi^OOOOOO LO (NrOWCO LOroCJCS roCOCNrO (N^^co p H H M 1-1 H H H Brought For- ward FROM Decem- ber O 1^ LO o MM r^ OO & ro "N ro "N '^ 1 OOOOOOOOOOOOOOOOOO ^^ '? (NMtNrOMCOO^CN'NWCO'^'Ncr) CNTj-rO CO 08 "O r-^'OOO ^r-J>-^'O^Ooo m t^^r^M iom i-~- .j>-0 r^ O i^rOf^OOO r^H H O MsO^o f-*0000 "-OOO CO rOfO^'^Wt-Of^c^cocO'^^^^c^ "NLoro O o Q i 1— I 8 •rt-'NioOOCOOMOOiHOt-iO'NO'O'N d u->vO inoi corO^H Ttir^OO fOO'^oO r- C-O M M i O Tj-cO iOrOJ>-0^ LovOoO IOCS "JOOnvO w OoicOMM M00HrO"^]>* OOMro-^ C^ M Meter No. 00 iot--uoioO lOMDCO ■■ti^O r-oQvo ^or-oo u^ONOO 0\CO OOOOO^ lOOf^QO O-Of^OO C^ vOOO'O N rOf^O lOt-^MOOOO OCN (NOO CN (N M c/5c/3c/:)^^c/3c/:3^^^a)cA}CA)cA)c/}c/2c/:3a} lOo'lOlOOO lOO lOWOOOO (NCX)VOOO (N M ir> oo OOvI^O^O M ro^O^OM CI w rOH CI cooo iS Geo. B. Freeman John B. Campbell Arthur Wagner G. P. Giessiiig Jesse Berch John Smith Richard Snow WiUiam Harris Walter Maine Richard Schmitt Harold Dums Mrs. B. J. Snyder Raymond Locke R. M. Peterson L. D. Cairnes M. D. Ray K. N. Riess W^ Wilson Totals 6 M W rO'^lJ^'O r^OO oo t-" N co-ri-tOvO t-^OO lOO PRINCIPLES OF ACCOUNTING constitutes the debit to the customers' accounts for pa3rments made before the discount period expires. For payments made after this date the gross bill is charged instead of the net. Credits to the customers' accounts are made in the column headed "Paid." A space is provided to show the date and the amount of the payment. All payments made up to January 1 2th, the last discount date, are made at the net rate. If a cus- tomer fails to pay until after that date, the gross bill is paid. Richard Snow, for example, paid his bill on January 17th as shown by the entries in the paid column on the seventh line and the amount corresponds to the gross charge. The general ledger entries for cash receipts from customers are posted from the proper columns in the cash book. A duplicate receipt is retained by the company which is used first for the cash book entry and then for the customers' ledger. Finally on the last day of the month the amounts remaining unpaid are carried forward to the proper column in the Feb- ruary section. In the illustration three such amounts are shown on Hnes two, five and ten. A single Hne can be used for a customer's account throughout the year by placing the information for succeeding months in adjacent columns. This can be accomplished without making the book unduly large by the use of a system of large and small pages in a single binder. The columns for the customers' names and addresses and for the meter numbers can be placed on the left-hand side of a large page, then a sufficient number of smaller pages can be inserted for carrying the remaining columns grouped by months as was shown for January in the illustration. The edges of the smaller sheets would then come even with the meter number column. This method of treating customers' accounts for public utili- ties has been quite widely adopted by gas, electric, water, and telephone companies but it has certain disadvantages which have prevented its being used in many places. Its greatest labor saving feature depends on the permanency of its customers. The whole list of names is revised but once each year. New names are added at the end of the book and whenever a meter is removed for a customer his line in the ledger remains blank for the rest of the year. This is a very important consideration in DEVELOPMENTS IN TECHNIQUE lOI what may be called a transient community, where a great many meters are being removed and new ones set each month. In such cases it is much simpler to maintain a separate ledger page for each customer's account. The following is a page from the customers' ledger of a gas company which comes within this class. For Month Index Consumed Amount Net Back Bill Paid Date Discount Ending 000 1917 1917 Jan. .24 24 2.40 2.40 Feb. s Feb. 89 65 s-ss 6.50 Mar. 24 ■6S Mar. IIO 21 2.10 Apr. Apr. May May- June June July July Aug. Aug. Sept. Sept. Oct. Oct. Nov. Nov. Dec. 1918 Dec. Jan. 1918 Jan. Feb. For each customer one of these sheets is kept in a loose-leaf binder. The order of names in the ledger follows the route order of the meter readers. As new meters are set new sheets are in- serted in the proper place and as old meters are removed the customer's sheet is removed from the binder. This form of ledger makes its use for sales book purposes somewhat more awkward than the preceding one but it is used for this purpose nevertheless. As soon as all bills have been entered for the month an adding machine total of the charges to all customers' accounts is taken. This total is the basis for the debit to Accounts Receivable and the credit to Revenue. Thus a special sales book again is unnecessary. I02 PRINCIPLES OF ACCOUNTING The illustrations given in this chapter show the present tend- ency to abbreviate the accounting records and to simplify the work of the bookkeeper. In every type of business the forms of records are being constantly altered and unproved in various ways to decrease the detail work required. The illustrations can only be suggestive, however, since the actual records found in a given case should and do depend on the tj^e of business and the kinds of information desired. No particular system of journal and ledger forms could be universally adopted. VI The Asset Accounts Accounts were classified in Chapters II and III in terms of assets and equities, and the important phases, positive and nega- tive, of these balance sheet classes. This classification is of fun- damental importance in that it constitutes the skeleton of any system of accounts which should always be kept in mind in the process of analyzing transactions into debit and credit entries. Further division and analysis are necessary at this stage, however, if the student is to have an adequate understanding of the nature of the common accounts which are used in recording business data and the significance of the various transactions which may affect these accounts. In the present chapter the asset accounts will be considered in some detail. The nature and function of each of the important sub-groups will be explained ; and typical oc- currences which give rise to entries in these accounts will be dis- cussed. This discussion will serve to illustrate further the prin- ciples of journalizing. Some consideration will also be given to the problem of detail classification for managerial purposes. In Chapter VII the equity accounts will be further classified and explained. ACCOUNTS WITH EKED TANGIBLE ASSETS Among the assets perhaps the most important general dis- tinction is between fixed and current items. Several references to this classification have already been made, and in the following pages it will be necessary to return to this division, repeatedly. Fixed assets, in turn, may be divided into material and immaterial — or tangible and intangible — items. In this section the im- portant types of accounts with fixed tangible assets will be dis- cussed. 103 I04 PRINCIPLES OF ACCOUNTING In this group may be included all those accounts which repre- sent the more permanent types of material property. Land, buildings, and machinery are common examples of the fixed tan- gibles. These assets represent the durable equipment of the enterprise. This equipment is purchased to be used in opera- tion, not to be sold. Usually a large part of the capital of an enterprise is invested in such assets. For this reason, and be- cause such items present difficult problems in connection with valuations, the accounts with the fixed tangibles constitute the most important group of fixed asset accounts. The debit side of such accounts — as is the case with all asset accounts — is used in recording additions. These additions should not be thought of primarily in the physical sense. The data wi,th which accounting deals are values, measured in terms of the money unit. Additions to these assets, then, mean value additions ; and such increases in a particular case may be due either to the receipt of additional physical units, to the improve- ment of units already owned, or to an advance in prices which alters the value of units in use. All possible situations which give rise to charges to these accounts may be put under these three cases. Then debits to the Buildings account of the A. B. Co., for ex- ample, may represent any of the following facts : (i) the original purchase price or construction cost of the buildings owned by the enterprise (or the purchase price or construction cost of new buildings or additions) ; (2) the amount of an improvement ; (3) the increase in the value of the buildings due to price changes. Cases (2) and (3) require brief explanation. An improvement, in the accounting sense, is an increase in the value of an asset caused by a change in the physical structure of the asset. The replace- ment of a shingle roof with a more expensive slate roof is an il- lustration. The difference between the value of the old roof and that of the new is an addition to the value of the building, and hence properly represents a charge to the Buildings account. Increases in. value above cost which are not due to improvements are usually caused by an advance in the prices of labor and mate- rials either during the period of construction or after the building is finished. It should be noted, however, that it is seldom neces- sary to make specific debit entries in the Buildings account to THE ASSET ACCOUNTS 105 cover such increases. With the exception of land most tangible fixed assets decline in value as a result of operating conditions at a rate more than sufficient to offset any advance in purchase prices or construction costs. The actual rate of expiration, never- theless, varies because of these price changes ; and if such a vari- ation is taken into consideration in accounting for value declines this virtually means the recognition, in the accounts, of price advances. The policy of recognizing all value increases — from whatever source — as proper matters for accounting record assumes that it is the function of the property accounts to show continuously the actual value of the equipment owned in any case. The legitimacy of such an assumption cannot be conveniently dis- cussed at this point. This and other fundamental problems of valuation will be carefully considered in Chapter XX. For the present it will be taken for granted that every asset account should show present values as far as possible. Entries in the credit side of these accounts represent subtrac- tions. These subtractions may indicate either of two distinct happenings : (i) a credit entry may represent the sale or disposal of a specific unit or units of an asset ; or (2) a credit may repre- sent the value expiration of units still in use as a result of business operation and unfavorable price changes. In the case of a suc- cessful enterprise there is a sense in which the expiration of an asset due to the conditions of operation may be conceived as the sale of an asset, or the exchange of one asset for another ; for certainly the equipment which is consumed in the process of production is normally replaced from the proceeds of the sale of product. But, as was stated in Chapter III, entries covering the expirations of assets cannot conveniently be made concur- rently with the entries recording the additions to assets resulting from the sales of finished goods. Hence, as an important ac- counting consideration, the distinction between the two tj^es of subtractions from assets should be emphasized. Then credits to Buildings, for example, may represent either of the following facts : (i) the selling price of a new or second-hand building or buildings ; (2) the amount of the value expiration of a building or buildings during a given period (normal or abnormal depreciation). Each of these cases will be briefly discussed. io6 PRINCIPLES OF ACCOUNTING Since an enterprise seldom sells all or any part of its fixed equip- ment credits representing case (i) are of very infrequent occur- rence. When a particular building or other asset is scrapped, however, it commonly has some small salvage value, and the entry covering this amount represents, in a sense, the sale or dis- posal of a fixed asset. Other transfers also occasionally occur. A firm, for example, which owns several buildings and sites, may find it desirable to sell a parcel of its real estate even when the unit sold is in good physical condition. The second case of subtractions mentioned above is of much more common occurrence. As already explained, most of the items which make up a firm's fixed equipment are continuously depreciating. With the possible exception of land a "fixed" asset is not usually a permanent asset. The managements of business enterprises have sometimes ignored this obvious fact to their sorrow. Wear and tear from use and the action of the elements, or deterioration, is the most universal, and perhaps the most important, cause of depreciation. Obsolescence, or value decHne due to the fact that a certain type of equipment has been rendered out of date by new inventions and improvements, is another important cause of depreciation — in some cases the most significant. Price changes which lower purchase prices and construction costs, and general economic changes which render specific types of equipment inadequate for the purposes for which they were intended (such as a change in the character of railway traffic which compels a railroad company to substitute box cars for flats), are also factors responsible for large amounts of depreciation.^ It is the prevailing practice to use valuation accounts to show all subtractions from fixed assets which represent depreciation. These expirations are recognized only at intervals and are credited to valuation accounts, as explained in Chapter III, instead of being credited directly to the asset accounts. One reason for the use of these subsidiary accounts is the desire on the part of the management in any case to preserve original cost figures in the asset accounts. Further, it is sometimes urged that since ' No attempt will be made at this point to discuss the difficult problems of depreciation accounting. Chapters XXII and XXIII are devoted primarily to this topic. THE ASSET ACCOUNTS 107 the amount of the value expiration of a fixed asset which occurs in a given period is merely an estimate it is desirable to set up the estimated figure in a separate account. It is doubtful if either of these considerations deserves the stress that has been laid upon them by accountants, although they are matters of some importance. Cost figures are not always of great signifi- cance ; and in any case they can be determined from the books of original entry. And the mere fact that a figure is an estimate is hardly sufficient reason for setting it up in a special account. It is a fact sometimes overlooked that accounting deals, to an important extent, with estimates rather than certainties. Never- theless the use of valuation accounts in this connection is entirely rational ; and it is a practice which is likely to persist. It is unfortunate that these valuation accounts are usually called "reserves." The term reserve suggests surplus, and is actually appKed in practice to special surplus accounts. This nomenclature undoubtedly leads to considerable confusion in interpreting these accounts — even among those with some knowledge of accounting technique. The point should be emphasized here that these accounts are in no sense a part of any of the proprietary or other equity accounts. They belong rather to the fixed asset accounts. Each valuation ac- count must be read in connection with the corresponding asset account. If, for example, the Buildings account of a certain enterprise shows a debit balance of $10,000 and "Reserve for Depreciation of Buildings" shows a credit balance of $2,000, this means that the estimated value of the asset, buildings, is the difference between these two amounts, or $8,000. The two accounts, taken together, show the status of the asset. The term allowance, as already suggested, is a more suitable designation than reserve for the valuation account ; and this expression, for the sake of clearness, will be used throughout the text. To sum up, then, it appears that entries in the main accounts with tangible fixed assets are not of very frequent occurrence. The original costs and the amount of all improvements are charged to the property accounts, and all sales are credited to these accounts. All expirations, however, are usually credited to valuation accounts. Occasionally increases in value due to io8 PRINCIPLES OF ACCOUNTING price changes more than offset the expirations and must be taken into consideration. The following transactions illustrate the important cases dis- cussed above : 1. The A. B. Co. has contracted for an addition to its plant to cost $10,000. The work is finished and the contract price is paid in cash. The journal entries for this transaction (in siun- mary form) would be as follows : Buildings $10,000 Cash fiOjOoo The entries covering the purchase of an important unit of prop- erty would usually be much more detailed than the above. If the A. B. Co. constructed the addition itself a set of construction accounts would be needed. If the work were done by an outside firm payment would usually be made in installments. The entries given, however, show the final effect of the transaction upon the Buildings account. 2. The past year has seen a considerable growth in the popu- lation of the city, and as a result land in certain districts has risen in value. The value of the A. B. Co.'s site has appreciated $2,000. This situation would be recognized in the accounts by the following entries : Land $2,000 ' Surplus $2,000 The increase in land value recorded by these entries means a net increase in proprietorship since no expirations whatever are involved. Consequently the increase in ownership can be cred- ited directly to Surplus. Since the increase has occurred during the year it might be considered proper to credit the Net Revenue account with the amount. Such an item is not, however, a net revenue from operation in the strict sense; and in general it is desirable to use the Surplus account to reflect all speculative changes in the equities. The problem of appreciation and the ' This increase has no doubt occurred gradually during the accounting period. The charge to Land, then, can be conceived as a summary of a large number of small changes. THE ASSET ACCOUNTS 109 entries which should be made to show such value changes in the accounts will receive careful consideration later in the text. 3. It is estimated that the depreciation of the buildings of the A. B. Co. for one month amounts to $125. This transaction represents a subtraction from a fixed asset of $125 and an equal charge to Expense.^ The entries would be : Expense $125 Bvuldings $125 Or, if a valuation account were used, the transaction would be journalized as follows : Expense $125 Allowance for Depreciation of Buildings $125 It is important that the student grasp the ex^ct nature of this variation in the entries which represent such a situation. The charge to Expense is the same in each case ; but in the second pair of entries a credit to a valuation account is substituted for a credit to Buildings. The significance of the credit entry, how- ever, must be the same in both cases ; in either instance it rep- resents a subtraction from the value of the buildings. 4. A building of the A. B. Co. which has become unfit for further use is sold to a wrecking company for $3,000. The cost of this unit, it will be assumed, was $15,000. If depreciation has been correctly accounted for the Allowance for Depreciation of Buildings account should show at this time credits amounting to $12,000 applicable to this unit. Such accuracy in estimating depreciation is, of course, very unlikely ; but to simplify the il- lustration it will be assumed in this case that there have been credits to the valuation account for the exact amount of deprecia- tion. The entries representing the sale of the old building would then be as follows : Cash $ 3,000 Allowance for Depreciation of Buildings 12,000 Buildings $15,000 ' A special expense account might well be used here. The classification of expense accounts will be discussed in the next chapter. no PRINCIPLES OF ACCOUNTING The only actual happening here is the exchange of a building worth $3,000 for an equal anaount of cash. Since the property unit is entirely discarded, however, there is clearly no object in longer maintaining additions and subtractions in separate ac- counts. Accordingly the two accounts, Buildings and its sub- sidiary, are balanced as far as this particular unit of property is concerned. Transactions affecting the accounts with tangible fixed assets will, of course, differ very widely in practice as regards the con- crete circumstances involved. The cases discussed and journal- ized here, however, represent the principal types of ■ occurrences which require recognition ir\. these accounts. The student should now be able to analyze any possible transaction involving fixed tangibles as far as its effect upon the asset accounts is concerned. The classification of the equipment accounts for managerial pur- poses will be discussed in a later section of this chapter. ACCOUNTS WITH FIXED INTANGIBLES a. First will be considered under this head the group which includes any account with a right against — or an equity in — the assets of an individual or enterprise other than the firm on whose books such account appears. Rights which may be said to constitute fixed assets are commonly represented by such in- struments as long-term notes, mortgages, bonds, stocks and other securities. Obviously such assets, in themselves, are im- material items, since they exist as rights rather than as tangible objects ; but a right may consist in a lien upon specific tangible assets. A mortgage, or a bond based upon a mortgage, for ex- ample, usually represents a lien upon some part or all of the tan- gible equipment of an enterprise. A promissory note, on the other hand, ordinarily represents a claim against an enterprise itself — or a general claim against the assets of the enterprise — rather than a lien upon specific assets. A share of stock is an evidence of a right of ownership in an incorporated enterprise rather than a right to particular assets ; but such a security, nevertheless, also represents a residual general equity in the assets of the enter- prise, as was noted in Chapter II. THE ASSET ACCOUNTS iii In this connection the distinction between a right as an asset and the same right as an equity should be emphasized. A right in a specific enterprise, from the standpoint of that enterprise, is an equity, and would appear in the accounts as such. From the standpoint of the individual or firm possessing the right, the item is an asset — provided, of course, that the equity in question has any value. In other words, rights appear in accounting records under duplicate heads — equities in one case, assets in the other. This duplication is, evidently, not possible in the case of tangible assets. In interpreting transactions involving rights, therefore, it is necessary to keep definitely in mind the particular enterprise whose accounts are affected by these transactions. As regards length of life — or the time the asset remains in the business — long-term securities are often as "fixed" in char- acter as buildings and machinery. Nevertheless there is another line of distinction between fixed and current assets which should be considered. A current asset might be defined as any asset which can readily he converted into cash or an equivalent. A fixed asset would, accordingly, be an asset which could not be easily liquidated for its full value. From this standpoint securities and similar rights may be considered current assets ; for usually all such rights can be converted into cash with comparative ease. A classification of assets into fixed and current items on this basis is a matter of practical importance in cases where the pur- pose of the classification is the determination of the immediate financial condition of the enterprise. Length of life, as well as liquidity, however, .is an important general consideration to be observed in classifying assets. In the case of an asset used in operation length of life is roughly ex- pressed in the accounts by the rate with which the item is trans- ferred from an asset account to an expense account. Then a current asset, from this standpoint, is an asset which passes quickly into the expense category. A fixed asset is, therefore, an item which remains an asset, in large measure, for a comparatively long interval. According to this definition a security which is held for investment is a fixed asset. But many rights never give rise to expense charges. A contractual right such as that rep- resented by a mortgage may remain of practically constant value — aside from interest accruals — = throughout its life. At matu- 112 PRINCIPLES OF ACCOUNTING rity the contractual sum is paid. This is true of short-term as well as long-term securities. On the other hand a right such as an annuity, which consists in a series of payments which include both principal and interest, expires as the payments are made, and the amount of the expiration in each case constitutes a sub- traction from the value of the annuity and a subtraction from the gross revenue received.^ It is evident that the classification of rights as fixed and current assets is a matter of particular diffi- culty. Whichever basis for distinguishing between fixed and current assets be adopted there is no hard and fast principle to be fol- lowed which covers all cases. As regards length of fife an asset such as a stock of postage stamps, for example, which will be consumed in a few days, is clearly a current asset ; and a fire- proof building, which will probably remain in a particular busi- ness for many years (and may be a valuable object for a century or more), is obviously a fixed asset. On the other hand a promis- sory note running, it may be assumed, for three years, might, with reason, be classed in either group. Similarly, in respect to liquidity, the assets of the typical enterprise vary from cash itself to assets which can scar-cely be converted into cash except through the process of production ; but the point in the series which divides the current assets from the fixed is usually difficult of exact determination. In some cases rights represent the large part of a firm's capital. Banking, insurance and trust companies are examples of such enterprises. In such cases the accounts representing rights form a very important part of the accounting structure. These ac- counts may be subdivided for statistical purposes almost indefi- nitely. An insurance company, for example, may find it de- sirable to keep subsidiary accounts for each distinct security issue which it owns as well as controlling accounts with the principal types of securities and other rights in its possession. In the case of underwriting companies and brokerage houses securities are ^ A share of stock in a wasting enterprise such as a mine represents a, sort of indefinite annuity, and is therefore normally a depreciable asset. Any right, of course, may expire either because of changes in the circumstances of the enterprise in which the right is an equity, or because of general changes in the market for such securities. Transactions involving the valuation of annuities and other securities will be considered in detail in Part Three. THE ASSET ACCOUNTS 113 usually purchased only to be sold again. Rights constitute the merchandise of such a concern, and the security accounts are analogous to the merchandise accounts of a retail enterprise. Evidently the assets handled in such a case are current rather than fixed. Banking and insurance companies, however, com- monly hold large amounts of securities and similar rights as in- vestment indefinitely, or until the specific contracts or securities terminate. This illustrates the fact that the distinction between fixed and current assets depends not merely on the nature of the asset itself in any case but upon the character of the enterprise possessing such asset as well. Further, almost every large corporation owns securities and rights in other organizations and enterprises which it holds for investment and other purposes. Such holdings are probably becoming more rather than less common. Recent purchases of government bonds on a large scale by "industrial" as well as investment companies illustrate this tendency. Debit entries in accounts with long-term rights cover, in gen- eral, the same possibiHties as do charges to the accounts repre- senting the tangible equipment. A debit item may represent the original cost or value of the asset. This original figure usually expresses the market price of the right at the time it was secured. Further, a debit entry may represent an increase in value above the original figure. Credit entries in these accounts may represent either of two types of occurrences: (i) the sale of specific units; or (2) the decline in value of units remaining on hand. These decHnes represent either the regular expiration of assets such as annuities, or a fall in market prices due to changes in the interest rate or other factors. It is obvious that no depreciation because of deterioration, obsolescence or inadequacy is possible in the case of rights, for such assets do not consist in material objects. Hence the problems of valuation arising in connection with rights are in general less complex than in the case of the fixed tangibles. The Bonds account of an insurance company, for example, would therefore be charged with the cost or value of all bonds secured, and with all appreciations. This account would be credited with the amounts received from sales of bonds or amounts 114 PRINCIPLES OF ACCOUNTING realized at maturity dates and with all declines in value.^ The following transactions illustrate these cases : 1. The company buys U. S. 4's to the amount of $50,000. The entries would be as follows : Bonds $50,000 Cash $50,000 2. An inventory discloses the fact that certain bonds have appreciated in value, f 8,000. The journal entries would be : Bonds $8,000 Surplus $8,000 The credit in this case might be to the Net Revenue account (as suggested above in the case of land appreciation), or even to Revenue, provided such appreciations were a regular source of in- come to the company. The recognition of such value changes assumes that it is the function of these "right" accounts — as well as the accounts with tangible assets — to show present values whenever this is practicable. 3. Bonds (Harrison Railway 5's, due 1925) are sold on the market for $62,000. The entries would be : Cash . . $62,000 Bonds $62,000 These entries assume that the bonds were sold at a price to yield the book value. If a gain were realized on this sale the amount of the gain should be a credit to Surplus as in the preceding case instead of a credit to Bonds ; but the concurrent debit entry would be to Cash rather than to the Bonds account since the gain is realized in cash in this case. 4. It is discovered that bonds owned by the company have fallen in value, $5,000. This transaction would be journalized as follows : Surplus $Si°oo Bonds $S,ooo ' Transactions involving accumidation of discount or amortization of premium also affect bond values. These transactions and other occurrences involving ques- tions of principal and interest will be discussed in Part Three. THE ASSET ACCOUNTS 115 A firm that buys and sells bonds as merchandise would find it convenient to use at least three bond accounts. One of these accounts would show purchases, another sales and a third would represent inventories. By combining these accoimts ^ the amount of net revenue or net loss for a given period could be ascertained. Such accounts are exactly analogous to the merchandise accounts which will be explained in Chapter VIII. In the entries shown above, all variations in the value of the insurance company's bonds are credited or charged to Surplus as the case may be, for it is assumed that these assets are held for investment purposes and that variations in their value are outside of the regular ex- pense and revenue accounts of the enterprise. It should be recognized that the transactions considered above are merely suggestive of the important types of occurrences af- fecting accounts with long-term securities. Enterprises whose assets consist largely in rights require intricate systems of ac- counts ; and the construction and analysis of such systems con- stitute a special branch of accounting of considerable importance. In this text it will not be convenient to discuss the details of such special systems; but some further consideration will be given in later chapters to transactions involving security valuations. b. Special mention should be made of those accounts which represent long-term rights to services rather than rights to Hquid assets as income or principal. The right to protection from fire- loss for a period of three years, represented by an insurance pre- mium, might be considered a fixed immaterial asset on the books of the company making the payment. A warehouse lease run- ning for ten years, payment ($5,000) made in advance, furnishes a better example. The amount of the payment would be a charge to a fiixed asset account, thus : Lease $S)°oo Cash $5,000 The asset in this case consists in the right to use a certain other asset for a ten-year period. Any payment which a firm makes for services which will be furnished over a considerable period represents a similar asset. Transactions giving rise to such rights are of fairly common occurrence in business practice. The term " deferred charge " 1 All other expense and revenue items would, of course, be included in the computation. ii6 PRINCIPLES OF ACCOUNTING is often applied to such cases. An account which represents such an asset should be debited with the original cost or value of the service, and credited each period with the amount of the expiration of the asset due to the partial utilization of the service. In the case of the lease mentioned above, for example, the follow- ing entries (assuming one-tenth of the asset expires in each period) would be made every year : Expense $500 Xease $500 Usually significant changes do not occur in the values of such rights, outside of the expiration which represents the consumption of the service involved in any case. Assets of this character may be bought and sold, however, at prices other than cost, and even outside of purchase and sale transactions value changes are possible. Troublesome accounting problems often arise in connection with such assets, and some special cases will be dis- cussed later in the text. c. A final group of fixed asset accounts embraces all those accounts which represent the values of privileges conferred by governments — copyrights, patents, franchises, etc. — and the value of public opinion (and other advantages) pecuHar to the individual concern — goodwill. These intangibles are more general in character than are the other rights discussed in this section. Sometimes the term "intangible" is restricted to such assets.^ Patents and franchises have a definite legal nature, but the values of the assets to which they give rise usually bear little relation to the cost of procuring the right in any case. In general these rights have no competitive market value at the time the original privilege is extended. Goodwill is particularly general in character and is apphcable not to specific tangible objects or definite contractual rights but rather to the property of an enterprise as a whole. Such assets may be bought and sold, however, and hence may require exact accounting treatment. But since transactions involving such items are rather unusual, and since the problems of analysis which arise in such cases are ' As already stated the terms tangible and intangible are used in this text in the sense of material and immaterial. THE ASSET ACCOUNTS 117 particularly difficult, further discussion of this group of asset accounts will be postponed for the present. Chapter XXIV is devoted to a consideration of the nature and accounting treat- ment of these and similar intangibles. FUNCTIONAL CLASSIFICATION OF FIXED ASSET ACCOUNTS In the case of large and complex enterprises afunctional classi- fication of the accounts which represent the fixed assets of the business is of great practical importance. For managerial pur- poses the fixed investment applicable to each department or phase of the enterprise should be segregated in the accounts as far as possible. Only by means of such classifications can the management secure from the accounting records the data needed inmaking comparisons for the purpose of determining the relative efficiency of specific plants, departments, processes, etc. In this connection the functional classification of expense accounts (see the next chapter) is of even greater importance ; but such a classification in any case is f acihtated by a corresponding division of the asset accounts. No attempt wiU be made at this point to discuss in detail any of the special systems of asset accounts required for particular types of enterprises.^ The student is better qualified to considef this subject after the completion of a survey of the general field of accounting principles. It is im- portant, however, that the point of view involved in this very significant matter should be suggested at this stage. A simple classification of the fixed asset accounts of an enter- prise conforms to the important departments or phases of the business. In a manufacturing estabhshment, for example, there are the assets devoted to manufacture or production in the narrow sense, the assets comprising the selling equipment, and the assets utilized for general or administrative purposes. The following outline of accounts illustrates such a classification : 1 Part Six of the text is devoted largely to a discussion of special systems of accounts for manufacturing, railroad and municipal enterprises. ii8 PRINCIPLES OF ACCOUNTING Manufacturing Factory Site ; r Factory Building ; I Allowance for Depreciation of Factory Building ; ' / Factory Equipment ; < \ Allowance for Depreciation of Factory Equipment ; Materials Warehouse Site ; f Materials Warehouse ; \ Allowance for Depreciation of Materials Warehouse ; f Transportation Equipment ; \ Allowance for Depreciation of Transportation Equipment. Selung Finished Goods Warehouse Site ; f Finished Goods Warehouse ; • \ Allowance for Depreciation of Finished Goods Warehouse ; f Branch Store Building ; 1 Allowance for Depreciation of Branch Store Biulding ; f Transportation Equipment ; \ Allowance for Depreciation of Transportation Equipment ; r Other Selling Equipment ; I Allowance for Depreciation of Other Selling Equipment. Administrative OfEce Site ; f Office Building ; \ Allowance for Depreciation of Office Building ; f Office Equipment ; 1 Allowance for Depreciation of Office Equipment. In the case of a large scale enterprise the asset accounts would- normally be subdivided for statistical purposes much further than as shown in the above outhne. Not only would each dis- tinct plant require a special grou^p of fixed asset accounts but subsidiary accounts under each main head might be opened. The account, Transportation Equipment, for example, might control several subsidiary accounts such as Trucks, Horses, Wagons, etc. The scheme of using subsidiary and controlling accounts for the fixed assets may be carried very far in a par- ticular case. The detail accounts may be collected in special asset ledgers, and a controlling account for each subsidiary ledger may be opened in the general ledger. Or the accounts in the ' The relation between a valuation account and the corresponding main asset account is indicated by a brace in each case. THE ASSET ACCOUNTS iiQ general ledger may control in each case one or more accounts in each of the special ledgers. In the above outline, for example, all of the accounts mentioned could evidently be classed under the three general accounts. Land, Buildings, and Equipment, and the corresponding valuation accounts. In railroad account- ing the "Classification of Investment in Road and Equipment" prescribed by the Interstate Commerce Commission is divided into three "general" and seventy-seven "primary" accounts. (See Chapter XXXI.) It should be noted that the division of asset and other accounts in special books according to phases and departments of the business is desirable not only in that it makes it possible for the manager (or anyone interested) to derive much more" information of importance from the accounts, but also in that it permits of speciahzation on the part of the clerical force working on the books. This is a practical necessity in cases where a large staff of bookkeepers and similar help is employed. In functional classification — as in all other divisions — cer- tain cases arise in which it is diflEicult to assign the assets to par- ticular groups of accounts on a rational basis. For example, the same transportation equipment may be used to haul both raw materials and finished goods. In such a case it is not easy to apportion the value of this equipment — on any but an ar- bitrary basis — between the manufacturing and selling depart- ments. But in large scale enterprises — where the equipment is highly speciahzed — such classification can be easily carried out, and may be very extensive indeed. There are also certain necessary outlays during the period of construction which are appHcable to the property as a whole but not to any specific tangible result, and which, therefore, cannot well be distributed in the accounts on a functional basis. (See Chapter XIX.) Another important line of division between fixed asset ac- counts arises in cases where several products are being produced by a single enterprise. In such cases the ideal arrangement would be the segregation in a special group of accounts of the fixed investment devoted to the production of each type of com- modity or service — with further classification according to phases of the business process as suggested in the above outline. Wherever the same property units are used to produce several 120 PRINCIPLES OF ACCOUNTING products, however, the determination of the investment required for each line is a problem practically impossible of rational solu- tion. A railroad company, for example, sells both passenger and freight service but practically the same right-of-way, roadbed, and track are used for both types of traffic. It would therefore seem a very unreasonable procedure to attempt to apportion the investment in "road" between the two services. Yet the central problem of cost accounting is the classification of "costs" or expense according to commodities or services produced ; and this yirtually involves just such an assignment of investment. It should be evident that all possible transactions which might affect the subsidiary fixed asset accounts as presented in a detail classification would be analyzed according to the general prin- ciples illustrated in the preceding sections of this chapter. If the asset accounts of an enterprise are mmierous, however, greater care must be exercised in determining the particular account which is to be charged or credited as the case may be. ' ACCOUNTS WITH CURRENT TANGIBLE ASSETS The general distinction between fixed and current assets has already been considered. Summing up the discussion of this matter it may be said that hquidity and length of life are the important factors to be recognized. Length of Hfe may refer to either of two conditions : (i) the rate with which an asset expires (or passes into the expense category) ; (2) the period during which an asset of almost constant value (such as a con- tractual right) is held by a particular enterprise. It should also be remembered that certain kinds of assets may be either current or fixed depending upon the nature of the enterprise possessing the asset in any case. The factory site of a manufacturing com- pany, for example, is a fixed asset. A similar parcel of land held by a real estate company, on the other hand, constitutes a cur- rent asset — ^ the merchandise of the enterprise. In this section the important classes of accounts with current tangible assets will be discussed. a. First under this head will be considered the accounts which represent items such as materials, merchandise, goods in process, finished goods, fuel, stationery, and other types of current sup- THE ASSET ACCOUNTS 1 21 plies and commodities. Such accounts present no peculiar problems of analysis (as compared with the accounts with tangible fixed assets) except in the cases where a current asset and a revenue are included in the same account. As already explained, the account, Merchandise, as often used by a trading company, is a mixed account, representing both asset and equity elements. The accounts Materials, Goods in Process, and Finished Goods, however, which are used in factory accounting, can be considered as tjTjical asset accounts ; for in these cases cost prices and selhng prices are not entered in the same account, and special accounts, such as Sales, are used to show gross revenue. The difference between these two cases will be further explained in Chapter VIII. Many transactions affecting such accounts occur in business practice. A large number of the purchase and sale happenings which furnish the bookkeeper with the major part of his routine work have to do with the current assets. This follows naturally from the nature of these items. And, although current assets remain in the business for a comparatively short period, signifi- cant value changes may occur in such assets. Raw materials and similar items may appreciate or depreciate, and the depre- ciation in such cases may be due either to price declines or to physical deterioration. Obsolescence is also a possible cause for the depreciation of some current assets. Merchandise, for example, may decHne in value because of seasonal or permanent changes in the character of demand. Normally the period in which a specific item remains in the business is so short as to make it impracticable to attempt to show these changes in the asset accounts. The clerical labor involved would be too great, and the correction automatically occurs when the item is sold and other property received in exchange. But when the period of turnover is abnormally long, or if a serious change in price occurs, it becomes desirable to make the necessary adjustments directly in the asset accounts. Valuation accounts can be used in record- ing the decreases in value due to depreciation, as in the case of fiixed asset accounts, or the asset account can be credited directly with the amount of the expiration in any case. Then debits to the Materials account of the A. B. Co., for ex- ample, will represent, normally, the cost of materials purchased. Credit entries in this account will usually represent the value of 122 PRINCIPLES OF ACCOUNTING materials taken from the warehouse and turned over to the fac- tory operatives. Yet if it be assumed that it is th^ function of this account to show the actual value of the materials on hand, any significant advance in the prices of these materials would also give rise to a debit entry for the amount of the increase, and any decHne in the value of units not consumed would require a credit entry (or a credit entry in a valuation account). In the case of an enterprise doing a trading as well as a manu- facturing business credits to the Materials account might (in addition to the occurrences already mentioned) represent the sale of materials at cost, at a loss, or above cost. If the entire amount of each sale were credited to Materials in such a case, this account would become a mixed account. If a perpetual inventory were kept, however, the credit entries recognizing such sales could be restricted (as far as Materials were con- cerned) to the amount of the asset subtraction in each case. In this event the Materials account would retain its character as an asset account. The following transactions illustrate the various important cases : 1. Materials are purchased for cash, $i,ooo. The transaction would be journaHzed as follows : Materials fi,ooo Cash f 1,000 This is a typical occurrence. 2. Materials are taken from the warehouse to be used in manu- facture. The entries would be : Goods in Process $500 Materials $500 This is another normal transaction. Credits can be made to the Materials account whenever any materials whatever are removed, or these credits may be made only at certain in- tervals. 3. It is estimated that materials on hand have decreased in value because of deterioration and unfavorable price changes, $500. The journal entries would be : THE ASSET ACCOUNTS 123 Expense $500 Materials $500 4. Materials are sold at cost for cash, $300. The journal entries covering this situation would be : Cash I300 Materials $300 If these goods were sold at an advance of $50, the entries (assum- ing a perpetual inventory) would become : Cash $350 Materials $300 Revenue 50 If the sale were below cost, $50, the entries would be : Cash $250 Expense 50 Materials $300 If the entire amount of the sale were credited to Materials in each case it would mean, as explained above, that the Materials account was being used as a mixed account. The accounts with tangible current assets may also be classi- fied on a functional basis. Thus, instead of one Materials ac- count, an enterprise may make use of several such accounts — an account for each type of raw materials or a special account to represent the value of the raw materials to be devoted to each particular product. But although the current asset accounts may represent an important part of a firm's investment, if a functional classification of expense accounts is carried out there is little advantage in classifying current assets on this basis, since specific asset items rapidly pass into the expense category. i. Among the accounts with current tangibles Cash is suffi- ciently important and peculiar to be given special consideration. Cash is an account found almost universally. Being the ac- cepted legal tender cash is necessary in nearly all types of busi- ness operations. (Checks, money orders and bank drafts, as well as actual currency, are commonly considered as cash when received or given.) It is the most liquid form of property. Be- 124 PRINCIPLES OF ACCOUNTING cause of its availability as a purchasing and debt-paying medium cash is in some ways the most desirable form of property. In accounting, however, the tendency is to lay too much stress upon the importance of cash, and transactions involving cash. Al- though cash is an important asset, for the reasons just given, the Cash account is not the most important or informational account in many cases. The chief peculiarity of Cash lies in the fact that normally none but actual "business" transactions affect this account. Exceptions to this normal condition arise in the case of lost or stolen cash and gifts. Further, if the gross amount of checks and drafts is charged to Cash and exchanges and other deductions (such as a tax on checks) are later allowed, such items reqmre credits to Cash for the amounts involved. Depreciation and appreciation do not usually occur in connection with cash. The value (or purchasing power) of the dollar varies, but this does not appear in the Cash account since the dollar is itself the measuring unit which is applied to all other values. Transactions (i) and (4) under (a) above illustrate ordinary occurrences affecting the Cash account. In the case of donations, or lost of stolen cash. Cash would be credited and Expense debited (Expense if the outlay or loss is of ordinary occurrence. Net Revenue or Surplus if the expiration is unusual and can commonly be avoided). Changes in the Cash account also arise in trans- actions involving concurrent changes in equity and subsidiary equity accounts. The following transactions are illustrative of such cases : 1. A invests cash in business, $5,000. The following journal entries would be made : Cash $S,ooo A, Capital $S,ooo 2. A promissory note against the enterprise amounting to $500 is paid. The entries would be : Notes Payable $500 Cash fsoo 3. Product is sold for cash, $200. The entries would be as follows : THE ASSET ACCOUNTS 125 Cash $200 Revenue $200 4. The Net Revenue account at the end of the year shows a credit balance of $1,200. A withdraws this amount in cash. Entries : Net Revenue $1,200 Cash $1,200 5. The bank charges the firm's account with $3, the amount of exchange on drafts and notes deposited. The entries on the firm's books (assuming that the gross amount of checks and drafts were charged to Cash as received) would be : Exchange $3 Cash $3 The charge to the Exchange account in this case would represent a deduction from revenue (assuming the funds involved were received from sales) with approximately the same significance as an item of cash discount on sales. The large part of a firm's cash is usually deposited with some bank. In such a case the firm's bank book shows (in summary form) the same information as the Cash account in the ledger. The ledger account is sometimes considered as representing the bank's relation to the enterprise rather than a tangible asset, cash, and is entitled with the name of the bank. Indeed it should be recognized that the medium used in modern business trans- actions consists essentially in rights against banks rather than tangible coin or other forms of currency. Cash, then, is not usually an asset represented by a tangible object in the same sense as is raw material. Nevertheless the claims represented by a Cash account in any case can normally be converted into currency on demand. It is usually necessary to keep some cash on hand from which to make small payments. Such cash is recorded in a " Petty Cash " account. Sometimes a petty cash book, or journal, is also kept. In some cases all funds received are first deposited, and then checks are drawn at intervals to secure the funds needed for small pajnnents. If disbursements are made from the till before all 126 PRINCIPLES OF ACCOUNTING receipts are deposited a record of such items is, of course, neces- sary. In most businesses safeguards of all sorts are thrown around the Cash account so as to prevent defalcations. In some cases an inordinate emphasis is placed upon such arrangements in view of the neglect of other important matters. A theft or loss of supplies to the amount of $50 is nearly as serious a matter as a misappropriation of cash for a like amount. ACCOUNTS WITH CITEIRENT RIGHTS a. First under this head may be grouped the accounts which represent current rights to contractual sums against other in- dividuals and enterprises than the firms on whose books such accounts appear. Notes Receivable and Accounts Receivable are the common examples. In the t)^ical trading or manu- facturing enterprise such assets as notes and accounts receivable arise largely through the sale of merchandise or finished goods on other than a cash basis. Usually, then, an account receivable is a "book" claim against a customer which represents the fact that goods have been shipped to the customer and that payment has not yet been made. The correspondence between firm and customer, and original pa,pers such as the bill of lading, furnish evidence of the authenticity of the sale and the validity of the account. A note receivable, likewise, is usually a claim against a customer, consisting, however, in the customer's written promise to pay a certain sum, with or without interest as the case may be, at a specified date. Such an instrument may be given at the time a sale is made, or later, to settle an open account. Accordingly Accounts Receivable (as well as the customer's personal account) is charged, and the Sales account is credited, with the amount of each credit sale. Whenever an account is paid Accounts Receivable is credited for the amount of the pay- ment. If a discount is allowed at the time of payment the amount of the discount, as already explained, constitutes a deduc- tion from the revenue previously credited to the Sales account," and hence is chargeable either to that account or to a special offset account. In such a case the gross amount of the original charge, rather than the amount paid, is credited to Accounts Receivable. Notes Receivable is charged with the face amount THE ASSET ACCOUNTS 127 of such instruments received, and is credited with corresponding amounts when the notes mature and are paid. Transactions affecting these accounts — particularly Accounts Receivable — are naturally of very common occurrence in the case of the or- dinary enterprise. These accounts present some peculiarities. Appreciation of such assets as notes and accounts receivable is practically im- possible, for these assets are current in character and represent contractual amounts. Depreciation of current rights, however, often occurs. In the case of nearly every business enterprise a more or less considerable subtraction from the face of the ac- counts receivable must be made at intervals to represent the estimated amount of uncollectible accounts. It is common practice to credit another account, Allowance for Uncollectible Accounts, for such amounts, in heu of Accounts Receivable. Such an account is a subsidiary valuation account similar to Allowance for Depreciation of Buildings. It is particularly im- portant that Accounts Receivable should show original figures, for, as explained in a preceding chapter, a subsidiary ledger lies back of this account, and it is important, in any such case, that the account in the general ledger be allowed to retain its char- acter as a controlling account. The entries involving valuations of accounts receivable will be illustrated in Chapter VIII. Par- ticular notes may also depreciate or even prove to be entirely worthless. In such cases it is necessary to credit Notes Receiv- able and debit an expense account for the amount of the expira- tion. The beginner often experiences some difficulty in making the entries involved in transactions which affect the Notes Receiv- able and Interest accounts. One or two illustrations will be given at this point. I. Merchandise to the amount of f 1,000 is sold and a six per cent note for sixty days is received. The entries on the books of the firm making the sale would be : Notes Receivable . . ... ... $1,000 Merchandise Revenue $1,000 With fifty days yet to run the note is assigned to a bank without change in the rate of interest. The firm receives the face of the 128 PRINCIPLES OF ACCOUNTING note, $i;ooo, and one-third of a month's interest, $1.67. The entries covering this transfer would be : Cash $1,001.67 Notes Receivable $1,000.00 Interest 1.67 These entries show an addition to an asset, cash, of $1,001.67, and a subtraction from another asset, notes receivable, of $1,000. The balance of the cash received, $1.67, is a payment for capital- service furnished by the firm ; and the credit to Interest repre- sents this item of net revenue. 2. If the note received in the above transaction bore no in- terest, and were discounted at the bank fifty days from the date of maturity at six per cent, the entries would be quite different. A non-interest bearing note is not worth its face until the due date. It is banking practice to apply the stated rate of discount to the future sum instead of to the actual present principal. Since the bank in this case must wait fifty days for the note to mature, the face of the note would be discounted for this period at six per cent in computing the present value. The entries on the books of the firm disposing of the note would then be : Cash $991.67 Discount 8.33 Notes Receivable $1,000.00 The discount in this case is a valuation item. The note is not worth its face. The credit to Merchandise Revenue — in (i) above — was overstated, and the discount item is essentially a deduction from the nominal revenue figure. Firms handling but small amounts of commercial paper com- monly ignore the distinction between discount and interest, and include all such items in one account. While this procedure is inaccurate it is not a matter of great significance where the amounts involved are small. Banks and similar enterprises, however, find it necessary to distinguish carefully between the two cases. Discount is "future" interest; that is, it becomes interest as the date of maturity for the instrument involved approaches. In Part Three of the text the problems of compu- THE ASSET ACCOUNTS 129 tation and analysis involving interest and discount will be fully discussed. If the iirm negotiating a note endorses the instrument — that is, becomes responsible for its pa)rment in case the original maker, or previous endorser, fails to meet the obligation when it matures — the note represents a contingent liability of the firm. Un- doubtedly a record of this fact should be made in any case, but it may not be desirable to attempt to show this information in the regular ledger accounts. An attempt is sometimes made to crowd into the accounts proper data which are somewhat extra- neous. The point should be emphasized again that there is much statistical information pertaining to a business enterprise which does not belong in the accounts. Strictly speaking, only asset and equity facts — or facts which represent phases of these classes — are proper matters for accounting record. In pre- paring financial statements, however, the accountant — par- ticularly the auditor — often makes use of auxihary information. If such a contingent Hability is shown in the accounts it is de- sirable to set it up by crediting Notes Receivable Discounted, instead of Notes Receivable, with the amount of all discounted paper. Thus, in (2) above, the entries would be : Cash $991.67 Discount 8.33 Notes Receivable Discounted . . . $1,000 Such an account represents a special case of subtractions from the notes receivable, and suggests the contingent character of these subtractions. The use of contingent items in balance sheet statements will be explained in a later chapter. Accepted bills of exchange are in effect promissory notes, and are usually carried in the Notes Receivable account. Until such an instrument is accepted by the payer, however, it is good practice not to formally enter the transaction. Even if cash is received by the drawer immediately from his bank, it is desirable to simply make a memorandum to that effect, and omit the record of the transaction in the accounts proper until the notifi- cation that the bill has been accepted is received. h. A final group of current asset accounts includes all accounts which represent short-term rights to services. Whenever pay- I30 PRINCIPLES OF ACCOUNTING ment for a service is made prior to the receipt or utiKzation of the service, the amount of the payment represents a current asset. Prepaid insurance, advertising and rent are common examples of such assets. The accounts with such items are debited when- ever the services which they represent are purchased. At in- tervals the expirations are recognized and transferred to expense accounts. Because such assets are highly transitory in character and contractual in amount the problems of valuation involved are particularly simple. Whenever payment for a current service is made at the mo- ment the service is consumed, or later, the account representing the service can be considered an expense account as explained in Chapter III. In general it may be said that this group of asset accounts "shades into" the expense accounts. The pay- ments for services such as insurance, however, are normally made in advance and cover a considerable period. The following transactions illustrate the important possi- bihties : 1. The firm decides to run an advertisement for three months in a local newspaper. A payment for the three months' adver- tising service is made, $300. The entries are as follows : Advertising . . . . $$CX3 Cash ... $300 2. An inventory is taken a month later, and the expiration of advertising service is entered thus : Expense $100 Advertising $icx3 3. If the service were paid for after being consumed, and had not previously been recognized in the accounts, the entries would become : Expense $300 Cash . $300 The transactions discussed in this chapter illustrate adjust- ments which are made in connection with inventories and ap- praisals as well as entries resulting from ordinary purchase and THE ASSET ACCOUNTS 131 sale happenings. The fact has been emphasized that, as far as the effect upon the asset account in any case is concerned, a value change in either direction due to a revaluation of remaining units is as significant as a change due to the addition or subtraction of specific units. No attempt has been made to discuss the technical process of balancing the accounts and making closing entries after the valuations are made. This topic will be con- sidered in Chapter VIII. VII Further Classification of Equity Accounts The equity accounts of a business enterprise, as already ex- plained, represent the facts of ownership. It is the function of these accounts to show the actual investment of each interest furnishing capital to the enterprise, and to reflect the changes in equities due to the variations in asset values resulting from nor- mal operating conditions and other causes. In this chapter the equity accounts will be discussed under the following heads : (i) accounts with fixed equities ; (2) classes of expense and revenue accounts ; (3) net revenue and surplus accounts ; (4) accounts with current liabilities. ACCOUNTS WITH FIXED EQUITIES As in the case of the assets, the equities in the business enter- prise may be divided into fixed and current items. A particular equity may be of indefinite life, as is normally the case with proprietorship, or an equity may be a contractual right covering a specified period, short or long. In this section cursory con- sideration will be given to the accounts representing fixed (or "capital") equities.^ . a. Accounts must be kept in each case to show the proprietor's equity — the original and accumulated proprietorship. As ex- plained in Chapter II, the proprietor is the owner in the narrow sense. It is this interest that assumes, in large measure, the burden of risk and management and has a residual right to assets as income or principal. In an enterprise such as a small retail establishment, where nearly all of the capital is furnished by the "proprietor," it is the essential function of the financial records ' Part Two of the text is devoted to a more complete discussion of the proprietary and fixed liability accounts as they appear under different forms of organization. 132 FURTHER CLASSIFICATION OF EQUITY ACCOUNTS 133 to show proprietorship and the change in this equity which ac- crues during each period of operation. If outsiders furnish part of the capital in any case, however, accounts must also be kept with these equities, and the items of income accruing to such interests must be regularly recognized in the net revenue ac- counts. And in many large corporations the Uabilities exceed proprietorship in amount. Yet even in such cases the final goal of accounting, in a sense, is the determination of proprietorship and proprietary income, or profit; for this equity, as just stated, is the residual interest. From the accounting standpoint, there- fore, proprietorship is the most important equity in the business enterprise. In a "single-proprietorship," or in a partnership, accounts headed with the name of the proprietor or the names of the dif- ferent partners as the case may be, are commonly used to repre- sent the proprietary equity. In the case of a corporation it is customary to consider this equity as being identical with the claims of the stockholders, which are represented by the capital stock and surplus accounts. This is a somewhat arbitrary con- ception of proprietorship, because of the impersonal character of this (or any other) equity under the corporate form of organi- zation, and because of the marked differences in the rights rep- resented by the various kinds of capital stock (see Chapter XII) . Capital stock is listed in the accounts at its par or formal value, and hence does not often exactly represent the original invest- ment of the stockholders. A valuation account. Discount on Stock, should be used to record offsets to corporate proprietor- ship at the time of organization. Premium on Stock, or a similar account, may be used to represent the excess of the original proprietorship over the par of the capital stock in any case. Surplus, according to general usage, represents proprietary in- come retained in the business. This item, in practice, is repre- sented by variously named accounts. Surplus, Undivided Profits, Profit and Loss, Loss and Gain, are the common examples. In addition to the general surplus account there may be special accounts which represent in each case a portion of surplus ap- propriated for a particular purpose. Examples of such accounts are Sinking Fund Reserve and Reserve for Improvements. (See Chapter XIII for a special discussion of surplus appropriations.) 134 PRINCIPLES OF ACCOUNTING The fixed proprietary accounts are credited with all invest- ments and all net proprietary earnings which are not immediately distributed, and are charged with all withdrawals and all net losses. The transactions directly affecting this group of accounts are made for the most part either at the time of organization or at the end of an accounting period, and hence cannot be explained in detail until the process of closing the accounts has been dis- cussed. In these accounts, as in all equity accounts, debits always indicate subtractions, and credits always indicate addi- tions, ij The following are illustrations of a few t5^ical transactions : 1. The subscribers pay in $10,000 in cash, and stock is issued to them for this amount. Entries : Cash $10,000 Capital Stock $10,000 2. The above stock is subscribed at $90 per share, par $100. The subscriptions are paid and the stock is issued. In summary form the entries would be as follows : Cash $9,000 Discount on Capital Stock 1,000 Capital Stock $10,000 3. The same as (2) except that the stock is subscribed at $110 per share. Entries : Cash . $11,000 Capital Stock $10,000 Premium on Capital Stock . . . 1,000 4. The amount of net revenue accruing to the stockholders, $1,000, is transferred to Surplus, thus : Net Revenue $1,000 Surplus $1,000 5. An appropriation of $3,000 as a reserve for improvements is made by the directors. This transaction involves simply a subtraction from a general surplus account and an addition to a special surplus account. The entries accordingly would be : FURTHER CLASSIFICATION OF EQUITY ACCOUNTS 135 Surplus $3,000 Reserve for Improvements , . . $3,000 b. In practice all long-term equities other than proprietorship constitute the capital liabilities of an enterprise. Notes payable (long-term notes), mortgages, bonds, and similar securities are the common examples of such equities. These items represent contractual rights to income and principal, and hence seldom in- crease because of invested earnings or decrease because of losses.^ As in the case of capital stock, the par or face of a fixed liability- may be more or less than the actual investment. Accordingly a special account is necessary for such a case to show the amount of discount or premium. Since the fixed liabilities are contractual, debits in the accounts with such items usually indicate subtractions due to the payment of the obHgation in any case with some kind of property (nor- mally cash), or to the exchange of one equity for another. Sim- ilarly, credits indicate additions made concurrently with the receipt of property or a corresponding reduction in another equity. The Mortgages Payable account, for example, would be credited with the amount of all mortgages issued and charged with the amount of all mortgages retired. These entries would nor- mally cover the contractual sums specified in the mortgage con- tract. Only in the case of liquidation or reorganization would it be necessary to make entries in such an account for any deduc- tions from the contractual amounts. The following transactions illustrate the ordinary cases : 1. Bonds are issued for cash at par, $10,000. Entries : Cash $10,000 Bonds Payable . $10,000 2. The bonds mentioned in (i) are retired with cash, $10,000. The entries would be the reverse of the above : Bonds Payable $10,000 Cash $10,000 1 The amortization of premiums and the accumulation of discounts may be thought of as representing decreases and increases, respectively, in bondholders' equities. These transactions are complex and will be discussed in a later chapter. 136 PRINCIPLES OF ACCOUNTING 3. Mortgages to the amount of $10,000 are retired and bonds are issued in exchange for the same amount. The entries would be: Mortgages Payable f io,c300 Bonds Payable |io,ooo 4. Bonds, par $10,000, are issued at a premium of ten per cent. Entries : Cash $11,000 Bonds Payable $10,000 Premium on Bonds 1,000 5. Bonds, par $10,000, are issued at a discount of ten per cent. The entries on the issuing corporation's books would be : Cash $9,000 Discount on Bonds 1,000 Bonds Payable . . , $10,000 CLASSES OF EXPENSE AND EEVENtTE ACCOUNTS Expense and revenue accounts, as explained in Chapter III, are subsidiary equity accounts. Revenue accounts are credited with all sales of product — gross additions to equities. Ex- pense accounts are charged with the amount of all services and commodities consumed — deductions from revenue. The net result of these two groups of accounts is the net revenue (or net loss) from operations for a given period. In other words it is the function of the expense and revenue accounts to present an exhibit of the productive process for each accounting period, and to show the net effect of that process upon the status of the equities — particularly proprietorship. A simple illustration will serve to emphasize further the gen- eral significance of these subsidiary accounts. A particular firm, it may be assumed, makes use of the following accounts with expense and revenue items : Materials Expense ; Fuel Expense ; Labor Expense ; Depreciation Expense ; Sales of Product ; and Rent Revfenue. The relation between these accounts can be shown thus : FURTHER CLASSIFICATION OF EQUITY ACCOUNTS 137 Expense anb Revenue Materials Expense Sales of Product Fuel Expense Rent Revenue Labor Expense Depreciation Expense The net balance of these accounts for a given period is the amount which is carried to the Net Revenue account. If expenses exceed revenues the difference will be a charge to Net Revenue; if revenues are in excess the difference is a credit to Net Revenue. The Net Revenue account will then show the amount available for distribution among the various equities. The following occurrences illustrate transactions affecting the expense accounts : 1. An appraisal shows that the company's buildings have de- clined in value, $1,000. This transaction would be journalized as follows : Depreciation Expense $1,000 Buildings |i,ooo 2. Fuel has been consumed during the month, $200. Entries: Fuel Expense I200 Fuel $200 138 PRINCIPLES OF ACCOUNTING 3. Labor services are purchased and utilized to the amount of $300. The journal entries would be : Labor Expense I300 Cash $300 4. Materials have been utilized, $500. The entries would be as follows : Materials Expense $500 , Materials $500 The following transactions involve credits to the revenue ac- counts : 1. Goods are sold for cash, $500. Entries: Cash $500 Sales of Product $500 2. The firm receives a month's rent, $100, for the use of a part of its building. The entries would be : Cash $100 Rent Revenue $100 Further illustrations of transactions involving expense and revenue items will be given in the next chapter. It is evident that as far as the integrity of the net revenue figure is concerned in any case all expense and revenue items might be listed in the debit and credit columns, respectively, of a single account. If there were no omissions or other errors the net re- sult would be the same as it would be if a large number of dis- tinct accounts were used. (In any case such a summary account is a convenient device, and its use will be explained in Chapter VIII.) The point should be emphasized at this stage, however, that the detail classification of expense and revenue accounts for managerial purposes is one of the most important matters in modern accounting. Brief consideration will be given to this topic in this section. In the case of an enterprise of any complexity it is not suffi- cient that total expense, and total revenue be correctly shown in the accounts. The net earnings of the bus'ness can be determined FURTHER CLASSIFICATION OF EQUITY ACCOUNTS 139 by combining these figures, and a rough test of efficiency may be had by comparing the expense and revenue totals in a particular period with the corresponding figures for preceding periods. But the management should have at its disposal much more elaborate information than this. As far as possible all the expenses appli- cable to each important department or phase of the business should be segregated in the accounts. Further, the expenses incident to the use of each important type of fixed asset and each current service or commodity might well be grouped in a special account. Only from such classifications of expense accounts is it possible for the manager to secure the data necessary for mak- ing comparisons to determine the relative efficiencies of particular plants, departments, processes, etc., and in fixing the responsi- biUties of employees. Still further, if a firm is producing several products it is highly desirable that the expenses incident to the production of each line, in so far as they can be isolated, should be charged to a special group of expense accounts. An enterprise may discover, for example, after making such a functional analysis of expense charges, that a particular product is being manufactured at an actual loss although the business as a whole has been making a fairly satisfactory showing. In such a case, obviously, net earnings can be increased by further speciaUzation. The essen- tial problem of cost accounting, as will be explained in Chapter XXIX, is the classification and distribution of expense charges in the accounts of an enterprise in such' a way as to reveal the actual cost of each important product. The following is an illustration of a simple classification of expense accounts for a manufacturing enterprise : ■" Manufacttxeung Maintenance of Factory Building ; Depreciation of Factory Building ; Maintenance of Factory Equipment ; Depreciation of Factory Equipment ; Maintenance of Transportation Equipment ; Depreciation of Transportation Equipment ; Materials Expense ; Factory Supplies ; Wages of Operatives ; I40 PRINCIPLES OF ACCOUNTING Superintendence ; Wages of Drivers ; Wages — Miscellaneous ; Fuel Expense ; Inward Freight ; Power and Light ; Miscellaneous Factory Expense. Selling Maintenance of Warehouse ; Depreciation of Warehouse ; Maintenance of Equipment ; Depreciation of Equipment ; Supplies ; Salesmen's Salaries ; Wages of Shippers and Packers ; Miscellaneous Wages ; Traveling Expenses ; Heat and Light ; Outward Freight ; Advertising ; Other Selling Expense. General Maintenance of Office BuUding ; Depreciation of Office Building ; Depreciation of Office Equipment ; Office Supplies ; Salaries of Clerical Force ; Heat and Light ; Officers' Salaries; Insurance ; Taxes.* , It is evident that, in apportioning expense charges between departments and phases of an enterprise, difl&culties arise similar to those mentioned in the preceding chapter in the discussion of the functional classification of the accounts with fixed > assets. The power plant in the factory building, for example, may be ' There is some question as to the legitimacy of considering taxes an expense. In the next section of this chapter this problem will be briefly discussed. FURTHER CLASSIFICATION OF EQUITY ACCOUNTS 141 used to furnish heat and Kght to the warehouse and office build- ing as well as to the factory. In such a case the distribution of fuel expense and other charges incident to the operation of the power plant between the three main classes of expense accounts shown above on any but an arbitrary basis is obviously a diffi- cult matter. Similarly, the same transportation equipment in a particular case may be used indiscriminately to haul raw mate- rials from the freight depot and to deliver finished goods to the railroad company or directly to a customer's warehouse. When it is further attempted to classify expenses in terms of costs incident to the production of each important t3rpe of product in any case, added difficulties in analyzing particular expenditures are encountered. Many classes of current services and conmiod- ities are normally utilized in the production of more than one line. A particular tjrpe of skilled labor, for example, — or even specific laborers,- — may be employed at different times upon work connected with several products. Further, the fixed assets are usually much less completely specialized than the current assets. A single factory building, for example, may be used in the production of several distinct lines of goods. Obviously, in such a case, the maintenance and depreciation charges applicable to the building must be distributed in the expense accounts on a rather arbitrary basis. The revenue accounts will normally be fewer in number than the expense accounts. An enterprise usually buys a long Kst of commodities and services even if but a single type of commodity or service is produced. And although a functional classification of revenues is an important matter in the case of an enterprise manufacturing or handling several lines, it does not present the difficulties that arise in distributing expense charges on a similar basis. In the case of a retail drygoods company, for example, while it might require considerable clerical labor to ascertain the exact amoxmt of the sales of each kind of goods handled no dif- ficult problems of analysis would arise. It would be necessary simply to follow actual business transactions as they appeared on the sale shps or other records. In such a case it would not be expedient, however, to set up a special revenue account with each minor type of commodity sold. The inconvenience of such a system would more than offset its advantages. But each im- 142 PRINCIPLES OF ACCOUNTING portant class of sales might well be credited to a special revenue account. The following list illustrates a possible classification of revenue accounts for a company manufacturing agricultural implements and doing a wholesale business in certain kinds of tools and other hardware suppUes as well : Implements ( Sales of Binders ; Sales of Wagons ; Sales of Hay Loaders and Tedders ; Sales of Mowers ; Sales of Cultivators and Harrows ; Sale^ of Drills and Seeders ; Sales of Other Implements. Haedwaee Sales of Carpenters' Tools ; Sales of Hardware Supplies. Other Revenue Rent of Ofi&ces ; Royalties. It can readily be seen that the expense and revenue accounts of a large and complex enterprise, if classified in any detail, may be very numerous indeed. The classification of operating rev- enues and operating expenses of steam roads prescribed by the Interstate Commerce Commission in 19 14 contains about two hundred primary expense accounts (grouped under eight general heads) and thirty-nine primary revenue accounts (under four main heads). It should be recognized, however, that no matter how far the division of these subsidiary equity accounts be carried in any case, the relation of such accounts to the net revenue figure and to the balance sheet equities is the same as in the simple case where but one or two accounts are used. FURTHER CLASSIFICATION OF EQUITY ACCOUNTS 143 NET REVENUE AND SURPLUS ACCOUNTS The general relation of the Net Revenue and Surplus accounts to the balance sheet classes was explained in Chapter III ; and several references have been made in the preceding pages to the possible use of these accounts to reflect variations in the values of fixed assets which arise outside of the normal course of business operation. In this section these matters will be briefly reviewed, and some consideration will be given to the important types of subsidiary net revenue and surplus accounts. The most important function of the general Net Revenue ac- count in any case, as already explained, is to show the net result of the expense and revenue accounts for a particular period, or, in other words, the net revenue figure, and the apportionment of this amount among the various equities in the enterprise. This account is therefore credited with the amount of net revenue and is debited with all accruals to the contractual equities and all distributions of proprietary income. Further, items of net in- come arising from extraordinary causes and from ancillary opera- tions may be credited to this account ; and unusual deductions from ownership, analogously, may be charged to Net Revenue. The balance of this account, if a credit amount, represents pro- prietary earnings allowed to remain in the business, and may be credited to Surplus. If a debit amount this balance represents a decrease in proprietorship and hence constitutes a charge to the Surplus account. If the assets of an enterprise are represented by a single equity one account will suffice to show the distribution and adjustment of the net revenue figure. If there are several distinct equities involved a separate account with each equity may be desirable. The most important general distinction in this connection is between accounts representing accruals to contractual equities (interest) and those which show the distribution of proprietary income (dividends, for example). Further, net losses and gains, and items of net income such as interest and dividend accruals on securities owned by the enterprise, may be set up in special accounts. All such accounts are subsidiary net revenue ac- counts ; and their relation to the general Net Revenue account can be shown thus : 144 PRINCIPLES OF ACCOUNTING Net Revenue Net Operating Deficit Net Operating Revenue Losses Gains Interest Interest Dividends Dividends The Dividends account represents either appropriations and distributions to the proprietors of an enterprise (stockholders in the case of a corporation), or additions to net revenue received as income from securities held in other enterprises. Dividends received are net rather than gross revenue because such items represent income resulting from the sale of the service of owner- ship itself, and consequently no expirations of capital (sup- posedly) are involved. Similarly the Interest account shows either the distribution of net revenue to the contractual equities or net revenue accrued as a result of the ownership of such rights. In the case of a corporation having outstanding a variety of con- tractual liens and securities as well as several classes of stocks a considerable number of such subsidiary net revenue accounts may be employed. Although in general the distinction between the expense and revenue and the net revenue accounts is clear, there are certain FURTHER CLASSIFICATION OF EQUITY ACCOUNTS 145 accounts which may, with some reason, be classed in either group. The account which shows tax accruals in any case, or the rela- tion of the enterprise to the state, is one of these liminal cases. As pointed out in Chapter I the rights of the private equities in the assets of a business enterprise are always subject to revision by the tax power of the government. The state's right con- stitutes a prior lien on assets, and in the case of the general property tax this right is exercised whether earnings exist or not. Normally, however, the earnings of an enterprise are more than sufficient to offset all tax accruals. Now it would seem that tax payments or accruals can hardly be considered as items of ex- pense. Expense charges are deductions from revenue which arise because of the expiration of services and commodities in business operation, and any service which the state furnishes to the business enterprise can hardly be conceived as a specific valuable consideration from the accounting standpoint. The service is too vague, and usually does not vary in proportion to the size of the tax levy. The payments are coerced, and are not analogous to market prices for definite services or commodi- ties. On the other hand, payments to the government cannot, with entire propriety, be considered as distributions to an equity since the state's claim does not appear upon the books except as it is entered as an accrual from time to time. This is one of those questions that cannot be decided arbitrarily according to general principles. Either viewpoint may be legitimate under certain circimistances. It depends upon the immediate use that is to be made of the accounts involved in any case. From the man- ager's standpoint taxes are not an expense charge, for he is in no way responsible for the outlay. From the standpoint of the investor such pajnnents have essentially the same significance as wages or any other expense, since the amount of such charges must be deducted before the sum available for distribution among the private equities is determined. On the whole the view that the Taxes account is a subsidiary net revenue account seems the more logical opinion. Further attention to this difficult point will be given in a later chapter. Rent charges and credits are sometimes confused with net revenue items. While such entries represent contractual ac- cruals it does not follow that the Rent account is in the net rev- 146 PRINCIPLES OF ACCOUNTING enue category. A firm, for example, leases a part of its building to outside interests. How are the payments to the firm to be considered? Clearly these are items of gross revenue, because depreciation and other expenses are involved in the production of this revenue. Rent, or hire, usually amounts to ten per cent or more of the value of the property leased. Only from a third to a half of this amount is net revenue. Further, rent expense is not a disposition of net revenue, but is a genuine expense. When a firm leases an asset from an outside party the payment it makes (assuming pajrment to be made in advance) represents the pur- chase of a definite privilege or service. As this service expires the amount of the expiration becomes an expense charge. This situation is analogous to the purchase and expiration of any asset. If payment is made after the utilization of the service the amount of the payment can be considered an immediate charge to an expense account. One might as well say that merchandise rev- enue (gross sales) before the deductions are made is net, as to consider the typical rent accrual as a net charge or credit to the equities. The use of the Surplus account to represent a part of the pro- prietary equity has already been explained. Since surplus arises primarily through the retention of profits in the enterprise in any case it is evident that the Surplus account will be credited with all net revenue balances which are not distributed among the private equities, paid to the state as taxes, or otherwise dis- posed of. Further, special deductions from proprietorship (losses) and extraordinary additions to this equity (gains) may appropriately be carried directly to Surplus rather than to the Net Revenue account. As already suggested, a particular enterprise may make use of several special surplus accounts. The relation between the general Surplus account and subsidiary accounts, positive and negative, is shown in the exhibit on page 147. In the case of a single-proprietorship or a partnership the per- sonal and capital accounts of the proprietors are usually directly charged or credited with items of deficit or surplus as the case may be. Small businesses may likewise dispense with an adjust- ment Net Revenue account. But in large enterprises, particu- larly under the corporate form of organization, several subsidiary FURTHER CLASSIFICATION OF EQUITY ACCOUNTS 147 equity accounts are commonly necessary. In later chapters the Net Revenue and Surplus accounts will be considered in more detail. The general significance of these accounts, however, and the nature of their typical subdivisions, should be clearly recognized at this stage. Surplus Accumulated Deficit Accumulated Profit Losses from Abandonments Reserve for Improvements ACCOUNTS WITH CURRENT LIABILITIES a. First under this head will be considered the accounts rep- resenting current claims against the enterprise which arise pri- marily through the purchase of materials or other assets on credit and through borrowings of current funds. The common ex- amples, are Notes Payable and Accounts Payable. The lia- bilities represented by such accounts constitute the floating in- debtedness of an enterprise. That is, although such items are equities in the strict sense of the term, the holders of specific notes and accounts furnish the cash and other assets involved^ temporarily and not with the intention of allowing their capital to remain in this form. Consequently these claims do not rep- resent investment as such. Nevertheless, although specific items may remain as equities for very short periods, the total of such liabilities on the books of a particular firm may represent continuously a significant sum. This means that in such a case a considerable fraction of the total assets of the business is rep- resented among the equities by current liabihties, although the personnel of the holders of these claims is constantly shifting. Credits to these accounts represent additions to the equities 148 PRINCIPLES OF ACCOUNTING involved, and debit entries indicate subtractions. Except in the case of insolvency or reorganization no deductions will or- dinarily be made from current or other liabiUties but such charges as represent the retiring of the obligation in any case with cash or an equivalent. As explained in Chapter IV, however, both accounts receivable and payable are often entered in the ac- counts at gross figures, and deductions are later allowed. In- come does not accrue on book accounts, but even short-term notes may be interest-bearing as explained in the case of notes receivable. The following transactions are typical of the occurrences af- fecting the accounts with these current liabilities : 1. Supplies are purchased on account from the S. Company amounting to $400 at the gross billed price. The journal entries on the books of the purchaser would be : Supplies $400 Accounts Payable $400 (S. Company) 2. A two per cent discount is offered on the account mentioned in (i) if cash payment is made within ten days. This discount is accepted. The entries would be as follows : Accounts Payable I400 (S. Company) Cash $392 Purchase Discounts 8 Such a discount has the significance of a deduction from the cost of supplies, as was explained in Chapter IV. 3. If the above mentioned account were settled with a thirty- day, non-interest bearing note for $400, the entries would be : Accounts Payable $400 (S. Company) Notes Payable $400 The Notes Payable account is often used to represent not only promissory notes but accepted drafts and bills of exchange drawn against the firm. Such instruments often draw interest at a specified rate. The following transactions illustrate happenings involving the Notes Payable and Interest accounts : FURTHER CLASSIFICATION OF EQUITY ACCOUNTS 149 1. A sixty-day, six per cent note for $500 standing against the firm is paid at the date of maturity, with interest. The interest, a deduction from net revenue, would amount to $5 in this case. Accordingly the entries would be: Notes Payable $500 Interest S Cash $505 2. The A. B. Co. owes the Y. Co. $500 for materials purchased. In full settlement of this account the A. B. Co. assumes a note in favor of the S. Co. and against the Y. Co. The face of the note is $490 ; the interest rate is six per cent ; the note runs for three months; and the date of assumption by the A. B; Co. is thirty days prior to the maturity date. The entries on the books of the A. B. Co. at the time the note is assumed would be as follows : Accomits Payable $500 ' Notes Payable I490 Interest Payable 4.90 Purchase Discounts 5.10 These entries recognize a subtraction from one liability, accounts payable, of $500, an addition to another liability, notes payable, of $490, and an addition to still another habihty, interest payable, of $4.90 (two months' accrued interest at six per cent). The difference between the book value of the new liabilities and that of the obligation retired is an allowance having the same signifi- cance as any purchase discount. 3. At the date of maturity the A. B. Co. pays the note de- scribed in (2) with three months' interest, $7.35. The entries at this time would be : Notes Payable $490 Interest Payable 4.90 Interest 2.45 Cash $497-35 Other transactions involving promissory notes and interest and discount calculations and entries will be given in a later chapter. ISO PRINCIPLES OF ACCOUNTING b. Another group of accounts with current liabilities are those representing accrued items. The account, Interest Payable, shown in the above entries, is an illustration. Other examples are Wages Payable, Taxes Payable, and Rent Payable. These accounts Represent rights of a still more transitory character. Such rights arise largely because of the famihar fact that the typical business enterprise utiKzes services a few days or weeks in advance of pa3rment for the same. Since such items are not recognized in the accounts except at the closing periods the treatment of these accrued liabilities in the accounts will be given in the next chapter. VIII Closing and Interpreting the Accounts As the operation of an enterprise proceeds, the various business transactions occurring will be journalized and recorded in the accounts according to the principles developed in the preceding chapters. At certain regular times, however, the management (and other interests) will desire summary information concerning the firm's financial position and the events of the operating period just past. To furnish such information it is necessary to "close the books," and to prepare systematic statements ex- hibiting (i) the present status of the business and (2) the process by which this momentary condition is immediately attained. Although several references to closing and adjusting entries have been made in the preceding pages, no specific discussion of this important topic has been presented thus far in the text. In the present chapter the technical process of making such entries and closing the accounts will be described ; and typical problems of interpretation that arise in this connection will be considered. The significance and preparation of the important financial state- ments will be discussed in Chapter IX. the trial balance The first step in the process of closing the accounts is the taking of a trial balance. If the books have been properly kept by the double-entry system in any case there has been an equal debit entry (or entries) for every credit entry (or entries) and vice versa, as already explained. Consequently the total of all debits from the general ledger accounts should equal the total of all credits from these accounts. If this condition is found to exist the accounts are said to be " in balance," and it is then assumed that the bookkeeping work has been correctly performed. It is 151 152 PRINCIPLES OF ACCOUNTING in part to test this relation between aggregate debit and credit entries that the periodic trial balance is "struck." The trial balance is simply a summary transcript of the general ledger which shows total debits and total credits by "open" accounts (or debit balances and credit balances). The following table illustrates such a statement : Trial Balance of the A. B. Co., August 31, 1918 1 Ledger Page Name of Account Dr. Cr. 2 Real Estate $ 40,000 $ 3 Buildings 70,000 4 Equipment 24,000 S Materials 120,600 8 Cash 57,900 31,700 16 Accounts Receivable ' 24,800 13,800 18 Notes Receivable 8,500 5,600 21 Securities Owned S,ooo 1,000 23 Labor 8,540 26 Fuel 600 28 Insurance 250 29 Miscellaneous Supplies and Services 800 36 Sales Discounts 2,100 38 Purchase Discounts 1,900 40 Sales 76,400 45 Rent 300 47 Commercial Interest 70 30 65 Capital Stock 170,000 67 Bonds 40,000 68 Notes Payable 6,300 15,000 75 Accounts Payable 11,200 24,930 $380,660 $380,660 It is the function of the trial balance to furnish a test for cleri- cal accuracy and to provide a convenient basis for the prepara- 1 It should be noticed that this statement represents a purely hypothetical case. The accounts given do not conform to any satisfactory classifications for an actual business enterprise. They have been selected rather because they will serve as convenient illustrations in the discussion of the important questions of technique and interpretation that arise in the process of closing the accounts. CLOSING AND INTERPRETING ACCOUNTS 153 tion of the financial statements. Only the open ledger accounts are collected in such a statement, for any accounts which exactly balance obviously need not be included. A single general ledger account, however, will normally show either a debit or credit excess. That is, while the aggregate of the debit entries in all the accounts should equal the aggregate of credit entries in all accounts, a particular account usually presents a preponderance in one direction or the other. The nature of the account in any case determines which side will commonly show this balance. These net debit or credit balances may be carried to the trial balance, or total debits and total credits, as in the statement shown above. The latter procedure is probably the better, be- cause a trial balance so constructed can be more easily interpreted than one which shows net balances only. If the totals from both debit and credit columns are used the bookkeeper's pencil footings, without combination, are carried to the trial balance. The fact that the trial balance "proves " is not a positive proof of accounting accuracy, but only a fairly reliable indication. There is a chance that the same error has been made on both sides of the ledger. Further, this test cannot prevent errors in principle, pr careless classification of the items involved in par- ticular transactions. In recording the sale of merchandise for cash, for example, the bookkeeper may have charged Accounts Receivable instead of Cash ; yet, as long as the amounts were correctly stated, the ledger would still be in balance. If the trial balance proves, however, it does show that there has been posted an equal debit entry (or entries) for every credit entry (or entries) and vice versa. Although the trial balance is in principle a very simple device the actual process of taking such a statement is a matter of some clerical difficulty — particularly for begiimers. It is easy to make small errors in computation and interpretation. Where special books such as the cash book are used, which combine a form of journal with one or more accounts, the accounts in these books — in so far as they do not appear in the general ledger — must be included. Further, it must be remembered that where controlling accounts are used, the controlHng accounts and not the subsidiary accounts appear in the trial balance, though when preparing a trial balance the bookkeeper usually makes sched- 154 PRINCIPLES OF ACCOUNTING ules from the subsidiary ledgers and checks the amounts appear- ing in the controlling accounts from these schedules. The arrangement of the accounts in the trial balance is not a matter of great importance. Usually this statement is prepared by following the ledger, page by page. Whatever scheme of classification — alphabetical or otherwise — that has been adopted in the ledger, therefore, will be duplicated in the trial balance. In the important financial statements which* are pre- pared after the process of closing is complete, however, other bases of classification should be followed. THE NECESSITY FOR INVENTORY AND APPRAISAL The question now arises as to whether the trial balance — which is a summary of the ledger accounts — shows the financial condition of the business at a given moment of time. This question must be answered in the negative ; and the explanation of this answer will serve to emphasize the fact already frequently referred to that the part played by the regular work of the book- keeper in furnishing the data of the business process has very definite limitations. Purchase and sale transactions, and other actual business transfers and exchanges are, for the most part, recorded on the books as they occur. Expense and revenue accruals, however, are rarely so recorded. Such value changes are only recognized periodically when the accounts are closed and statements are prepared. At the moment the trial balance is taken, therefore, the ledger does not represent the exact status of the enterprise. It shows at this time simply a classification of the debit and credit entries posted by the bookkeeper to cover actual "business" transactions. In the case of the typical enterprise, as already explained, it would not be expedient to attempt to record expense and revenue accruals in the accounts as they occur. It would be altogether too laborious and complicated a process as a rule to try to show in the Fuel account the subtractions due to the hourly or daily consumption of coal, for example. The more permanent prop- erty equipment is no doubt depreciating continuously; but it would not be feasible to present this fact continuously in the accounts. Thus the accounts do not show, currently, the ex- CLOSING AND INTERPRETING ACCOUNTS 155 pirations of assets due to the conditions of operation and the passage of time. The necessity arises for the inventory and ap- praisal. If some of the subtractions from assets are not im- mediately recorded in the accounts, inventories must be taken to determine the amount of each type of property actually on hand, and, consequently, the amount that has expired in any case. This sort of information is always necessary to supplement and correct the book records. Further, current services and commodities are often received and utilized in one accounting period although payment is made in a succeeding period. In such a case it is evident that there will usually be no entries in the accounts representing these ex- pired items for which payment has not yet been made. If the operating sheet is to cover all changes which have actually oc- curred within a given period, it will be necessary to recognize such accrued expense charges. Similarly the actual amount of revenue that has accrued (that is, that has been earned) within a particular period may not be shown concurrently in the accounts. A firm, for example, owns some bonds in another enterprise on which interest is payable every six months. The regular time for closing the accounts, it will be assumed, is two months before the interest payment date. It will be necessary, therefore, in closing the accounts, to "accrue" the interest for four months. It is evident that the net change in the equities, net revenue, cannot be determined until all accruals are taken into considera- tion. The amount of merchandise sales, for example, may rep- resent gross revenue ; but until all subtractions from assets have been charged to expense as a deduction from this figure the actual increase (or decrease) in the equities cannot be ascertained. The taking of inventories is therefore a matter of the utmost im- portance. The shorter the accounting period the more closely the accounts will follow the actual situation. In general the year is the most significant fiscal period ; and certainly the inventories should be taken and the accounts closed at least once each year. Some enterprises — for example, the railways — close their accounts and prepare statements once a month. This is a desirable pro- cedure for managerial purposes. In the case of a business sub- IS6 PRINCIPLES OF ACCOUNTING ject to seasonal fluctuations, however, the yearly statements fur- nish the most important general information. The problems of valuation that arise in the actual process of taking inventories are many and difficult. The values of fixed assets such as buildings must be determined by appraisals; and, in view of the many factors affecting the values of these assets, the appraisals are often very difficult. Technical skill and knowledge of business conditions must be called into play in the appraisement of complex t)^es of fixed assets. In the case of current assets such as raw materials, methods of enumeration and measurement can be followed to secure the physical inventory. The number of units multiphed by the value per unit gives the value inventory. The values of current rights such as notes and accounts receivable are determined by estimation. The integrity of the parties involved is the decisive factor in making such estimates. In the case of contractual accruals of rent and in- terest, the inventory figures are furnished by computations based upon a proper analysis of the relations involved. In the case of both fixed and current assets there is the added difficulty of determining a proper basis for valuation. Inventories may be based on either original cost, cost of replacement, present value to a "going concern," or liquidating or market value. This problem, which is the essential theoretical consideration involved in valuations, will be discussed in Chapter XX. It is sometimes feasible in the case of materials, supplies, and similar assets to keep a perpetual inventory of the stock on hand. If materials placed in process are taken from the storeroom only upon properly authorized requisitions, an entry may be made in the Materials account each day to show the amount of materials transferred to Goods in Process. Even if a perpetual physical inventory is kept in the stock records, however, it is not always practicable to attempt to recognize in the ledger accounts the changes caused by such a continuous shifting of assets. In this chapter attention will be given primarily to the actual process of closing the accounts, assuming the inventories to have been properly taken. CLOSING AND INTERPRETING ACCOUNTS 157 CLOSING ACCOUNTS WITH FIXED ASSETS As an illustration of the process of closing the accounts with fixed assets the Buildings account will be first considered. In the illustrative trial balance given in a preceding section this account shows a debit balance of $70,000 on August 31st. Assuming the accounting period in this case to be a month, this balance represents the value of this asset at the beginning of the month of August plus any additions made during the month, less any subtractions for the period. Since total debits and total credits are shown in this trial balance it is evident that in the case of Buildings no subtractions from any cause whatever have been recorded during August. The management now decides, it may be assumed, that the buildings have decHned in value during the month because of various causes one-half of one per cent ; that is, an appraisal would now show a value of ninety-nine and one- half per cent of book value, or $69,650. The expiration of prop- erty, therefore, or the depreciation expense as far as this asset is concerned, amounts to $350. It is this latter amount that must now be subtracted from the asset account and be carried to an expense account. Assuming that the Buildings account is cred- ited directly with this subtraction, this account, closed, would appear as follows : Buildings I9I8 Aug. I Inventory J2 70,000 I9I8 Aug. 31 Inventory J96 V 3 so 69,650 70,000 70,000 Sept. I V 69,650 The amounts entered on the right-hand side of this account represent the closing computation. The credit of $350 to Build- ings represents a definite subtraction from an asset and requires a concurrent charge to an expense account. This transaction would, accordingly, be represented by a journal entry. The right- hand inventory figure, however, is not a subtraction but a bal- ancing entry. (It is assumed that the enterprise in this case has IS8 PRINCIPLES OF ACCOUNTING been in operation for only one month. This accounts for the reference to a journal page opposite the first left-hand entry in the above account. This $70,000 figure then represents the charge to Buildings made when the account was opened. There have evidently been no purchases or other additions during the month.) It is a desirable procedure to balance every account at the end of each accounting period so as to mark the separation of the periods sharply, and to show definitely the current status of each item. In bookkeeping practice a balance is taken by adding the amount of the balance in each case to the opposite side of the account. In this way actual subtraction — in the accounts at any rate — is avoided. The left-hand inventory figure cancels the fictitious entry on the opposite side, and shows the actual balance on hand, September ist. Since these inventory entries have no effect upon Buildings or any other account they do not represent a transaction and therefore need not be journalized. In theory the closing entries must be made and posted before the account is balanced. If a special account. Depreciation Expense, were now opened these entries would be as follows : Depreciation Expense $350 Buildings $350 Or a still more highly specialized expense account. Depreciation of Buildings, might be charged instead of Depreciation Expense. A valuation account, Allowance for Depreciation, might be credited with the asset subtraction instead of Buildings, as ex- plained in a preceding chapter, if for any reason it is desired to maintain original or cost figures in the Buildings account. In this case Buildings would be closed simply by balancing, and would show September ist, as before, a balance of $70,000. Al- lowance for Depreciation (or Allowance for Depreciation of Build- ings) would show at this time a credit balance of $350. The two accounts, taken together, give the net value of the asset, build- ings. The point should be emphasized again that the charge to an expense account is the same in either case — whether Build- ings or a subsidiary valuation account be credited. The expense account that is used must in its turn be closed. The closing of such accounts will be explained in a later section of the chapter CLOSING AND INTERPRETING ACCOUNTS 159 Occasionally the estimated value of a fixed asset at the end of an accounting period just equals the book value — that is, the value appearing in the asset account (assuming there is no valu- ation account) at the time the new inventory is taken. In the case of the Real Estate account given in the above trial balance of the A. B. Co. for example, the book value or debit balance is $40,000. Assuming that an appraisal of the real estate shows its value to remain unchanged at $40,000, it is evident that neither expense nor revenue is involved in the operating period just past as far as this asset is concerned. The Real Estate ac- count would, therefore, be closed simply by balancing, no jour- nal entries being required, thus : Real Estate I9I8 Aug. I Inventory h 40,000 1918 Aug. 31 Inventory V 40,000 40,000 40,000 Sept. I V 40,00c The only advantage of an actual closing of the account in this case is that it shows that a new inventory has been taken and that the estimated value of this asset on September ist is the same as the book value August ist. The bookkeeper's habit of leaving accounts with a single entry unchanged as regards dates for several periods should be avoided. Accounts such as Cash, from which neither expense nor revenue is ordinarily com- f)uted, are similarly closed by simply adding both sides and strik- ing a balance. All accounts which represent the more permanent property items are closed as shown in the above cases. From the nature of the fixed assets it follows that normally the variation in value for a single period will be slight relative to the total amount ap- pearing in the asset account. Usually, however, some change occurs ; and if the policy of keeping the accounts "up to date" is observed, these variations will be recognized at the end of each period. i6o PRINCIPLES OF ACCOUNTING MATEIOALS, SALES AND SUBSIDIARY ACCOUNTS In the typical manufacturing enterprise the cost of the mate- rials used in production during a given period constitutes a major item of expense ; the amount of the sales of finished goods rep- resents the principal revenue. Similarly, in the case of a retail or other trading company, the amount of merchandise sales for the accounting period is the most important gross income, and the cost of merchandise used is a large (usually the largest) de- duction. The computation of these amounts in any case, and the closing of the various accounts involved, is an important, and somewhat difi&cult, part of the bookkeeper's work. In this section the process of closing Materials, Sales and subsidiary accounts will be discussed. For an illustration it will be convenient to refer again to the trial balance given on a preceding page. This trial balance, as already explained, is supposed to represent the condition of the general ledger of the A. B. Co. on August 31st. Further, it will be assumed as before that this company has been in operation for a single month. This accounts for the fact that although the accounts Materials and Sales appear in the trial balance there are no subsidiary accounts such as Goods in Process or Finished Goods in this statement. The Materials account at this time shows a debit balance of $120,600. Since total debits and total credits are shown in this trial balance it is evident that no credits have been entered in this account during August. This balance, therefore, represents the value of raw materials on hand at the beginning of the month plus the amount of any purchases (or other additions) made during the period. This means that no record has been kept in the accounts of materials which have passed on in the process of production. All purchases have been charged to the Materials account as made, and all sales of finished goods have been credited to Sales. But the ac- counts do not show the value of finished goods on hand or of goods in process, or the amount of raw materials still in the store- room. In order to close these accounts, therefore, and bring the books up to date, it will be necessary first to take inventories to determine these facts. An inventory on August 31st, it will be assumed, discloses the CLOSING AND INTERPRETING ACCOUNTS i6i following data : (i) the value of all materials now in the store- room is $40,000 ; (2) goods in the shop in various stages of manu- facture are valued at $8,000 ; and (3) finished goods in the ware- house are estimated at $12,000. It will now be necessary to open several new accounts. A Goods in Process account should be charged with the value of semi-manufactured goods. An ac- count. Finished Goods, should be debited with the value of the, completed product on hand. It will also be convenient to open a special summary account, Trading, which may be used to show all adjustments of the sales total and the cost of materials. The following exhibits show all of these accounts, including Materials and Sales, as they would appear when closed. Matertals ^ I9I8 Aug. I 31 Inventory J4 P.B.6 80,000 40,600 1918 Aug. 31 To Trading Inventory J96 V 80,600 40,000 120,600 120,600 Sept. I V 40,000 Goods in Process 1918 Aug. 31 To Trading Inventory J96 8,000 1918 Aug. 31 Inventory V 8,000 8,000 8,000 Sept. I V 8,000 1 When the accounts are closed by means of journal entries no explanation in the ledger is necessary other than a reference to the journal page on which the details of the transaction may be found. In each of the illustrations given in this section, however, the name of the account which is concurrently charged or credited as the case may be is shown opposite the closing entry. In some cases ledger accounts are closed without actual journal entries. That is, the closing amounts are trans- ferred directly from account to account by the bookkeeper, and no entries are made in the journal. This procedure is not desirable, however. Closing transactions are actual happenings in the accounting sense, and are usually of particular impor- M l62 PRINCIPLES OF ACCOUNTING Finished Goods I9I8 Aug. 31 To Trading Inventory J96 12,000 1918 Aug. 31 Inventory V 12,000 1 2,00c 12,000 Sept. I V 1 2,00c Sales 1918 Aug. 31 To Trading J96 76,400 76,40° 1918 Aug. 31 S.B. 8 76,400 76,400 Trading 1918 Aug. 31 From Materials To Expense and Revenue J96 J96 96,400 1918 80,600 |Aug. 31 15,800 From Goods in Process Fromi Finished Goods From Sales J96 J96 J96 8,000 12,000 76,400 96,400 The closing journal entries, evidently, would be as follows : (i) Trading . . . Materials Goods in Process Trading 80,600 $80,600 (2) tance. The details of these transactions should be given in the general journal. Probably the best procedure for the bookkeeper is the following : (i) make the closing computations on loose sheets; then (2) make the proper entries in the journal; (3) post to the accounts affected; and finally (4) balance the accounts by making use of the inventory amounts. CLOSING AND INTERPRETING ACCOUNTS 163 (3) Finished Goods $12,000 Trading $12,000 (4) Sales . . . $76,400 Trading ... . . . $76,400 (5) Trading $15,800 Expense and Revenue $15,800 It is important that the significance of these entries be clearly recognized. The entries under (i) show the total subtraction from materials made during the month and carry this subtrac- tion to Trading as a deduction from revenue. But not all of these materials have been consumed in the manufacture of goods sold during this period. Finished goods in the warehouse amount to $12,000, and goods in process are valued at $8,000. If, then, the value of all materials taken from the storeroom is considered as a deduction from revenue it is necessary to offset this deduc- tion with the goods in process and finished goods amounts. One method of making such adjustments is shown in the entries under (2) and (3) above. The credits to Trading in these cases represent not revenues but offsets to overstated costs. The concurrent charges to Goods in Process and Finished Goods recog- nize the asset balances in these accounts. The gross revenue shown by the Sales account is transferred to Trading by the entries under (4). The balance of Trading, $15,800, is now carried to Expense and Revenue. This latter account is a summary computation account — often called Profit and Loss — to which is carried the net balance of the materials and merchandise accounts and all other expense and revenue balances. (The nature and use of such an account will be further explained in a later section.) It is evident that the balance of the Trading account is not net revenue, but simply sales less certain important elements of total cost or expense. The entries and accounts shown in the above case illustrate the general characteristics of the process of combining gross revenues and material costs at the end of the accounting period. Many variations in this procedure, however, are possible. The i64 PRINCIPLES OF ACCOUNTING total subtraction from materials, for example, might be first charged- to Goods in Process rather than to Trading. After making the inventory adjustment the balance of the Goods in Process account could be closed into Finished Goods. The balance of this latter account, in turn, might then be transferred to Trading. If the results of a daily inventory of materials were recorded in the accounts this procedure would be particularly desirable. Another variation would involve the elimination of the Trading account. In this event Materials, Goods in Process, Finished Goods and Sales might be closed directly into an Ex- pense and Revenue account. The adjustments of gross revenue and cost of materials in the typical case are usually more numerous than as shown by the above entries. An account is often kept, for example, to show the amount of defective or otherwise unsatisfactory materials returned. The nature of such an account can be shown by a definite illustration. A certain company buys materials on ac- count amounting to $i,ooo. The entries (in the general ledger accounts) would be : Materials $i,ooo Accounts Payable $i,ocx5 Of this shipment materials amounting to $200 are found to be of another type than that ordered, and are accordingly returned as unsatisfactory. The selling company allows the buying company credit on its books for the full amount of materials returp.ed. The entries on the bu3dng company's books would therefore be : Accounts Payable $200 Materials Returned I200 The balance of the Materials Returned account at the end of the period ($500, it will be assumed) may be closed into Materials by the following entries : Materials Returned $500 Materials $500 Or the balance of this account might be carried directly to Trading. CLOSING AND INTERPRETING ACCOUNTS 165 Similarly, returns of finished goods by customers require an adjustment of the gross revenue figure either by closing the amount of such returns into the Sales account or by carrying this amount directly to Trading. The following entries illustrate a possible case : (i) . Sales Returns |4CXD Accounts Receivable $4C3o (2) Sales $400 Sales Returns $400 Rebates and allowances and other offsets and discounts re- quire similar adjustments. All such amounts are current valua- tion items, and the accoimts with these items must therefore be closed at the end of each period. Some further attention will be given to this matter in a later section of this chapter. Thus far in discussing the inventories of goods in process and finished goods it has been implied that such amounts are of par- ticular importance because of their influence on the cost-of-mate- rials figure for a given period. This is a proper imphcation, but except in cases where the element of manufacture is entirely absent or negligible it is not the whole story. It should be recog- nized that such adjustments also prevent the over- or under- statement of other expenses for the period. All charges for com- modities and services expired are in part applicable to goods in process and finished goods on hand. In other words a part of the total of all asset expirations for a particular period is represented in the value of goods in process and finished goods. In some cases the element of manufacture may be more significant than the element of raw materials, for such items as labor services consumed, fuel burned, the depreciation of factory building, etc., may contribute more to the value of finished goods than the cost of the materials utiHzed in their production. It is evident in the above case of the A. B. Co., for example, that if all asset expirations are treated as deductions from August revenues, other expenses than materials will be overstated ; for all of these costs are not applicable to goods sold during the month. i66 PRINCIPLES OF ACCOUNTING This is the more apparent since this is the first month the com- pany has operated. If manufacturing and selling were to pro- ceed at exactly the same rate month by month hereafter, pay- ments for labor services and all similar charges could be considered as deductions from revenue when made; that is, the expense amounts would be correctly stated although the incidence of specific items would be illogical. But unless this unusual con- dition exists it will be necessary to take into consideration each month the inventories of semi-finished and finished product in order to determine the expense and revenue totals properly appHcable to each period. At the end of the next period it will not be the total inventories of goods in process and finished goods which the company's bookkeeper must carry to Trading or to Expense and Revenue as an offset to overstated expense charges, but rather the increase in these inventories over the amounts determined on August 31st. If these inventories show a decrease on September 30th it will be necessary, analogously, to consider the amount of the decrease an addition to expense; for otherwise September's costs will be understated. In determining the value of goods in process or of finished goods, therefore, the problems of cost accounting are involved. The total cost of production — exclusive of selling expenses — must be apportioned among the various stages of manufacture and spread over units of finished and semi-finished goods. A physical inventory gives the number of units ; an analysis of costs gives the value per unit. The difl&cult part of the process, evidently, is the allocation of costs. An account. Cost of Goods Sold, is often set up, and is charged with that part of total expense applicable to goods sold during the period. The balance of total cost incurred represents the value of materials, goods in process, and completed product on hand. Many subsidiary accounts and cost records are used in the typical case. No attempt will be made here to discuss the intricacies of factory cost accounting. This brief statement, however, should serve to suggest the nature of the problem, and its accounting significance. Even in the case of a trading enterprise, where the element of manufacture is entirely absent, there are certain costs which may be incurred in a particular period — in addition to the principal merchandise cost — which are not entirely applicable to product CLOSING AND INTERPRETING ACCOUNTS 167 sold during that period. Freight and cartage, and the cost of unpacking, shelving, and otherwise preparing goods for sale are examples of such items. In taking inventories of merchandise on hand it is necessary to take such charges into consideration if the exact amounts of expense and revenue applicable to each period are to appear in the accounts of that period. If purchases and sales run fairly even month by month, however, these items can be charged to expense as they arise without serious error. In discussing the process of taking inventories of current assets in a later chapter some further attention will be given to this topic. CLOSING MERCHANDISE ACCOUNTS In the case of retail and other trading companies the mer- chandise accounts present certain special problems of analysis at the end of the accounting period which should be discussed at this point. As explained in a preceding chapter Merchandise is sometimes kept as a mixed account — that is, an account which presents the comphcation of combining specifically both asset and equity elements. This case will first be considered. The Merchandise account in the trial balance of the Y. Co. December 31st, it will be assumed, shows total debits of $122,600 and total credits of $56,400. The first total represents the cost of all merchandise purchased during the period just ended plus the cost of goods on hand at the beginning of the period ; the credit total shows the total value of goods sold during the period at selling prices. An inventory at this time shows goods on hand to the amount of $78,600 valued at cost. Then $122,600 less $78,600 gives $44,000, the merchandise cost of the goods sold. Subtracting this figure from $56,400 gives a difference of $12,400, the merchandise revenue, or "gross trading profit" as it is some- times called, for the period.^ In closing the Merchandise account the bookkeeper shows this computation thus : 1 It should be noted that the term revenue can be applied with equal propriety to total sales, or to sales less merchandise costs. There is no fundamental reason for considering revenue in any case to be a balance remaining after a part but not all of the total expense of production has been deducted. 1 68 PRINCIPLES OF ACCOUNTING Merchandise I9I7 Bet. I 31 Inventory Inventory V P.B.5 Jss 82,000 40,600 12,400 I9I7 Dec. 31 Inventoiy S.B.3 V 56,400 78,600 135,000 135,000 1918 Jan. 1 V 78,600 1918 This method of closing illustrates again the bookkeeping prac- tice of adding to the opposite side instead of subtracting. The inventory brought down at the left cancels the balancing entry on the credit side and shows the property balance on hand.^ On January ist the Merchandise account represents $78,600 in property and nothing else. It is convenient to think of this closing computation in the case of Merchandise or any similar account in the way stated above : total debits less the new in- ventory shows the cost of goods sold ; total credits less the cost of goods sold gives merchandise revenue. The bookkeeper, however, instead of using two instances of subtraction adds to the opposite sides and accomplishes the same result. If a special Merchandise Revenue account were now set up to show this item of revenue the entries transferring the item from Merchandise to Merchandise Revenue would be : Merchandise $12,400 Merchandise Revenue $12,400 When this revenue is carried to a general Expense and Revenue account the following entries would be made : Merchandise Revenue $12,400 Expense and Revenue $12,400 ' Thinking of the Merchandise account on December 31st as an expense and revenue account there is another way of viewing this closing computation. Since the total of the old inventory plus purchases is treated as a deduction from sales it is necessary to consider the new inventory as a revenue item — an addition to sales. CLOSING AND INTERPRETING ACCOUNTS i6y If no special Merchandise Revenue account had been kept, the item of revenue would have been carried directly from Mer- chandise to Expense and Revenue, thus : Merchandise $12,400 Expense and Revenue $12,400 The debits to Merchandise in both of these cases represent not an addition to the left-hand side, but a subtraction of the revenue or equity element from the right-hand side ; that is, such entries represent the transfer of an item of revenue from one account to another. The use of such a mixed account for small enterprises is entirely proper ; but the nature of each of the different phases of mer- chandise should be clearly recognized. In the retail trade, mer- chandise as purchased is the raw material ; merchandise in the hands of the consumer constitutes the finished product. The element of manufacture is entirely absent and production con- sists primarily in furnishing place and time utiUties. This situa- tion, however, should not be allowed to obscure the fact that production is actually taking place, and that merchandise pur- chased and merchandise sold belong to entirely distinct classes of accounting data. The sales total represents gross revenue; the cost of goods sold constitutes the principal expense; mer- chandise on hand is often the most important asset. A mer- chandise account such as the one above, therefore, shows asset, expense, and revenue items. If these items are listed in the proper columns, however, and are correctly interpreted, no con- fusion results from the use of such a "combination" account. In the ease of a large retail enterprise it is desirable to use several accounts instead of one general account — as in the case just explained — to show the various phases of merchandise involved. A convenient procedure is the use of four distinct accounts for this purpose : (i) Merchandise Inventory ; (2) Mer- chandise Purchases ; (3) Merchandise Sales (Revenue) ; and (4) Merchandise Cost (Expense). At the time the trial balance is taken — using the figures in the above case — (i) would show a debit balance of $82,000; (2), a debit balance of $40,600; (3), a credit balance of $56,400 ; and (4) would show no entries. The I70 PRINCIPLES OF ACCOUNTING inventory is as before $78,600. What are the entries necessary to close these accounts ? Merchandise Inventory shows a debit balance of $82,000, and the present inventory is but $78,600. The procedure in closing this account would be similar to the case of Buildings described in a preceding section. Merchandise as an asset has decHned in value $3,400. Of the $82,000 listed in this account, $3,400 has expired. This transaction would be journaHzed as follows : Merchandise Cost $3,400 Merchandise Inventory $3,400 If the new inventory had been larger than the old, a debit to Merchandise Inventory and a credit to Merchandise Cost for the amount of the increase would be necessary. Merchandise Purchases shows a debit balance of $40,600. This account is not treated as an asset account in this case but as an expense account, the asset adjustment, if more or less goods than the amount purchased are sold, being made through Mer- chandise Inventory as shown above. The amount in this ac- count will then be closed into Merchandise Cost, thus : Merchandise Cost . . $40,600 Merchandise Purchases .... $40,600 Merchandise Cost and Merchandise Sales can now be closed into Expense and Revenue by the following entries : Expense and Revenue $44,000 Merchandise Cost $44,000 and, Merchandise Sales $56,400 Expense and Revenue $56,400 The merchandise accounts, closed, would now appear as follows : Merchandise Inventory I9I7 Dec. I Inventory Inventory V 82,000 1917 Dec. 31 Inventory J55 V 3,400 78,600 82,000 82,000 1918 Jan. I V 78,600 . CLOSING AND INTERPRETING ACCOUNTS 171 Merchandise Purchases ' I9I7 Dec. 31 P.B.5 40,600 I9I7 Dec. 31 Jss 40,600 40,600 40,600 u Merchandise Sales 1917 Dec. 31 S.B.3 56,400 SMoo Merchandise Cost I9I7 Dec. 31 J55 JS5 3,400 40,600 1917 Dec. 31 Jss 44,000 44,000 44,000 The Expense and Revenue account would now show the fol- lowing condition as far as merchandise items are concerned : Expense and Revenue 1917 Dec. 31 Jss 44,000 1917 Dec. 31 Jss 56,400 The procedure Just outlined is a convenient and logical method of handling the merchandise accounts. In this case merchandise • The debit balance shown in this account is intended to represent the total of all postings made during the month ; and this is true of all the trial balance figures used in these illustrations. 172 PRINCIPLES OF ACCOUNTING cost is carried to the debit side of the Expense and Revenue ac- count ; and gross revenue frOm sales, before any deductions have been made, is carried to the credit side. As was shown above, however, it is perfectly possible to make all these computations in one account, and to carry merchandise revenue less merchan- dise cost from this single account directly to Expense and Rev- enue. The chief reason for using several accounts is the need for differentiating sharply between departments and phases of the business for managerial purposes. Further, where special journals are used this procedure connects the ledger accounts more definitely with the books of original entry. An alternative procedure is the use of all the accounts shown above with the exception that a computation account. Merchan- dise Trading, is used instead of Merchandise Cost. This ac- count is similar to the Trading account discussed in the preceding section, and is of advantage particularly in cases where it is de- sired to secure an intermediate revenue figure before net expenses have been deducted. Using a Merchandise Trading account for the above case the closing entries would be as follows : (i) Merchandise Trading $3,400 Merchandise Inventory .... $3,400 which adjusts Merchandise Inventory ; and, (2) Merchandise Trading $40,600 Merchandise Purchases .... $40,600 Merchandise Sales $56,400 Merchandise Trading $56,400 which close purchases and sales into Merchandise Trading ; and, (3) Merchandise Trading $12,400 Expense and Revenue $12,400 which carries the item of revenue less merchandise cost into Ex- pense and Revenue. The Merchandise Trading account, closed, would now stand as follows : CLOSING AND INTERPRETING ACCOUNTS Merchandise Trading 173 I9I7 Dec. 31 Jss Jss Jss 3,400 40,600 12,400 1917 Dec. 31 Jss 56,400 56,400 56,400 A Merchandise Trading account is especially useful if it be desired to further adjust the merchandise revenue item before it is carried to a general Expense and Revenue account. Dis- counts on purchases and sales, as explained in a preceding chap- ter, are valuation items which must be used to adjust merchan- dise cost and merchandise revenue, before the exact amount of revenue is ascertained. One method of making this adjust- ment is to close the balances in the Purchase Discounts and Sales Discounts accounts into Merchandise Trading. Using the amounts appearing in the trial balance on page 152 for an illus- tration, the entries would be : Merchandise Trading $2,100 Sales Discounts $2,100 and. Purchase Discounts $1,900 Merchandise Trading $1,900 Similarly, other allowances and rebates as well as purchase and sales returns may be set up in special accounts which are closed into Merchandise Trading at the end of each period. The process of closing such accounts is similar to the procedure shown in the preceding section in connection with materials and finished goods returned. It is sometimes urged that other expenses, such as "in-freight," are costs of merchandise, and as such should either be closed into Merchandise Purchases or Merchandise Trading. This pro- cedure is not unreasonable, particularly where merchandise is the most significant cost and product. But arguments nearly as valid can be made in favor of closing all expense items in such cases into some merchandise account. And if this were done the 174 PRINCIPLES OF ACCOUNTING account in question would simply become a general Expense and Revenue account. It is doubtful if the dictates of logical analy- sis are further satisfied by such adjustments. Further, in most cases no new information of sufficient importance is furnished to warrant the expenditure of the necessary clerical effort. As sug- gested in the preceding section, however, the amount of such costs as in-freight appHcable to goods on hand at the end of a period should be considered in determining the inventory figure. In the case of a manufacturing enterprise, evidently, the Mate- rials account may be divided into two accounts, Materials In- ventory and Materials Purchases. Such accounts are closed in the same way as the corresponding merchandise accounts shown above. Where a firm deals in several types of merchandise, or requires several kinds of raw materials, a whole series of these accounts may be used. Similarly a distinct sales account may be opened for each important type of product. The process of closing the accounts in such cases is more complex than in the cases here discussed, but it would be accomplished in an analo- gous manner. In discussing merchandise inventories and merchandise ex- pense and revenue items in this section it has been assumed for convenience that no change in cost prices has occurred during the period in question, and that no value declines because of physical deterioration or obsolescence have taken place. If the inventory item used had involved such changes, however, the closing entries would have been made in exactly the same manner as shown above. CLOSING ACCOUNTS RECEIVABLE Accounts representing depreciable rights against other indi- viduals and firms are often closed simply by balancing, as are the equipment property accounts, and the expirations are re- corded in subsidiary valuation accounts. Accounts Receivable furnishes an important illustration of this procedure. In the illustrative trial balance appearing on page 152 this ac- count shows total debits of $24,800 and total credits of $13,800. The debit total represents the sum of the additions to this kind of property made during August plus the balance at the begin- CLOSING AND INTERPRETING ACCOUNTS 175 ning of the period. (If it be assumed, as before, that the A. B. Co. has been operating for a single month it is probable that Accounts Receivable had no balance on August ist.) The credit total shows the amount of such claims paid during the month. These figures represent the totals of the daily or weekly- postings to Accounts Receivable from the sales book, cash book, or other journal. At the end of the month this account would be closed by taking a balance, and would then appear as follows : Accounts Receivable I9I8 Aug. 31 Balance S.B.8 24,800 1918 Aug. 31 Balance C.B.4 J97 V 10,200 3,600 11,000 24,800 24,800 Sept. 1 V 11,000 The balance of this account, however, is not Kkely to represent the actual value of the outstanding book accounts. In the case of nearly every business enterprise the customers' accounts which prove to be entirely worthless or are not paid in full amount to a more or less considerable fraction of the total of such accounts arising during a given season or year. A reasonable allowance, therefore, should be made at the end of each accounting period for the amount of "bad debts" applicable to the business of that period. If such a deduction from revenue is not recorded in each case the accounts will not show a net revenue figure based upon the recognition of all actual accruals of cost and income within the period. For an illustration of the treatment of an allowance for bad accounts it will be assumed that of the balance ($11,000) shown in the above case three per cent, or $330, is a reasonable estimate of the amount which will prove uncollectible. How should this item be recorded in the accounts ? Since Accounts Receivable is a controlling account for the customers' ledger no deductions for estimated bad debts should be shown directly in this account. Otherwise the totals of the debit and credit balances of the individual accounts in the sub- sidiary ledger will not equal the debit and credit totals in Ac- 176 PRINCIPLES OF ACCOUNTING counts Receivable. The controlling account, therefore, should be closed by balancing as shown above. It will then be neces- sary to open a valuation account, Allowance for Uncollectible Accounts, in which to record the offset, or valuation item, of $330. The journal entries would be as follows : Expense and Revenue $330 Allowance for Uncollectible Accounts . $330 (A special account, Uncollectible Accounts Expense, might be charged with the amount of this deduction. In this case it would be necessary finally to close the subsidiary expense account into Expense and Revenue.) The charge to Expense and Revenue deducts the proper amount from the revenue of the period, and the credit to the valuation account indicates the decHne in assets. The balance of Accounts Receivable less the balance now appearing in the subsidiary account shows the estimated value of the outstanding book accounts. The later entries affecting Allowance for Uncollectible Accounts throw some hght upon the nature and use of such a valuation account. On August 31st, it may be assumed, A. Wilson owes the A. B. Co. $200 on open account. A few weeks later this customer becomes bankrupt and when his estate is liquidated the unsecured creditors receive but ten cents on the dollar in settlement of their claims. The entries on the books of the A. B. Co. at this time would be : Cash $ 20 Allowance for Uncollectible Accounts .... 180 Accounts Receivable $200 (A. Wason) These entries recognize the retirement of a specific account and hence both the controlling account in the general ledger and the customer's personal account in the subsidiary ledger should be credited. The difference between the amount reahzed and the face of A. Wilson's account is the amount of the charge to Al- lowance for Uncollectible Accounts. This amount . has been previously charged against revenue, and the subtraction from the asset has been indicated by a credit to the valuation account. CLOSING AND INTERPRETING ACCOUNTS 177 Since a specific asset is now being written off, a credit directly to the asset account should be substituted for a credit item in the subsidiary account. ,1| At the end of an accounting period it may be necessary to rec- ognize changes in the values of other rights as well as accounts receivable. In the trial balance of the A. B. Co. Notes Receiv- able shows a net debit balance of $2,900. If there is good reason for thinking that the notes now held by the company are worth less than this sum this fact should be recognized in the accounts. The amount of the estimated loss applicable to the current period should be charged against the revenue of the period. The sub- traction from assets may be indicated by a credit to a valuation account as in the above case. When, later, a specific note is discovered to be worthless, Notes Receivable would be credited and the valuation account debited for the amount of the note. In this case it will be assumed that the inventory figure is the same as the balance of the Notes Receivable account. The account. Securities Owned, appearing in the same trial balance, represents still other rights which are subject to value changes. Assets such as securities often fluctuate in market price. The desirability of recognizing such changes in the ac- counts is a matter of some dispute. It has been pointed out several times in the preceding pages that if it is the function of the accounts to present as nearly as possible the actual situation all value changes should be recorded. In so far as the ownership of securities, however, arises outside of the regular business of an enterprise, variations in the values of such assets can hardly be considered as affecting either gross revenue or expense totals. The entries given under cases (2) and (4) on page 114 suggest a more proper treatment for such value changes. In the illus- trative case of the A. B. Co. it will be assumed that the balance of the Securities Owned account, $4,000, is also the inventory figure. This account would then be closed by balancing and no closing journal entries would be required. CLOSING OTHER CURRENT ACCOUNTS In addition to the cases already discussed there are many other common accounts with current commodities and services that involve expense (or revenue) items, and hence furnislji prob- 178 PRINCIPLES OF ACCOUNTING lems of interpretation at the end of the accounting period. In the illustrative trial balance of the A. B. Co., given at the begin- ning of this chapter, are shown Labor, Fuel, Insurance, Mis- cellaneous Supplies and Services, and Rent as examples of such accounts. These accounts will be briefly discussed in the order mentioned. Labor shows a debit balance of $8,540. This represents the usual situation; the business enterprise buys labor services but seldom has such services for sale. An examination of the payroll on August 31st, it will be assumed, shows that not only have all the services represented by this debit total been received and consumed, but that services to the amount of $630 have been consvmied for which payment has not yet been made. That is, $8,540 plus $630, or $9,170, represents the total value of labor power which has been utilized during the past accounting period, or, in other words, the total labor expense. It is this amount, and not the cash outlay, which should be charged against the revenue of the past month. (The amount of labor cost appli- cable to goods in process and finished goods on hand is assumed to be included in the inventory figures for these assets ; and gross revenue is adjusted to allow for this and similar items as explained in a preceding section.) The closing entries would be : Labor Expense $9,170 Labor $9,170 If no special Labor Expense account were used the entries would be: , Expense and Revenue $9,170 Labor $9,170 The Labor account, closed, would now appear as follows : Labor I9I8 Aug. 31 Inventory C.B.5 V 8,S40 630 1918 Aug. 31 Inventory J97 9,170 9,170 9,170 Sept. I V 630 CLOSING AND INTERPRETING ACCOUNTS 179 The inventory item on the debit sijie of this account repre- sents the amount which must be added to the trial balance figure to give the total labor expense for the period as explained above. The inventory balance in this case represents not an asset but an equity item. The amount of $630 is due certain laborers, and the Labor account is used for convenience to show their equities. It is important that the effect of this accrued liability on the en- tries of the next period be noted. The item of $630 will, of course, be paid shortly. At that time Cash will be credited and Labor debited. Entering this amount, therefore, as an equity (a credit) at the end of this period prevents an overstatement of the labor services consumed in the succeeding period and shows as well the exact status of the enterprise in this respect at the present moment. The Fuel account in this case shows a debit balance of $600. On August 31st, it will be assumed, coal in the bins amounts to $200. The closing entries, evidently, would be as follows : Fuel Expense $400 Fuel $400 If no special expense account were opened the entries would be : Expense and Revenue $400 Fuel $400 The Fuel account, closed, would now appear as follows : Fuel 1918 Aug. 31 Inventory C.B.s 600 1918 Aug. 31 Inventory J97 V 400 200 600 600 Sept. I V 200 The accounts Insurance, and Miscellaneous Supplies and Serv- ices, would be closed in a similar manner. The latter account includes such items as postage, stationery, transportation serv- ices, etc. It corresponds to the more familiar "General Ex- pense." Such accounts would normally show asset inventories. i8o PRINCIPLES OF ACCOUNTING In this case it will be assymed that insurance prepaid on August 31st a,mounts to $125, and that stationery and other supplies on hand are valued at $100. The journal entries closing these ac- counts would then be as follows : (i) Expense and Revenue $125 Insurance $125 (2) Expense and Revenue $700 Miscellaneous Supplies and Services . . $700 The accounts would be balanced and the inventories brought down as in the case of the Fuel account shown above. The Rent account in this case shows a credit total of $300. This amount, it will be assumed, represents a payment to the A. B. Co. for the use of one floor of its building. This floor is leased by the S. Co. for $1,200 per year, payable quarterly in advance. On August ist the first quarterly payment was made. It is evident that at the end of the month the A. B. Co. can con- sider but one- third of this sum as revenue applicable to the cur- rent period, since the company is still obligated to furnish a val- uable service during the months of September and October. In other words, $200 of the balance now appearing in the Rent ac- count represents not revenue but a current liabihty — a liability which will be retired by the furnishing of a continuous service during the next two months rather than by a lump payment with cash or an equivalent. The journal entries necessary to close this account would be as follows : Rent $100 Expense and Revenue The Rent account, closed, would stand as follows : Rent $100 igi8 Aug. 31 Inventory J97 V 100 200 1918 Aug. 31 Inventory C.B.4 V 300 Sept. I 300 3°o CLOSING AND INTERPRETING ACCOUNTS i8i In many cases rent is paid after the service involved is furnished instead of being prepaid, as in the above illustration. Both asset and liability inventories are possible in connection with such a case. Accruals of rent in favor of the lessor represent an asset — a right against the lessee of the nature of an account receiv- able. Such accruals also constitute a part of the rent revenue for the past period, although this portion of the earnings has not yet been reaUzed in cash. On the books of the lessee rent accruals represent a liability — a claim against the lessee for service ren- dered of the nature of an account payable. Further, such an accrual should be considered a part of the lessee's operating ex- penses for the past period, since it represents the value of a serv- ice used in production during the period although the payment for the service has not yet been made. In addition to the accounts which represent the purchase and sale of current commodities and services accounts with current valuation items appear in nearly every trial balance. Examples of current valuation items are cash discounts on sales and pur- chases, rebates, and other allowances. Such offsets can be closed into the merchandise accounts, as has been explained, or they may be carried directly to Expense and Revenue. In the trial balance of the A. B. Co. there are two such accounts. Sales Dis- counts and Purchase Discounts. The entries closing the bal- ances of these accounts into Expense and Revenue would be as follows : (i) Expense and Revenue $2,100 Sales Discounts $2,100 (2) Purchase Discounts $1,900 Expense and Revenue $1,900 Although the total amount appearing in the Sales Discount account is evidently a proper deduction from the gross revenue figure for the current period, it would seem to be not quite ac- curate to consider the total of all purchase discounts allowed during August as offsets to current costs ; for a considerable part of the total of all purchases of materials made during the month is not applicable to August sales. It would appear, therefore, i82 PRINCIPLES OF ACCOUNTING that the amount of purchase discounts applicable to goods on hand should be credited to Materials rather than to Expense and Revenue. If, however, the inventories of materials, goods in process, and finished goods are based upon net prices for mate- rials and suppHes, the amount which is transferred from Trading to Expense and Revenue will involve the necessary adjustment. SUMMARY ACCOUNTS FOR SUNDRY ASSETS AND LIABILITIES The accounts in which are recorded the purchases of current commodities and services such as fuel and insurance can with reason be considered as either asset or expense accounts as was explained in Chapter III. The method of closing shown in the preceding section is consistent with the view that such accounts are asset accounts. If these accounts are viewed as expense accounts^ however, another method of closing would seem more logical. This alternative procedure (which is frequently used in practice) will be briefly explained. Since an expense account cannot well show an inventory bal- ance, the figure in any case which represents the amount of a cur- rent asset which has not expired during the current period should be transferred at the end of the period to a special asset account. An account called "Sundry Assets," or by a similar name, may be opened for this purpose. In the case of the Fuel account shown in the last section, for example, the inventory figure which represents the value of coal on hand on August 31st should be closed into Sundry Assets. The journal entries closing the Fuel account if this procedure were adopted would be as follows : Sundry Assets $200 Fuel $200 (2) Expense and Revenue $400 Fuel $4cx) The entries under (i) transfer the asset balance at the end of the month from Fuel, an expense account, to Sundry Assets. The entries under (2) shift the amount of fuel expense for the period CLOSING AND INTERPRETING ACCOUNTS 183 from Fuel to Expense and Revenue. The Fuel account would now show no balance. The principal advantage to be derived from the use of such a special asset account arises in connection with the preparation of the balance sheet. Several small asset items may in this way be transferred to a summary account and appear in the balance sheet in total, rather than under several heads. Thus the asset balances of the Insurance and Miscellaneous Supplies and Services accounts mentioned above may also be transferred to Sundry Assets. The importance of this convenience, however, may be easily exaggerated. It is quite possible to collect several account balances under one head for balance sheet purposes without opening a special ledger account and closing the various balances into this account. In other words, while a balance sheet may consist simply in an asset-equity arrangement of the ac- count balances after the process of closing is completed, any complete statement of assets and equities based upon these balances — however the items be combined or arranged — may be said to constitute a balance sheet (see Chapter IX). When a Sundry Assets account is used it is necessary to close this account and reopen the various expense accounts involved at the beginning of the following period. On September ist, for example, it would be necessary to reopen the A. B. Co.'s Fuel account by the following entries : Fuel $200 Sundry Assets $200 These entries, evidently, are just the reverse of the above closing entries. The debit to Fuel can now be conceived as the first purchase of coal applicable to the operation of the business dur- ing September. Similarly, an account. Sundry Liabilities, may be opened to serve as a summary account for the various small liability items which are discovered to be accrued at the end of an accounting period. In the case of the Labor account discussed in the pre- ceding section, for example, the following entries would be neces- sary to close the account if this procedure were adopted : (i) Labor . . $630 Sundry Liabilities $630 1 84 PRINCIPLES OF ACCOUNTING (2) Expense and Revenue $9,170 Labor $9,170 On September ist the entries under (i) would be reversed, thus : Sundry Liabilities $630 Labor $630 It is obvious that after the reopening entries are made in any of these cases the account involved shows exactly the same status whether closed by bringing down the inventories directly — as shown in the last section — or by making use of special summary accounts for the inventory items. The second method is somewhat more cumbersome than the first, in that it involves the use of an additional account in each case and requires addi- tional closing and opening entries. It is doubtful whether the advantages of this procedure outweigh the disadvantages. CLOSING THE EXPENSE AND REVENUE ACCOUNTS As has been indicated several times in the preceding pages the special expense (and revenue) accounts which are opened for statistical purposes at the end of the accounting period should finally be closed into a summary account, Expense and Revenue. The amounts appearing in such accounts as Depreciation Ex- pense, Labor Expense, Fuel Expense, etc., as well as in such in- termediate summary accounts as Trading, for example, are trans- ferred to this summary account. The journal entries necessary to close the accounts mentioned (using the amounts given in the preceding illustrations) would be as follows : (i) Expense and Revenue $350 Depreciation Expense $350 (2) Expense and Revenue $9,170 Labor Expense $9,170 (3) Expense and Revenue $400 Fuel Expense $400 CLOSING AND INTERPRETING ACCOUNTS 185 (4) Trading $15,800 Expense and Revenue .... $15,800 In the trial balance of the A. B. Co. shown at the beginning of this chapter there were evidently no pure expense or revenue accounts ; for — with the exception of the valuation accounts Purchase Discounts and Sales Discounts — an inventory has been assumed in each case discussed. It would be quite possible, however, for the amount of a commodity or service consumed ia a particular case to coincide with the amount appearing in the trial balance. Freight and Cartage, and Repairs to Machin- ery are typical examples of expense accounts which are likely to show in the trial balance the actual deductions from revenue for the period. AU such accounts are also closed by transfer- ring the debit balance in each case to Expense and Revenue. If it be assumed that in addition to the expenses already men- tioned in the preceding pages there is an item of depreciation expense in coimection with equipment of $300, the Expense and Revenue account of the A. B. Co., when closed on August 31st, would appear as follows : Expense and Revenxje I9I8 1918 Aug. 31 J96 350 Aug. 31 J 96 15,800 J96 300 J97 100 J96 330 J97 1,900 J97 9,170 J97 400 J97 125 J97 700 J97 2,100 J98 4,325 17,800 17,800 The balance of Expense and Revenue is the net revenue (or net deficit) figure — the difference between the amount of all accruals of revenue for the current period and the total of all commodities and services which have expired in producing this i86 PRINCIPLES OF ACCOUNTING revenue. In the above case revenues exceed expenses by $4,325. The last debit entry is not an expense charge but represents rather the withdrawal of the net revenue element from the summary account. The closing journal entries would be as follows : Expense and Revenue $4)3 25 Net Revenue $4,325 In accounting practice the Expense and Revenue account is often labeled "Profit and Loss" or "Loss and Gain." The particular terminology used in any case is not a matter of great importance provided the nature of the account is clearly under- stood. There is a tendency in practice, however, to combine both gross expense and revenue items and net revenue charges and credits in the Profit and Loss account. This practice should be avoided. The distinction between gross revenue and net revenue items is one of the most important distinctions in ac- counting. To confuse the Expense and Revenue and the Net Revenue accounts destroys, in a measure, the value of such accounts ; and any such procedure is likely to lead to improper classification in the financial statements. In the case of the typical large scale enterprise where an at- tempt is made to classify expenses not only in terms of the im- portant t3rpes of commodities and services consumed but on a functional basis as well, the special expense accounts set up may be very numerous, and the task of opening and closing such a series of accounts will be correspondingly detailed. A number of intermediate summary accounts which are finally closed into Expense and Revenue are usually employed. Examples of such accounts are Buying Expense, Manufacturing Expense, Selling Expense, and General Expense. Similarly, revenue items may be classified in some detail in the accounts. The classifications given on pages 139-140, and on page 142, are illustrative. Care must be taken in such cases that each subsidiary account be closed into the proper intermediate account. Otherwise the conclusions drawn by the management from the data furnished by these special summary accounts will be misleading. In any case, however, the process of closing is accompUshed in an analogous manner to the procedure outlined above. CLOSING AND INTERPRETING ACCOUNTS 187 CLOSING THE NET REVENUE AND EQUITY ACCOUNTS The last step in closing the accounts in any case is the dis- tribution of net revenue (or the allocation of net deficit) to the various equities in the enterprise. In this connection the rela- tion of the contractual equities to the enterprise will be first con- sidered. In the trial balance of the A. B. Co. shown on page 152, no Bond Interest account appears. This is due to the fact that there has been no actual disbursement to the bondholders during the month of August, and that there were no accruals in favor of the bondholders on August ist. (It will be assumed, for con- venience, that the bonds were issued on August ist.) But since the bondholders have contractual claims upon net revenue — or upon capital if there is no net revenue — their equity in the enterprise accrues as a function of time, and consequently the actual increase in this equity during an accounting period seldom coincides with the amount paid.^ In this case it will be assumed that the outstanding bonds were issued at par, and that the interest rate is six per cent, payable semiannually. The accrued interest for the month of August, therefore, amounts to $200. It is this amount which represents the interest of the bondholders in the net revenue of the account- ing period just past. The entries opening the Bond Interest account, and appropriating $200 from Net Revenue, would be as follows : Net Revenue . . . Bond Interest $200 $200 Bond Interest, closed, would now appear as follows : Bond Interest I9I8 Aug. 31 Inventory V 200 1918 Aug. 31 Inventory J98 200 200 200 Sept. I V 200 1 Preferred stockholders' claims may also be said to accrue in time, but it is not customary to recognize these accruals in the accounts. Stockholders as well as 1 88 PRINCIPLES OF ACCOUNTING The Commercial Interest account in the illustrative trial balance shows a debit total of $70 and a credit total of $30. This account is used to show the payments made to the equities represented by notes payable, and items of net revenue received by the company from bank balances and from promissory notes held against other parties. The interpretation of this account presents some difficulty. The debit total represents payments actually made during the period plus interest due the firm at the beginning of the period if there were any such accrual. The credit total shows the amounts received by the company during the period for rendering the service of capital plus any interest accrued and unpaid at the beginning of the period. It will be assumed that an examination of the company's notes receivable and payable at this date shows that interest is accrued on notes receivable to the amount of $20, and on notes payable, $50. The Commercial Interest account, closed, would now appear as follows : Commercial Interest igi8 Aug. I 31 Inventory Inventory- Inventory V C.B.5 V IS 55 5° 1918 Aug. I 31 Sept. I Inventory Inventory Inventory V C.B.4 V J98 10 20 20 70 120 120 Sept. I V 20 V so The closing entries, evidently, would be : Net Revenue . . $70 Commercial Interest $70 It is important that the various elements represented in such a complex account be carefully distinguished, (i) All interest payments made during the period are entered on the debit side. These items represent distributions of net revenue to certain contractual equities, in this case represented by notes payable. (2) All payments received by the firm for furnishing capital to outsiders are entered as credits. These credits are additions to bondholders, however, have rights of legal procedure against the enterprise if their legitimate claims to a portion of net revenue are not being recognized. CLOSING AND INTERPRETING ACCOUNTS 189 net revenue, for they represent the sale of the services of the owners where no deductions are involved. (3) The interest in- ventory which shows the amount of interest accrued payable is entered as a credit. This element of the account then repre- sents a simple equity or Hability. (4) Interest accrued receivable is recorded as a debit inventory. (Each inventory is first en- tered on the opposite side for the purpose of making the closing computation.) This item represents an asset, a right against outside parties.^ The balance of this complex account represents the net debit or credit to Net Revenue. (It is common practice to charge such a balance to expense. The legitimacy of this pro- cedure will be discussed in the next chapter.) It would be possible to use four accounts instead of one to show the different elements in the above case ; and wherever the item of commercial interest is large it is no doubt best to adopt this or a similar procedure. The titles of such accounts could be : (i) Interest Paid ; (2) Interest Received ; (3) Interest Pay- able (equity) ; (4) Interest Receivable (asset). It is evident that some enterprises could make use of a large number of interest accounts, not only to record the various phases of interest, but to show the relations of the different classes of contractual equities to the company as a whole. Distributions to the proprietary equities, such as dividends on capital stock, are analogous to interest payments in their effect upon net revenue and the fundamental classes in the ac- counting equation. But usually these distributions are residual and not contractual in character. It will be assumed in the case of the A. B. Co. that the directors decide to post a dividend of one and one-half per cent on August 31st, the entire amount to be appropriated from net revenue. The entries covering this dividend declaration would be : Net Revenue $2,55° Dividends . $2,550 When these dividends are finally paid the journal entries would be as follows : ^ Discount arising when notes payable are discounted (sometimes called prepaid interest) should be carefully distinguished from an asset interest inventory if one does not wish to obscure the net revenue figure. I90 PRINCIPLES OF ACCOUNTING Dividends $2,550 Cash $2,550 These entries, evidently, would balance the Dividends account. In a later chapter the treatment of dividend transactions will receive further consideration. Transactions involving tax payments or accruals also affect the Net Revenue account, as already explained. Taxes are usually paid annually or semiannually; but if these items can be ascertained beforehand with a reasonable degree of certainty accruals should be taken into consideration. It will be assmned in the case of the A. B. Co. that the management decides to ap- propriate from the net revenue for August the amount of $250 as a reserve to represent the accrual of state and federal taxes. The payments made at the end of the fiscal year may not be exactly on this basis, since the company's relation to the govern- ment is not contractual. This estimate, however, it will be as- sumed, is based upon all the information available. The entries recognizing this accrual would be : Net Revenue $250 Reserve for Taxes $250 At this moment, then, the equity of the government is recog- nized on the books to the extent of $250. As was emphasized in a preceding chapter, any actual loss that constitutes a net decrease in equities is a net revenue or surplus item, and not an expense. As long as such items are small this analysis is not of very great importance, but a significant loss, if treated as an expense, obscures the net revenue figure and in part destroys the value of the expense and revenue accounts for managerial purposes. Hence all actual losses should be debited to the Net Revenue or Surplus accounts rather than to Ex- pense and Revenue. In this case it will be assumed that there have been no unusual occurrences giving rise to actual loss. The Net Revenue account of the A. B. Co. on the basis of the entries that have been discussed would now appear as follows : CLOSING AND INTERPRETING ACCOUNTS Net Revenue "■ 191 1918 1918 Aug. 31 J98 J98 J98 J98 J98 70 200 2>SSO 250 1,255 Aug. 31 J98 4,32 s 4,32s 4,32s The last debit entry appearing in the above account represents the balance of net revenue which has not been specifically ap- propriated, and hence may be transferred to Surplus. The entries closing Net Revenue and opening the Surplus account would be : Net Revenue $1,255 Surplus $i,2SS A considerable increase in the stockholders' equity, in addition to the amounts appropriated as dividends, interest and taxes, represents the result of the operation for the period. If opera- tion had resulted in a net deficit, the stockholders' equity, at least, would have been decreased. The Surplus account, balanced, would now appear as follows : Surplus I9I8 Aug. 31 Balance 1,255 1918 Aug. 31 Balance J98 1,25s I,2SS 1,255 V 1,255 The equity adjustments are all made in this case through the subsidiary equity accounts. Net Revenue, - and Surplus. The accounts Capital Stock, Bonds, Notes Payable, and Accounts Payable are left unchanged as they appear in the trial balance shown at the beginning of the chapter. 1 This account has been called the " Profit and Loss Allocation " account. See Oilman, Principles of Accounting, p. 213. IX The Preparation of Statements After the accounts of an enterprise have been properly adjusted by means of closing entries the balances appearing in the general ledger reveal again the exact current status of the enterprise (assuming the inventories to be correct) ; and the financial history of the concern for the past accounting period can be determined by a careful examination of the books of account and original entry. In other words, the ledger balances at this time disclose the present condition of all asset and equity items, and the process whereby this condition was immediately attained is represented — in summary form at least — by the trial balance figures and the closing adjust- ments. The task of reading this information directly from the accounts, however, is somewhat difficult, and hence an im- portant part of the accountant's work consists in the prepara- tion of statements or exhibits which present in compact well- arranged form the items necessary to an intelUgible showing of the various important phases of the business process and its results. This sort of information is invaluable for the pur- poses of the operating management, the board of directors, the owners, and prospective creditors or investors. These interests wish to secure the accounting data of the enterprise involved in any case in summary and readable form since they have not the time, opportunity, or skill to glean the desired information directly from the accounts. The three important financial statements are : (i) the expense and revenue statement; (2) the net revenue and surplus statement; ^ • The surplus statement is sometimes considered to be a distinct exhibit. See Chapter XXV. 192 PREPARATION OF STATEMENTS 193 and (3) the balance sheet. These statements will be briefly dis- cussed in the order named. Some special-column devices for computing and presenting these statements — of value chiefly to the student and the practicing accountant — will also be considered. In this chapter attention will be directed prin- cipally to the more general characteristics of financial state- ments and their relation to the underlying system of accounts in any case. A more elaborate discussion of accounting state- ments wiU be given in Part Five. THE EXPENSE AND REVENUE STATEMENT The expense and revenue statement in any case is a systematic presentation of all expenses and all revenues applicable to a given accounting period.^ That is, such an exhibit shows all items of gross income which have accrued during the period, and the amounts which represent the commodities and services which have expired in producing this revenue; and its concluding figure is the net revenue or net deficit. It is this statement which presents the results of business operation, and hence reflects, in a measure, the efficiency of the operating officials. It is the net balance of this statement which shows whether the events of the past period have resulted in a favorable or unfavorable change in the status of the private equities involved. If all items of expense and revenue are carried to a simimary account as explained in the preceding chapter, that account itself is virtually an expense and revenue statement, except that the amounts are not itemized. In simple account form, therefore, the expense and revenue statement is an itemized replica of the Expense and Revenue account, showing all ex- penses in one column and all revenue items in another. The A. B. Co.'s expense and revenue statement for August, for example, as constructed from the Expense and Revenue account shown on page 185, would appear as follows : 1 In accounting practice this statement, combined with the net revenue and sur- plus statement, is variously called the "income sheet," the "profit and loss state- ment," the "loss and gain statement," etc. 194 PRINCIPLES OF ACCOUNTING A. B. Co., August 31, 1918 Expense and Revenue Statement Depreciation of Buildings $ 35° Trading Revenue . $15,800 Depreciation of Equipment 300 Rent from Building 100 Allow, for Doubtful Accts. 330 Purchase Discounts 1,900 Labor Expense .... 9,170 Fuel Consumed . . . 400 Insurance Expired . . 125 Misc. Supplies and Services 700 Sales Discounts . . . 2,100 Net Revenue (to Net Revenue Statement) 4,325 $17,800 $17,800 The maimer of determining the various amounts shown in this statement was explained in Chapter VIII. The net revenue figure, $4,325, is carried to the net revenue statement to be distributed and appropriated in accordance with contractual agreements and at the discretion of the board of directors. The simple exhibit shown above would not be considered a satisfactory expense and revenue statement for most pur- poses. In the first place the account form is rather technical, and the laynian consequently finds it somewhat difiicult to interpret a statement prepared in this way. The "report," or narrative form, has some advantages in this respect. Further, the above statement is much too condensed to form a satis- factory operating sheet. The computations and adjustments which gave rise to the item of trading revenue, for example, should be shown in some detail. The following exhibit shows the expense and revenue statement of the A. B. Co. prepared in the report form, and including the computation of the trading revenue figure (see page 195). In this statement discounts on purchases and sales are treated as deductions from the cost of materials and total sales, respectively. This accounts for the fact that the amount of trading income is $15,600 instead of $15,800 as in the preceding exhibit. Accountants are not at all agreed as to the exact incidence or location of such discounts in the financial state- ments. Large rebates and allowances such as "trade" dis- PREPARATION OF STATEMENTS 195 counts, are generally handled as shown, below. Cash discounts, however, are often accorded different treatment. But in agree- ment with the explanation of such items given in Chapter IV the discounts in the above case are placed in the trading section of the expense and revenue statement. Expense and Revenue Statement — A. B. Co. For Month ending August 31st, 1918 Trading — Total Sales $76,400 Deduct — Sales Discounts 2,100 Gross Trading Revenue ... . . $74,300 Materials on hand August ist ... $80,000 Purchases during August 40,600 $120,600 Deduct — Inventory of Materials August 31st . . . . $40,000 Inventory of Goods in Process August 31st . 8,000 Inventory of Finished Goods August 31st . 12,000 Purchase Discounts . . 1,900 6 1, goo Cost of Goods Sold . 58,700 Trading Income $15,600 Manufacturing and Selling Costs — • Depreciation of Buildings $ 350 Depreciation of Equipment 300 Allowance for Doubtful Accounts .... . 330 Labor 9jr7o Fuel 400 Insurance 125 Miscellaneous .... 700 Total 11,375 Manufactiiring Net Revenue $4,225 Other Income — Rent from Building 100 Total Net Revenue $4,325 There are certain inaccuracies in the above statement — not affecting the concluding net revenue figure, however — which 196 PRINCIPLES OF ACCOUNTING should be noted. The total of manufacturing and selHng costs is overstated by the amount of such costs applicable to the inventories of goods in process and finished goods as was ex- plained in the preceding chapter. In other words a part of the stated deductions from the gross cost-of-materials figure constitutes an offset to overstated manufacturing and selHng expense figures. The cost of materials is understated ; and the total of other expense is overstated by the same amount. If an adequate system of cost accounts is in use in any case the state- ments may be prepared in such a way as to avoid such mis- statements. Further, it is very unKkely that the amount of the discounts accepted on purchases during August is applicable to materials actually consumed in producing the finished goods sold during the month. If, however, it be assumed that the inventories of materials, goods in process, and finished goods are based upon net figures as far as the prices of materials are con- cerned, the entire amount of purchase discounts should be con- sidered as a deduction from costs as was stated in Chapter VIII. Since the A. B. Co. is assumed to be a manufacturing enter- prise, there is some question as to the propriety of treating the cost of materials as a trading deduction from gross revenue. The cost of materials, it might be urged, is essentially a manu- facturing cost. The procedure shown above can be justified only on the ground of an assumption that in the case of the A. B. Co. the element of manufacture is so slight that the com- pany is, in many respects, very similar to a trading enterprise. The figures given in this case are in agreement with such an assumption. Of the total expense for the month ($58,700 plus $ii,37S) about eighty per cent is the cost of materials (ignoring the errors already referred to). But it must be admitted that even in cases where the cost of raw materials constitutes a very large part of the total expense the process of manufacture may very decidedly alter the nature and appearance of the materials used. In such cases, evidently, goods purchased and goods sold cannot from any viewpoint be said to be identical. Hence such an enterprise cannot be considered a trading company. For the sake of simplicity, however, the trading section in the above statement is presented in much the same form as would be suitable for a regular trading enterprise. PREPARATION OF STATEMENTS 197 The particular way in which an expense and revenue state- ment should be arranged depends not only upon the type of enterprise involved in any case but also upon the use that is to be made of the statement. In general it is the operating management which is particularly interested in this exhibit. Other interests such as the directors, stockholders, or creditors may be concerned, however, and the form of the statement may well be varied somewhat to suit the needs of each class. For general purposes variations of the report form are probably the most usable. In the case of a complex enterprise it is desirable to classify the items in the expense and revenue statement on departmental and functional bases much more elaborately than was done in the above illustrative case. The construction and analysis of such statements, and the uses to which a succession of these exhibits may be put, will be fully discussed in Chapter XXV. THE NET REVENUE AND StTRPLXJS STATEMENT This statement begins with the amount of net revenue as shown by the expense and revenue statement, and shows the disposition of this amount among the various interests that have claim to it. It shows, further, the adjustments which must be made in the proprietary equity because of variations in asset values which arise outside of regular operating transac- tions. In the case of a corporation this statement presents a record of the authorizations of the board of directors in regard to net revenue and surplus. If there are several distinct equities in the enterprise in any case it is desirable that the net revenue section be subdivided into as many parts as there are distinct classes of equities in order that the rights of each group of owners in the net revenue may be clearly presented. In its simplest form this statement is an itemized presentation of the Net Revenue and Surplus accounts. In the case of the A. B. Co. the net revenue statement for the month of August — based upon the closing entries and accounts discussed in the last chapter — would appear as follows : igS PRINCIPLES OF ACCOUNTING Net Revenue and Surplus Statement A. B. Co., August 31, 1918 Commercial Interest $ 70 Bond Interest 200 Dividends Posted • 2,550 Taxes Accrued . . 250 Surplus for Month . ■ 1,255 $4,325 Net Revenue (from Ex- pense and Revenue State- ment) $4,325 $4,325 Arranged in narrative form this statement might be presented as follows : Net Revenue and Surplus Statement — A. B. Co. For Month Ending August 31st, 1918 Total Operating Net Revenue for Month (from Expense and Revenue Statement) . . $4,325 Deduct — Taxes Accrued during August 250 Net Income" Accruing to the Private Equities $4,075 Contractual Deductions — Net Commercial Interest Deductions $ 70 Bond Interest Accrued during August 200 270 Net Proprietary Income .... $3,805 Deduct — Dividends Declared 2,550 Surplus for August $1,255 There is some question as to the propriety of considering such items as commercial interest as belonging in the net revenue section rather than in the expense and revenue statement. As was explained in Chapter VII accruals of income in favor of individuals or interests furnishing capital to the enterprise in any case are not expense items according to strict logic. Ex- pense charges measure the expiration of commodities and serv- ices purchased by the management and consumed in producing the revenue of a given period. Various equities — stockholders, bondholders, noteholders, etc. — furnish the capital which is used in making these purchases. The excess of revenues over expenses constitutes the return to these interests. This amount is distributed to the equities in accordance with the rights and PREPARATION OF STATEMENTS 199 privileges which each class enjoys. From this standpoint all interest accruals are clearly in the same general accounting category as are dividends and other proprietary items. In some cases, however, it would seem somewhat unreasonable to insist that this logical analysis be followed in the statements. If, for example, ninety-five per cent of the capital in a particular case is furnished by the proprietors, contractual accruals of net revenue will be comparatively sKght in amount ; and such items can be included in the expense and revenue statement without serious error. In such a case the net revenue and surplus state- ment will be practically a proprietary sheet. Further, if the expense and revenue statement be conceived as a record of the stewardship of the operating officials and employees, and is used to fix their responsibihties, then interest on current borrow- ings can be considered an expense in so far as the operating management is really responsible for these borrowings. Whenever contractual equities are significant in amount and run for long terms, however, the interest charges involved should be treated as net revenue items. If such charges are treated as expenses, the concluding figure of the expense and revenue statement will depend upon the particular scheme of financing employed as well as upon the results of business operation. This is entirely unreasonable. To include interest on bonds, notes, mortgages, etc. — together with gross revenues and expenses — under the general caption "profit and loss," as is done by so many accountants, is a practice which destroys in a large measure the value of the statements for managerial purposes. A simple illustration will perhaps serve to make clear the impropriety of such a procedure. The A. Co. has outstanding among other equities, bonds to the amount of $100,000. Interest charges on these bonds amount to $6,000 per annum. In 19 16 this sum is included with the operating expenses in the so-called profit and loss statement. It happens that the bond contract contains a provision which permits bondholders to exchange their securities for preferred stock under certain conditions. During 1917 a considerable number of bondholders avail themselves of this privilege. Interest charges are thereby reduced to $3,500. Operating expenses and revenues, it will be assumed, are exactly the same as in 200 PRINCIPLES OF ACCOUNTING 1 91 6. The profit and loss statement for 191 7, however — which again includes interest charges with operating expenses — would show a net revenue greater than the 191 6 balance by the amount of the decrease in interest charges. Could these statements as they stand be used for comparative purposes to determine the efficiency of the operating management ? The distinction between expense items and net revenue charges is of particular importance in connection with the preparation of the statements, for it is often on the basis of these statements that the operating management and the board of directors make the important decisions of business and financial poHcy. And other interests such as the individual stockholder and bondholder, or the prospective creditor or investor, usually see nothing of the accounting records with the exception of the statements. It is essential, therefore, that the important state- ments be prepared in such a way as to best serve the purposes of these various interests. The net revenue figure is one of the most significant amounts shown by the accounts ; and account- ing practices should be carefully scrutinized with a view to preserving the integrity of this figure. If returns to contractual equities are listed among the expenses the results of operation as such are obscured. Tax accruals, as was explained in the last chapter, stand in an anomalous position in the accounting structure. The state does not furnish capital to the enterprise in any case, and hence tax payments do not represent a return to capital. As far as the logic of the case is concerned it would seem to be equally proper to place the deduction for taxes in the net revenue section or in the expense and revenue statement. Indeed the only entirely satisfactory treatment for taxes in the statements is to recognize this item as congruous with no other figure. But if the tax charge is not segregated it would seem to be the most rational procedure to place this item among the net revenue deductions as was done in the above case. Tax accruals represent a charge for which the manager is in no way responsible, and which in no way reflects upon the efficiency of operation. Hence this item should not be fisted among the expenses. The present " excess-profits " and income taxes are certainly levies upon in- come, and are in nowise deductions from gross revenue. PREPARATION OF STATEMENTS 201 In the second of the above exhibits the items are arranged according to priority of Hen. This order is probably the most satisfactory. Although the net revenue and surplus statement is rather simple in this case it is evident that in the case of a large corporation having outstanding several types of stocks, bonds, and other securities the net revenue section of the financial statements would be an exhibit of considerable size and im- portance. In the case of a simple single-proprietorship or partnership, on the other hand, this statement may shrink to insignificant dimensions or even practically disappear. In the illustrative case of the A. B. Co. no surplus appropria- tions have been assumed. In practice, however, both interest and dividend appropriations are often made from surplus, rather than from current income; and in some cases such dis- tributions are even made fr.om invested capital. Items of net loss or net gain may also be treated as deductions from or addi- tions to surplus, as was previously explained; and the surplus balance may be subdivided into a number of special accounts by order of the board of directors. In such a case the surplus statement may be prepared as a distinct exhibit, showing accu- mulated as well as current surplus. The A. B. Co., however, has no accumulated surplus, and there are no appropriations and adjustments. Hence the surplus section- in this case is rather a simple affair, consisting merely in the surplus figure for August. This figure represents the amount of net proprietary income which for the time being is retained in the business as investment. In later chapters surplus adjustments will be further discussed. THE BALANCE SHEET The balance sheet is the most important financial statement. This is true not only because the balance sheet is the basis of the entire accounting structure, but also because of the practical uses to which this statement may be put by the various interests involved in any case. A balance sheet, if properly prepared, furnishes invaluable information to directors, stockholders, bondholders, managers, prospective creditors and other in- terests concerned; for if the inventories and appraisals are correct this statement gives an accurate presentation of the 202 PRINCIPLES OF ACCOUNTING financial status of the business at the end of the accounting period. The balance sheet, in its simplest form, may be called a "bal- ance of balances." It is a summary of the general ledger after the process of closing the accounts is completed. It is only at this time that the books represent the actual state of affairs. Many of the expenses are accruing continuously, and the day after closing in any case the accounts will fail to represeiit the actual status of the enterprise to some extent. The longer the interval between inventories the larger and more numerous will be the discrepancies. Arranged in the simple account form the balance sheet of the A. B. Co. on August 31st would appear somewhat as follows : Balance Sheet A. B. Co., August 31, 1918 Real Estate . . . Buildings Equipment Materials Goods in Process . . . Finished Goods Cash Accounts Receivable Notes Receivable . . . Securities Owned . . . Fuel Insurance Miscellaneous Supplies and Services . . . Commercial Interest * 40,000 69,650 23,700 40,000 8,000 12,000 26,200 10,670 2,900 4,000 200 125 100 20 |237;565 Capital Stock . . Bonds .... Notes Payable Accounts Payable Rent Dividends . . . Labor .... Bond Interest Reserve for Taxes Commercial Interest Surplus .... $170,000 40,000 8,700 I3>730 200 630 200 250 so 1,25s $237,565 The above statement shows simply the balances of the asset and equity accounts of the general ledger by account titles. Although it should be recognized that the balance sheet is always based upon these balances, the point should be em- phasized that there is no reason why account titles should be exactly followed in the statement. Other individuals than bookkeepers and accountants wish to read the balance sheet; and since the account names are -often abbreviated and tech- nical, the items in the balance sheet may well be labeled with PREPARATION OF STATEMENTS 203 longer and more intelligible titles. "Wages Payable," for example, would be a more appropriate balance sheet heading than "Labor." Further, the above statement shows no valua- tion accounts ; and, as was explained in the preceding chapter, it is convenient to record some asset expirations by using valua- tion accounts. Still further, it is usually desirable to arrange the items on both sides of the balance sheet into subsidiary groups. Many of the important facts which a balance sheet should show can be ascertained only from a comparison of special groups of asset and equity items. The balance sheet of the A. B. Co., revised in accordance with these suggestions, arid arranged in the report form, would appear as follows : Balance Sheet — A. B. Co. August 31st, 1918 Assets Fixed : Real Estate $40,000 Buildings $70,000 Less — Allowance for Depreciation of BuUdings 350 69,630 Equipment $24,000 Less — Allowance for Depreciation of Equipment 3°° 23,7°° Total Fixed Assets $i33j35o Current Working : Materials $40,000 Goods in Process 8,000 Finished Goods 12,000 Total Working Assets 60,000 Current Liquid : Cash $26,200 Accounts Receivable $11,000 Less — Allowance for Doubtful Accounts '■330 10,670 Notes Receivable 2,900 Securities Owned 4,000 Interest Accrued 20 Total Liquid Assets 43,79° 204 PRINCIPLES OF ACCOUNTING Sundry Current : Fuel $200 Insurance Prepaid 125 Miscellaneous Supplies and Services 100 Total Sundry Assets 425 Total $237,565 Equities Capital : Stock $170,000 Bonds 40,000 Total Capital Equities $210,000 Current Liabilities : Notes Payable $ 8,700 Accounts Payable 13,730 Bond Interest Accrued 200 Commercial Interest Accrued 50 Taxes Accrued 250 Wages Payable 630 Dividends Payable 2,550 Total Current Liabilities 26,110 Deferred Credits : Rent Prepaid (September and October) .... 200 Surplus : August Balance 1,255 Total $237,565 Some of the headings in the above statement require brief explanation. The term "working" is often applied to those assets such as raw materials which are made up into finished product and are in this way finally converted into other assets such as cash and accounts receivable. There is some question as to the propriety of Ksting finished goods under this head ; for such goods represent the product ready for sale. The pro- ductive process, however, is not actually completed in any case until the sale has been made; and although this part of the process may cause little or no change in the physical nature of the goods involved, it is still a necessary step in production and requires certain definite costs. Liquid assets are assets which will either normally be converted directly into cash within a comparatively short time or at any rate may readily be so PREPARATION OF STATEMENTS 205 converted. The securities which the A. B. Co. owns are in- cluded in this group on the basis of the assumption that they may be Hquidated with ease. Fuel, unexpired insurance, supplies on hand and services prepaid are examples of assets which normally expire from use in business operation and can- not be easily Hquidated in any other way. Among the equities the amount of rent paid in advance, although really a current habihty, is set up under a special head because of its pecuHar nature. This item will never be paid in cash but will be gradu- ally retired as the A. B. Co. furnishes the use of a part of its equipment to the lessee. Although it is somewhat difficult to estabUsh lines of division among asset and equity items which can be consistently followed in all cases, nevertheless the arrangement of the balance sheet data into sub-groups is a matter of very considerable importance. Comparisons between fixed assets and capital equities, between hquid assets and current Habilities, between current assets and fixed assets, etc., are highly illuminating. The particular pur- poses to be served in any case should, of course, condition the nature of the balance sheet. The uses to which the sub-groups in a balance sheet may be put in making comparisons will be fully discussed in Chapter XXVI. For certain purposes a much condensed balance sheet may be most adequate. The balance sheets published by large corpora- tions are usually highly summarized. Care should be taken in preparing such general balance sheets that incongruous items are not grouped in such a way as to make misinterpretation very likely. Such captions as "real estate, goodwill, etc." for ex- ample, should not appear in any balance sheet. Certain com- binations, however, are legitimate. The following is the balance sheet of the A. B. Co. in condensed form : Assets Plant and Equipment Less Allowance for Depreciation . . . . $134,000 650 Materials and Other Working Assets . . . Notes and Accounts Receivable . . . . Less Allowance for Doubtful Accounts . . $13,900 • ■ 330 $133,350 60,000 13,570 2o6 PRINCIPLES OF ACCOUNTING Seoirities Cash . . . Sundry Assets $ 4,000 26,200 445 1237,565 Equities Capital Stock $170,000 Bonds 40,000 Notes and Accounts Payable 22,430 Dividends Payable 2,550 Interest and Taxes Accrued 500 Sundry Liabilities 830 Surplus '. 1,25s $237,565 Many other schemes of arrangement are possible. The equities, for example, may be classified in the balance sheet as proprietorship and HabiUty items. When the account form is used, moreover, asset valuation items are often Hsted in the right-hand column among the equities, and equity valuation items — if there are any such — are placed in the asset column. The following statement represents — in summary form — the A. B. Co.'s balance sheet prepared in accordance with these suggestions : Assets Plant and Equipment Working Assets . . Notes and Accounts Receivable . . . Securities .... Cash Sundry Assets . . $134,000 60,000 13,900 4,000 26,200 445 $238,545 Equities Liabilities : Bonds $40,000 Notes and Accounts Payable .... 22,430 Sundry Liabilities . . 1,330 Proprietorship : Capital Stock . . . 170,000 Surplus 1,255 Dividends Payable . 2,550 Valuation : Allowance for Depre- ciation .... 650 Allowance for Doubtful Accounts .... 330 $238.545 PREPARATION OF STATEMENTS 207 The item of dividends payable is included among the proprietary items in this case on the ground that, although a legal liability, it represents a part of the present stockholders' equity. A single balance sheet, although a very useful statement in that it shows the status of the enterprise in compact form, gives sKght clue to the business process which has brought about this condition. But from a series of successive monthly or annual balance sheets, together with auxihary information in regard to investment and distributions of net revenue, the accountant can reconstruct the important elements in the financial history of the enterprise in any case. Since the bal- ance sheet is the "origin and terminus of every account,"^ a series of such statements, properly interpreted, throws con- siderable light on the business process. In Chapter XXVII the construction and analysis of comparative balance sheets will be discussed. THE TEN-COLUMN STATEMENT As a first step in making up the financial statements the ten-column statement is a convenient working device. The exhibit on pages 208 and 209 illustrates such a sheet. The ten-column statement begins in any case with the trial balance — a summary of ledger debits and credits. In the inventory columns appear such asset and equity inventories as are at variance with the trial balance figures. An analysis and combination of the trial balance and inventory figures give the data for the balance sheet and other special columns. The above statement is based upon the trial balance of the A.B. Co. appearing on page 152, and the inventories and adjustments already discussed in connection with this trial balance. It will be desirable to examine the construction of this exhibit in some detail, for the ten-column statement is an important working device. The first account shown in the trial balance columns is Real Estate, with a debit balance of $40,000. No new inventory is given, hence it may be assumed that the value of this type of property is unchanged. There has been no expiration of value ; hence there is no expense charge to be considered in connection ' Sprague, Philosophy of Accounts, p. 26. 2o8 PRINCIPLES OF ACCOUNTING ^f o o 8 8 o o <3 O O lo t^ O tM H ^ M J O u ffl 8 8 o o d o 000 000 O CM O 00 O 00 o I h-l o O i H =1 o o 8 8 8 8 8 o o d O 10 O w CS H 8 8 O O O O V3 O 00000 O O ■+ O "^ 10 o uo vo w o o o o 00 11 1^ i-i 10 w fO 00 vo ^ PREPARATION OF STATEMENTS 209 a o m g I en 1-1 o O ^ o o r- o W Cl LO 000 000 0> "^ H ^ be n n yn 10 ir> (1 PO (N cs c^ uo t- r^ w 00 m t--. ■+ t-i 00000 0^00^^^^ 0000 0000 CO -^ fO 8 8 8 S H ^O i^ 'd- r^ J>- -^ H (N 8 8 tS- X \d rt 01 ol H •« 3 ^ n ti. Oi T-1 rn rt r/i £ 0) a Ph 1 rn 1 4-) 'ft -3 rt ^ C3 PLic5?p5ump56um!z;< D ;3 1=1 > <11 rt 4-> 00 00 O mi>.o fOO lot^oo r^ O r^ 00 2IO PRINCIPLES OF ACCOUNTING with this asset. The trial balance figure, therefore, since it is identical with the present value of the real estate, is carried directly to the asset column of the balance sheet. In the case of the next account. Buildings, a new inventory is given. The present value of this asset is $69,650. The difference between the new inventory and the debit balance of the Buildings ac- count represents the amount of depreciation expense for the past period as far as this asset is concerned. This difference, $350, is accordingly carried to the expense column. The new inventory figure, however, is not carried to the balance sheet. A valuation account. Allowance for Depreciation of Buildings, is used in this case. The balance in the Buildings account is carried to the asset column, and the expiration is indicated by placing the valuation item, $350, among the equities. The two accounts taken together now indicate the actual present value of the asset. The accounts Equipment, and Allowance for Depreciation of Equipment, are handled in the same way. Neither of these valuation accounts appears in the original trial balance because, as previously explained, the company involved has been operating for a single period. In preparing a ten- column statement at the end of the next accounting period any new items of depreciation would be added to the balances then appearing in the valuation accounts, and the totals thus deter- mined would be carried to the equity column. The new de- preciation charges would be listed in the expense column. The Materials account shows a debit balance of $120,600. The present inventory is $40,000. The inventory figure is listed among the assets ; the difference between these amounts is carried to the expense column. As has already been explained, this difference does not represent the actual cost of materials for the period. As a matter of clerical efficiency in working out a ten-column statement, however, it is convenient to treat each account as a unit, without reference to any other heading. When this is done any overstatement of expense or revenue under one head is offset by an equal understatement in some other coimection, and vice versa. In this case the inventories in connection with Goods in Process and Finished Goods are used to adjust overstated costs as was previously explained. These accounts show no trial balance figures. The inventory items. PREPARATION OF STATEMENTS 211 therefore, are carried to the balance sheet as they stand. These same amounts must also be listed in the revenue column as cost adjustments. Since no new cash inventory is given it may be assumed that the net debit balance as shown by the trial balance represents the cash actually on hand. Hence there is neither expense nor revenue in connection with this property item. The debit balance, $26,200, is carried to the asset column. If cash had been lost or stolen the inventory would not have coincided with the balance of the Cash account, and an "extraordinary" ex- pense would have arisen. Notes Receivable and Securities Owned are also accounts which show in the trial balance the exact present status of the assets involved. The balances of these accounts, accordingly, are listed in the asset column. There is an inventory in connection with Accounts Receivable, however, which is $330 less than the net balance of the account. This difference is listed in the expense column as a charge against revenue. The actual balance is carried to the asset column ; and the amount of the expiration is Hsted among the equities under the head. Allowance for Uncollectible Accounts. As was explained in another connection it is essential that a valuation account be used in such a case. The Labor account shows a liability inventory. The debit total in this account indicates the total amount of labor services purchased and paid for during the period. As was explained in Chapter VIII, the credit or liability inventory shows that this entire amount of labor services has been consumed during the period and that in addition services have been used to the amount of $630 for which payment has not yet been made. Then the total amount of labor expense is the debit total of the Labor account plus the inventory representing wages un- paid, or $9,170. This amount is carried to the expense column. The inventory figure, $630, represents a current right against the assets of the company and is accordingly listed among the equities. Fuel, Insurance, and Miscellaneous Supplies and Services show asset inventories in each case. The inventory figures are carried to the asset column. The difference between the inventory and the trial balance amount in each case is ex- pense, and this difference is listed among the expenses. If no 212 PRINCIPLES OF ACCOUNTING inventories had been given in connection with these three ac- counts the reasonable assumption would be that the net trial balance figure in each case constituted an expense rather than an asset figure. This follows from the nature of the commodities and services involved. Purchase and sales discounts are offsets to goods purchased and sold as was previously explained. They are current valua- tion items and should be carried to the expense and reveiiue columns to adjust overstated costs and revenues. Since such items are neither asset nor equity balances they do not appear in the balance sheet. i The Rent account shows a credit balance of $300. If there were no inventory item given it would mean that this entire amount were revenue, and should be carried to the revenue column. In this case there is a liability inventory of $200. The amount of revenue for this period, therefore, is but $100. The inventory figure is Hsted among the equities. The different types of inventories possible in connection with the Rent ac- count were explained in the preceding chapter. Items of interest should be considered as net revenue debits and credits as was explained in the last chapter. The net balance of Commercial Interest, then, after being adjusted by the inventories, is carried to the debit column of the net revenue and surplus statement. The liability inventory is Hsted in the equity column and the asset inventory is carried to the asset column. The beginner is inclined to wish to combine these items and show only the difference in the balance sheet. This should never be done. These columns should show all asset and equity items, and hence no cancellation is proper. Ob- viously one entire column of the balance sheet might be cancelled against the other, since the totals are the same, and this pro- cedure would destroy the statement. Any algebraic summation of asset and HabiUty items is simply a step in this direction. The Bond Interest account does not appear in the trial balance. There is an inventory item in connection with this account, however, representing bond interest accrued but unpaid. This item is clearly an equity balance and is carried to the balance sheet. It is also an accrued deduction from net revenue, and hence is Hsted in the debit column of the net revenue and surplus PREPARATION OF STATEMENTS 213 statement. Similarly no figures appear in the trial balance for dividends and taxes. Among the inventories, however, are listed a dividend appropriation of $2,550 and a tax accrual of $250. The dividend inventory is an equity item and is ac- cordingly carried to the balance sheet. It is also a distribution of net revenue. The tax accrual is a government claim and is also listed among the equities. It is carried to the net revenue columns because it constitutes a deduction from net revenue as was explained in the preceding chapter. Capital Stock, Bonds, Notes Payable, and Accounts Payable are tj^ical equity accounts. No inventories or adjustments have been assumed in connection with these accounts ; and hence the net balances as shown by the trial balance statement are carried directly to the equity side of the balance sheet. Starting with a trial balance that "proves" the numerical computation involved in a ten-column statement is shown to be correct if the final balance of the net revenue and surplus columns added to the equity side of the balance sheet (the asset side in the case of a net deficit) equates resources and equities. The asset column shows the present status of all assets; but the equity column does not include the unappropriated net revenue balance. The total of the equities to date is not dis- covered until the balance of the net revenue and surplus columns is incorporated with the surplus from the preceding period. When this is done assets again equal equities. In the illus- trative case of the A. B. Co. there is no accumulated surplus. Hence the surplus for August, $1,255, is ^Iso the balance of the Surplus account. To aid the student in working out such statements as the one just discussed a few general suggestions may be given at this point. It is evident that whenever a debit or asset inventory is given in connection -with an asset account, the inventory figure is carried as an asset to the balance sheet (assuming that there is no valuation account), and the difference between the inventory item and the net amount shown by the trial balance constitutes the expense item that is carried to the ex- pense column. If a valuation account is used the book value of the asset (the amount appearing in the main asset account) is Hsted in the asset column. The amount of the expiration is 214 PRINCIPLES OF ACCOUNTING added to any credit balance already found in the valuation account, and the sum so determined is carried to the credit column of the balance sheet. Where a valuation account such as Allowance for Depreciation is found in the trial balance care must be taken that the net book value of the asset — i.e., the difference between the amount appearing in the main asset account and the balance already shown in the Valuation account — be compared with the new inventory in determining the amount of expense. If the amount of the new inventory is greater in any case than the net book value appearing in the trial balance this means that appreciation has occurred. The amount of the increase in such a case should be carried to the revenue column if it can be considered as appKcable to the current period. If this is an unusual happening, or covers several accounting periods, the item of appreciation should be listed in the credit net revenue or surplus column. The in- creased inventory may be listed as an asset, or the amount of the increase may be deducted from the balance appearing in the appropriate valuation account if there is such an account. Whenever there is a Habihty or credit inventory in connection with a current asset or expense account, there is no asset to carry to the balance sheet. The liabiHty inventory figure is listed among the equities, and the sum of the inventory and the balance of the account as shown by the trial balance is carried to the expense column. Inventories in connection with net revenue accounts are handled in the same way except that the adjusted figure is carried to the appropriate net revenue column. Whenever an asset inventory is given, such as the goods in process inventory in the above case, and there are no corre- sponding trial balance figures, the amount of the inventory is Usted among the assets and is also placed in the revenue column to offset overstated expense charges. If such an inventory represented a gift or donation the corresponding credit would be carried to the net revenue columns. It should be borne in mind that there is nothing arbitrary about such a device as the ten-column statement. It involves simply a particular method of distributing debit and credit items. The trial balance shows an equality of debit and credit totals. These debit and credit balances, adjusted by means PREPARATION OF STATEMENTS 215 of inventories, are distributed as assets and equities, as expense and revenue charges and credits, and as net revenue and surplus items. Each inventory adjustment affects the sum totals of debits and credits alike. The underlying equation is thus at all times maintained ; and by striking a final balance, as ex- plained above, the accuracy of the work is proved. From a completed ten-column statement the regular balance sheets and other statements previously described may be readily prepared. THE WORKING SHEET Although the ten-column statement is a convenient clerical device it is not in common use. Accountants quite generally employ another form of "working sheet" which includes more or less of the closing entries and an "adjusted" trial balance. Because of its wide use the student should be familiar with the general characteristics of this form. An illustration will serve to explain the nature of the working sheet and the way it is constructed from an underlying trial balance and accompanying inventories. The following is the trial balance of C. A. Black, Proprietor, as of December 31st, 1917 : Accounts Dr. Cr. Accounts Payable $ $ 10,600 Accounts Receivable 29,000 Cash 8,200 C. A. Black, Capital 22,500 Interest Received 5°° Interest Paid ... . 800 Merchandise Inventory 20,000 Miscellaneous Expense i,3°° Notes Payable 12,000 Office Equipment 800 Other Selling Expense 3)S°° Office Salaries 4,7°° Purchases 87,000 Purchase Returns ... ij3°o Rent 600 Store Equipment 3,000 Sales 128,000 Sales Returns ^,5°° Salesmen's Salaries 12,000 Sales Discounts 1,5°° $174,900 $174,900 2l6 PRINCIPLES OF ACCOUNTING o o CO O o CO O O O O IT) o lO 00 O o o g o o 6 to o O O Q O CI O n pq o CO ^ H c/3 <; o o o o o o o lO lO o o o o O c^ o o 00 8 8 00 1^ t-'- O 8 P4 en C« C/J C/3 C/3 ^ CU PREPARATION OF STATEMENTS 217 I o ft M u Ph M K d ^ m Fi <1) <; P 1 tn 1 < H W a (/J C) ^ 3 pi ^ 01 g CO g 1-4 u po - H M @l 4* 4/^ 00 CO 00 -^ VO to E,*^ . CO * ^ H^ S^ 75 Qu ^ "S M m OJ >< Q Ph U 4-» 1 2i8 PRINCIPLES OF ACCOUNTING The inventories and adjustments are as follows : merchandise, $23,000; taxes accrued, $260; office salaries due but unpaid, $150; salesmen's salaries unpaid, $320; interest accrued on bank balance, $30; interest accrued on notes payable, $110; rent prepaid, $40; store equipment, $2,700; office equipment, $720. The exhibits on pages 216 and 217 illustrate a working sheet prepared from the above data. The t3^e of working sheet illustrated above may con- veniently be used for the purpose of constructing adjusting entries, and to prove the clerical accuracy of this work. The adjusted trial balance shows the condition of the ledger after all necessary special accounts have been opened, but before the various expense and revenue items have been combined in a summary account, and before the amount of net income has been transferred to the various equity accounts. Such an intermediate trial balance is of advantage as a test for accuracy in any case in which the closing entries are very numerous and complex. The letters used in the columns con- taining the entries serve to connect the corresponding debit and credit items. An advantage which this form of working sheet has over the ten-column statement shown in the preceding section Hes in the fact that the various adjustment headings are presented. This procedure makes it possible to interpret the statement more easily than if several distinct facts were listed under a single head. In the illustrative ten-column statement, for example, expense and liability items are shown in a single line with the trial balance figure of the Labor account and its inventory. In the more common form of working sheet the liability item would be set up under a distinct head such as "Accrued Wages Payable." The simplicity of the ten-column statement, however, and the fact that it shows the inventories, make this form in some respects the more usable device. In the above working sheet no distinction is made between expense and revenue and net revenue items. This is typical of actual practice. Most accountants prepare a working sheet as a proprietary statement, the concluding net figure being the net proprietary income. As already explained, however, to PREPARATION OF STATEMENTS 219 include interest charges — a return to capital — and taxes — a net revenue deduction rather than an operating deduction — with the expense charges, is a practice which conforms neither to logical relationships nor to practical considerations in many cases. • X The Determination of Net Revenue In the discussion of the closing and interpretation of accounts in Chapter VIII the general problem of ascertaining net revenue was raised. It was shown that in any case the trial balance — a summary of the open ledger accounts — does not alone fur- nish the data from which may be determined either the present financial status of the business or the expenses and revenues for the past accounting period. It is necessary to take inven- tories and to make adjustments in order to ascertain the accruals of cost and income and the current condition of all properties and property rights. In other words, the data of the business process must be carefully analyzed at the end of each period so that each item may be allocated to its proper place in the ac- counts ^nd statements. In this connection many difficult problems of interpretation and classification arise. In this chapter some of the more important of these topics will be discussed — particularly as regards the relation of each question to the integrity of the net revenue figure. the significance of net revenoe In an important sense the final goal of accounting in any case is the net revenue figure. It is net revenue (or net loss) which measures the change in the status of the private equities during a given period. It is this amount which reflects the ownership phase of the results of the business process. Increase in wealth — which is measured in the accounts by the net revenue figure — is the purpose of the business enterprise from the standpoint of the individual owners. Since the accounts are kept primarily from this standpoint it might be said that nearly all questions of accounting analysis center around the determination of net revenue. 220 DETERMINATION OF NET REVENUE 221 The net revenue figure is the amount available for partition among the various individuals and interests that furnish the capital in any case. It may not always be either expedient or possible, however, to withdraw this sum in cash or an equivalent. (See the following section.) In such an event net revenue may be retained as new investment, each equity account being credited with its proper share. A partnership, for example, shows in its accounts a net revenue of $10,000 for the year. Assuming that there are no liabilities on which interest accrues this amount is available for division among the partners, A and B. It may be, however, that the demands upon the firm's current assets because of the need for additional equipment are so great that there is little cash available for dividends. Further, it may be that it would be unwise to borrow at this time. If such is the case the net revenue figure may be disposed of by credits to the partners' accounts in accordance with the articles of copartnership. It is particularly important that net revenue be accurately determined at the end of each accounting period in the case of a business organization which acquires its capital from several distinct classes of investors. (See Chapter I.) A particular corporation, for example, may have outstanding as equities not only stocks, bonds, and notes, but several types of stocks and bonds. If net revenue is not accurately determined each year not only are transient individual owners likely to be mis- led but the interests of an entire class of investors such as the income bondholders, for example, may be jeopardized. In the case of a small single-proprietorship, on the other hand, where practically the entire investment is the proprietor's, this prob- lem of equities does not arise. In so far as net revenue summarizes the results of the efforts of the operating management and the employees, this figure may be used for comparative purposes as a rough test for effi- ciency. If net revenue be broadly defined, however, as repre- senting the net change in the status of the equities, this figure cannot as a rule be said to show merely the results of operation in the technical sense. The speculative accidents of the situa- tion are also involved. This topic will be further discussed in a later section of this chapter. 222 PRINCIPLES OF ACCOUNTING The nature of net revenue and its relation to the other funda- mental concepts of accounting was explained in Chapter III. In this connection it will be desirable to review this matter briefly. The business enterprise secures from the various in- vestors a sum of cash or an equivalent. These funds are in- vested in plant, equipment, raw materials, etc. To work up the raw material into a finished product it is necessary to hire laborers, buy supplies, and secure other commodities and services. All such items are purchased with part of the original cash, with new capital, or on credit. As production is accomplished sales are made of the finished product and current assets such as cash, accounts receivable, etc., are received in exchange. As these current assets become cash they may be used again to buy more material and the other necessary commodities and services. Ignoring price changes it might be said that the excess of all assets received from sales (and from speculative and accidental opportunities) within a given accounting period, over the amount of fixed assets expired, materials used, and other commodities and services consumed in producing these sales (or otherwise destroyed) constitutes net revenue. It is the return to the investor for the services he performs — a remuneration for the burden of ownership. In the accounts this amount is repre- sented by the balance of the expense and revenue accounts. Net revenue is a part of the economist's "cost of production." At least it is a component of the price which the consumer pays. It is not, however, nor any portion of it, an expense of the busi- ness enterprise. The confusion of expense and economic cost is one of the most common errors made by accountants. An expense arises because of the expiration of some commodity or service purchased by the enterprise. The enterprise does not buy the services of the owners. Nor does any one owner such as the stockholder buy the services of other owners such as bondholders. Rather it may be said that each investor furnishes his service in anticipation of a return on his investment due to the fact that revenues normally exceed expenses. In other words interest and dividends are in essentially the same accounting category, as was previously explained, and are charges against net revenue rather than gross revenue. The nature of the service which the investor furnishes differs DETERMINATION OF NET REVENUE 223 widely in various enterprises. In single-proprietorships and partnerships the proprietors often not only assume the manage- ment of the enterprise but furnish a large part or even all of the ordinary labor services as well. In such a case net revenue is clearly not synonymous with the interest and profit of economic theory. The four principal distributive shares, wages, rent, interest, and pure profit, may all be represented. In the cor- poration, on the other hand, labor services and management may be purchased for the most part from individuals who furnish no capital and hence do not have equities in the enterprise in the ordinary sense. It is often urged that accounts should be set up which charge as expense a reasonable return for the proprietor's labor and a reasonable interest allowance for the capital he furnishes. Such fictitious accounts are practically useless, and usually do more to confuse the owner than to instruct him. If the proprietor works in his store from six o'clock in the morning until ten at night he is perfectly well aware of that fact. What he wishes to know is the return he is making on his business and his efforts. If this return does not give him a reasonable rate on his investment and decent wages for his work he does not need a special ledger account to tell him that fact. For the purposes of financial accounting there is little need of separating net revenue into its economic elements. Further, the use of fictitious expense accounts, if actual errors are avoided, does not affect the net revenue figures. Suppose, for example, that an "expense" account, Interest on Capital Owned, be charged with an amount equal to six per cent on the investment. In what account is the concurrent credit incident ? Clearly some revenue account must be credited with the same amount; and this procedure does not affect the net revenue figure in any way. If an account in some other classification is credited the net revenue figure will not be correctly stated. In connection with income taxes cases arise in which the use of fictitious expense accounts seems at least partially Justified. A particular tax, for example, may be levied upon net proprietary income, and may fall upon all types of business organizations without discrimination. In such a case the corporation which buys labor services and management has an advantage over the single-proprietorship where the proprietor is at once in- 224 PRINCIPLES OF ACCOUNTING vestor, manager, and common laborer. In the case of the corporation the stockholder's dividend may be largely interest and pure profit. In the case of the single-proprietorship the proprietor's net income may be in large measure wages. To avoid injustice in such cases it would seem reasonable to allow the proprietor in the small concern to charge expense with a reasonable salary for his own services. If he does not with- draw this salary in cash, however, the corresponding credit should be entered in a surplus or other proprietary account. This transaction can be conceived in this way : one expense of running the business is the salary of the manager who is also an owner ; but instead of withdrawing this salary the proprietor immediately invests this amount in the business. Such a transac- tion does not reduce the proprietor's return. It simply divides his income between wages and return to capital. In general it is unwise to attempt in the accounts to divide either total net revenue or net proprietary income into its eco- nomic elements.^ This is a part of the individual investor's economy ; and it can be safely left to the individual. THE CASH STATEMENT The expense and revenue statement should exactly represent the operating situation for a particular accounting period. That is, this statement should show revenues and expenses accrued in the fiscal period just past. All commodities and services con- sumed in the period constitute the total expense ; all revenues earned during the period constitute total revenue. Thus a distinction should be sharply drawn between statements of cash receipts and expenditures, and of expenses and revenues. This point needs further elaboration, for in actual practice the distinction is not always recognized. Particularly in munici- pal enterprises is the treasurer's report accepted in Heu of an expense and revenue statement. In most cities the statement from which the budget for the ensuing fiscal period is prepared • In cost accounting problems arise which involve the computation of interest on investment as a cost. It is doubtful even in such cases, however, if such compu- tations should be set up in the accounts. See Chapter XXIX. DETERMINATION OF NET REVENUE 225 is that of receipts and disbursements. This is merely a state- ment of cash received and paid out during the year — in other words an itemized Cash account. It reflects the stewardship of the officers in regard to one kind of property — cash. This is clearly not the same information as that shown by an expense and revenue statement. Cash disbursements and expenses are not synonymous terms. Payments are often made for perma- nent improvements which are not expenses. Disbursements may be made in one year to cover the expenses of a previous year. Similarly, the expenses of a particular period often do not appear among the current disbursements, but will be paid in later periods. Further, certain expenses may not involve expenditure for years, if ever. An example of such an expense is the depreciation of durable property. Depreciation may be regularly charged to operating expense and yet no replacements may occur for a long period. The situation in regard to revenue earned as compared with cash receipts is analogous. An illustration will perhaps make the distinction between these different kinds of information entirely clear. The officials of an urban water company petition the city council that the company be allowed to raise the rates to its customers. They urge that the company is being operated at a deficit, and fur- nish, to support their contention, the following statement of receipts and disbursements : The a. Co., December 31, 1917 Receipts Cash on hand December 31, 1916 $21,4°° Quarterly Rates $33,967 Metered Water 14,722 Mason Work 836 Metered Rentals 17° Miscellaneous 71 Bank Loan 1,000 Sale of Abandoned Property 5,5°° Total Receipts for the year 56,266 $77,666 Q 226 PRINCIPLES OF ACCOUNTING Disbursements Operation : Pumping Station Expense $ 6,402 Fuel .... ... ... . S>o6i Office and Distribution Expense 10,072 Rebates and Stoppages 605 Maintenance : Repairs to Distribution 607 Repairs to Pumping Station 644 Repairs to Meters 581 Interest on Bonds 15,000 Sinking Fiuid Installment 15,000 New Extension ... 18,000 Insurance 414 Total Disbursements for the year 72,386 Cash on hand December 31, 1917 $ 5,280 On the basis of the above figures the company contends that the water plant has been operated at a deficit for the year of $16,120 (the shrinkage in cash), and asks that the water rates be raised. A careful examination of the items in this statement will serve to throw some hght upon the propriety of the company's petition. All of the items shown among the receipts of the current year appear to be from revenue sources with two ex- ceptions. The amount realized from the sale of abandoned property is evidently not a revenue; it represents a receipt from the sale of part of the capital equipment, and it is likely that a large element of expense is involved in the transaction. And the amount borrowed from a bank is not a revenue ; revenue cannot be earned by borrowing. Among the disbursements the sinking fund installment clearly does not represent expense. Sinking Fund is not an expense account, but represents rather a special fund of assets set aside to redeem bonds or for some other purpose. Even if this fund were immediately used to retire some equity the expenditure would in nowise be an expense charge. Revenue cannot be earned by contracting debts; neither is expense incurred by paying debts. " New Extension, $18,000 " represents quite evidently an expenditure for capital improvements, and hence should not be included among the DETERMINATION OF NET REVENUE 227- expense items. Further, the amount paid as bond interest represents a distribution of either net revenue or capital to a contractual equity, and hence cannot be considered an operating expense. The following table represents the expense and revenue state- ment for the year constructed from the cash book records in accordance with the above suggestions : Revenue Quarterly Rates Metered Water Mason Work . Meter Rentals Miscellaneous Total . . Operation : Pumping Station Expense . Fuel Office and Distribution Expense Rebates and Stoppages Maintenance : Repairs to Distribution Repairs to Pumping Station Repairs to Meters Insurance . . . Total Net Revenue . . Expense $33,967 14,722 836 170 71 I 6,402 S.061 10,072 60s 607 644 S8i 414 $49,766 24,386 $25,380 This statement shows a net revenue for the year of $25,380, as compared with a deficit in cash of $16,120. After the interest charges of $15,000 are met there remains of net revenue the amount of $10,380, the net proprietary income. Although this income has evidently not been realized in cash it may well be that it amounts to a fair return upon the stockholder's in- vestment. The above expense and revenue statement, however, is prob- ably inaccurate. Although an itemized statement of receipts and disbursements gives some clue to expenses and revenues, it is not possible to revise any cash statement in such a way as to make it a dependable income sheet. Depreciation for the year, 2 28 PRINCIPLES OF ACCOUNTING for example, is not taken into consideration. Further, the statement of revenue assumes that revenue earned during the fiscal period coincides with cash receipts from revenue sources. This is a very unlikely situation. Doubtless some of these receipts represent revenue earned in the preceding period ; and it is probable that the receipts do not include all the revenues accrued within the current period. No doubt an analogous situation exists in regard to the expense items. This emphasizes the need for distinct expense and revenue records. The success or failure of operation for a given fiscal period can only be shown by a statement of revenue earned and expense accrued in that period. The excess of cash received over cash disbursed for the year, or vice versa, usually bears little relation to net revenue or net loss for the period. DEFERRED CHARGES AND CREDITS It has been stated above that the expense and revenue state- ment should include all the expenses for the period covered by the statement. It occasionally seems advisable, however, to treat certaih extraordinary charges as items applying not solely to the particular period in which the expense is first recognized, but to several periods. Suppose, for example, that because of rapid changes in mechanical technique, an electric power com- pany finds a number of dynamos obsolete, even though this property has suffered little physical deterioration. It becomes necessary to replace with the improved types, it may be as- sumed, property to the amount of $50,000 which is almost new. Assuming a scrap value of $8,000 this means an expense for the year of $42,000. The management may with reason argue that this is an unusual expense, unlikely to occur again, or at least not oftener than once in several years. Consequently it would seriously distort the expense and revenue statement and the resulting net revenue figure to charge the entire amount into the expense of a single year. Therefore it is decided in this case to charge but $10,000 of this expense against the revenue of the current year, and to carry $32,000 on the asset side of the balance sheet as a deferred expense. This may be considered an entirely legitimate procedure ; and deferred expense items are very fre- DETERMINATION OF NET REVENUE 229 quently met with in accounting practice. Such items, however, should not be confused with the assets. A deferred expense of this type is not an asset, but a deduction from the equities which the management has not been willing to recognize as a current deduction, although the loss has actually occurred. The desire to preserve financial standing, and a reasonably even flow of income, is the usual excuse for such deferred items. The following is a somewhat different illustration. A firm has been involved in htigation for three years. The company's lawyers have been paid nothing but retaining fees. The case is settled and the lawyers are paid $25,000. It seems evident that this is an expense, not of any one year, but of the three years. If it were possible to forecast this expenditure the most desirable procedure would be to charge the revenue of each year with one-third of the total expense. It is not hkely, however, that the management could accurately estimate in advance the length of the suit or its cost. In this event the item — when finally paid — may be carried as a deferred expense if it is so large as to seriously affect the current statement of income. The final disposition of these deferred expense items is a matter of importance. Such charges, evidently, should not be carried indefijiitely on the books, but should be transferred as soon as convenient to current revenue or to accumulated surplus. In general it would seem best to close these balances against annual or accumulated surplus. A deferred expense is really a deduction from proprietorship which should have been provided for by charges to revenue during the years in which the loss might be said to be accruing. Since this was not done, earlier income sheets have been incorrect to some extent. But to load these charges upon the results of operation in succeeding periods would seem to be an improper method of making the correction. If losses accruing in previous periods are charged against current revenue a new error is made. It is better practice to dispose of such deferred expense balances by means of credits to the de- ferred expense account and charges to unappropriated surplus. The balance sheet of almost every large corporation shows one or several deferred expense items. Chary use should be made of such accounts, however, and only in unusual circum- stances should an item which represents an actual deduction 230 PRINCIPLES OF ACCOUNTING from equities be carried in suspense, instead of being charged against current revenue or present surplus. Deferred charges — so-called — of a different type from the above cases frequently occur. Such are expenditures for services from which the benefit is not exhausted for a long period. A common illustration is the expenditure for stripping "over- burden" in the case of certain kinds of mining properties. In the porphyry copper mines of Nevada, for example, the earth — which may be many feet deep — must be removed from a large area before the actual process of mining the ore can begin. Once the overburden is removed, the ore is mined very rapidly with steam shovels, and no. further expenditure need be in- curred for stripping as far as that portion of the ore body is concerned. It may take one or two years to remove the top earth ; and in that time not a pound of ore is mined, nor a cent of revenue received. It is common practice in such a case to carry the costs of stripping on the balance sheet as a deferred debit item. It should be emphasized, however, that such an item is really neither an expense nor a loss, but rather an asset, representing the value of a service purchased and paid for, but not yet consumed. It is an expense of mining all the ore much as all capital outlay is an expense of earning the revenue through- out the life of the property; and it should be charged as an expense currently, in proportion to the weight of ore mined, reve- nue received or some other appropriate basis, in the same manner as any expiration of property due to business operation is charged. Although the general distinction between an actual deferred asset and an expense or loss is clear, it is sometimes hard to draw the line in specific cases. Suppose, for example, that a firm maintains a department for the purpose of making tests and experiments with a view to developing new processes and methods. Are the necessary expenditures properly chargeable to an asset account, or should they be considered an expense? In so far as such a department is a permanent adjunct of the business, and is necessary to keep the firm abreast of competi- tors, such expenditures are clearly expense outlays — a current cost of operation. It is often urged, however, that if the experi- ments can reasonably be expected to result in a profitable process the costs should be carried as a deferred asset in the balance DETERMINATION OF NET REVENUE 231 sheet. In general it would seem more reasonable to charge such outlays against current revenue — unless the net revenue figure is thereby seriously distorted. If the experiments result favorably it will be time enough then to revise the analysis. At that time the value of the process itself, or of the patents representing it, can be placed on the books as an intangible asset. In many balance sheets actual losses and other proprietary valuation items are grouped with prepaid services under the head "deferred debit items," or a similar caption. This practice seems clearly improper. It should be recognized, however, that it is not possible to lay down hard and fast rules for distinguish- ing between these dissimilar facts which cover all cases. The nature of each deferred charge must be determined in view of the concrete circumstances giving rise to the charge. Certainly in analyzing a balance sheet all such items should be carefully scrutinized. The nature and treatment of prepaid revenues should be briefly considered in this section. An illustration will perhaps serve to explain the significance of such a deferred credit. A water transportation company, whose boats ply to and from certain resort points, sells season ticket books during the month of May amounting to $12,000. In this month tickets are taken up having an aggregate value of but $5,000. Ignoring the ques- tion of selHng expense it is evident that the company has earned during May but $5,000, the amount of the cancelled tickets. The balance of the tickets sold represents a deferred revenue — a HabiHty item of the nature of the prepaid rent balance discussed on page 180. The company is still obligated to fur- nish to certain individuals services with a selling price of $7,000. The entries covering these transactions — in summary form — would be somewhat as follows : (i) Cash . .... $12,000 Sales of Tickets . . . . . $12,000 (2) Sales of Tickets $Si000 May Revenue $5, 000 232 PRINCIPLES OF ACCOUNTING The balance of the Sales of Tickets account is a deferred revenue — a habihty — and would appear as a deferred credit balance in the balance sheet prepared on May 31st. This balance is transferred to current revenue as the tickets which it represents are taken up. Such an analysis of sales is not of great importance from the standpoint of the investors provided it is the annual statement of net revenue which is used as a basis for dividends and other appropriations. From the manager's standpoint, however, it is essential that total earnings be properly apportioned among the various operating periods. Prepaid revenues are not as common in business practice as are revenues earned but unpaid. In many cases a company sells the finished goods in advance of completion, although pay- ment is not made until delivery. Extreme instances of such contracts are found in such industries as shipbuilding. In these cases it is usually considered proper for the company to accrue a reasonable proportion of the total revenue in each period, even if no payment whatever has been made. In any case — as was emphasized in a preceding section of this chapter — it is seldom a rational procedure to follow cash transactions in determining current revenue. Deferred revenue credits are sometimes grouped with asset valuation items on the right-hand side of the balance sheet. This practice is not a desirable one, as prepaid revenues and offsets to assets are in nowise congruous items. WASTING ASSETS Practically all kinds of assets expire in business operation, but many types of property are of such a character that they cannot be replaced concurrently with the expirations, if at all. Such properties are mines, forests, and other natural resources, and properties arising from terminable state or private grants such as patents, copyrights, franchises, leases, etc. Consider, for example, the case of a mine. Every pound of ore removed lessens the value of the property (assuming that there is no change in current costs or in the price of the product). A par- ticular corporation may be able to acquire new property of a DETERMINATION OF NET REVENUE 233 similar nature, but frequently this is not possible. Then in such a case if revenue is retained in the business to cover the decline in capital assets, it must be retained in the form of cash or other liquid funds. It is common practice, however, to return the capital to the stockholders in the form of dividends as the property expires. In such a case the dividend amount should be carefully apportioned between net income and the return of the original investment. Otherwise, as is frequently the case, a serious misstatement of net revenue results. Often the stockholder considers his dividend check as representing pure income, and later, to his surprise, he discovers that his original investment has disappeared. It is imperative that if all prop- erty expirations are not included in the expense charges the residuum from the expense and revenue statement shall not be considered as net revenue, and that if this figure be paid as dividends it shall be carefully apportioned between net revenue and capital return. This analysis should be made on the financial records of both the corporation and the stockholder. Although in some cases the nature and extent of the ore body may be estimated with reasonable accuracy from the results of preliminary drilling, in vein mines it is often exceedingly difficult to determine by exploration the size or character of the mineral deposits. In such cases it may be urged that it is not feasible to amortize the cost of the mine itself by charges against revenue. The venture is a highly speculative one ; and the owners under- stand the risks. Accordingly no purpose is served by attempt- ing to write down the capital assets. The size and character of the ore body are largely matters of guess ; new deposits are being continually discovered ; old veins are found to be faulted. Hence there is no rational basis for estimating such depreciation charges. Even in such cases, however, it would be a conserva- tive policy to charge a reasonable allowance for expired capital against each year's revenues. Experience has demonstrated that such properties do not last indefinitely. In any case the . depreciation of equipment — shaft, power-plant, etc. — should of course be regularly recognized by charges against revenue. In some cases the physical expiration of assets in a wasting enterprise may be quite easily measured. A lumbering com- pany, for example, may be organized for the specific purpose of 234 PRINCIPLES OF ACCOUNTING cutting the timber on a given tract. The value of the timber removed each year — on a cost basis — could be estimated with approximate accuracy. It might seem that this amount — ■ in addition to running expenses — should be charged against gross sales each year if net revenue is to be correctly stated. The problem of interest is involved in the valuation of such a property, however, in much the same way as in the case of a regular annuity. Hence the "present value of future revenue method " is the most logical device for measuring the deprecia- tion of such a terminable property. This and other methods of measuring depreciation will be discussed in Chapter XXIII. Patents, copyrights, leases, etc., are similarly assets which cover definite periods and which should be depreciated in each case during the life of the asset by charges against revenue. All such rights and privileges expire in time and often cannot be replaced in kind. The amount of the expiration in each case must be treated as an expense and included among the current charges. If capital retained by such charges is returned to the stockholder, this fact should be recognized in the accounts. The accounting treatment of such intangibles will be further discussed in later chapters. MAINTENANCE AND IMPROVEMENT The problem of ascertaining whether a given expenditure represents a repair or a renewal (and hence is an expense charge), or whether it represents an improvement (and hence is a capital outlay), is often a serious one. Particularly in the case of complex properties such as railroads it is sometimes a very difficult matter to draw the line between maintenance and improvement. This problem has been rendered unnecessarily involved because of the common tendency among accountants and operating officials to confuse physical and value facts. When it is once clearly recog- nized that accounting is concerned primarily with the value representations of things, part of the difficulty disappears. It is not the physical object which appears in the accounts in any case, but rather the value of the object. In other words, the technical nature of a productive instrument has accounting significance only as it conditions the value of the instrument. DETERMINATION OF NET REVENUE 235 If a machine which cost $5,000, for example, and has been carried on the books since the date of purchase at that figure, is replaced by another machine of like physical efficiency but which costs $6,000, it would seem evident that $1,000 of the new expenditure represents a capital outlay. It is true that no more physical product is produced by the new machine than by the old ; but it is also true that the investment now necessary for the pro- duction of the particular product involved is $6,000. To show this new figure in the financial records is simply tardy recogni- tion of the fact that the capital cost of producing a certain commodity or service has increased. The proper journal entries covering the above transaction would therefore be : ^ (i) Expense $SjOO° Machine No. i $S,ooo (2) Machine No. 2 $6,000 Cash $6,000 The accounts should always show the present value of the property being used by an enterprise in producing its product if statistics drawn from the accounts are to furnish the manager with the information which will enable him to make rational use of the economic resources at his disposal. According to this view the new machine mentioned above would be entered in the accounts at $6,000 even if its physical efficiency were less than that of the old machine. Or if the new machine were of an improved t)^e and cost less or more than the original ma- chine, it should in any case be entered on the books at its cost new. The fact that ninety-pound rails are used to replace seventy-pound rails, for example, does not tell those interested whether the property is being maintained or whether an improve- ment is being made. The question is : what is the capital outlay necessary to make this replacement ? If the new expendi- ture is greater than the cost of the old equipment, the difference represents an addition to capital; if the necessary expenditure 1 These entries are made according to the " replacement policy " of handling depreciation. See Chapter XXII. 236 PRINCIPLES OF ACCOUNTING is less than the old cost, then the investment in the particular property item involved is less than before. Even if it be decided to adopt the above position, there are in many cases practical difficulties in the way of determining just where to draw the Hne between repairs and replacements, and improvements or betterments. In connection with the upkeep of a complex piece of property, where there is no test of market price available, it may be almost impossible to deter- mine accurately which outlays are actually expenses and which are capital charges. Repairs (so-caUed) to a factory building, for example, may be so extensive as actually to increase the value of the building, but it may be very hard to determine just what is the amount of the improvement. Arbitrary estimates and rules are necessary in such cases. Such estimates should, of course, be based on all available information in each particular case. Approximate accuracy is all that can be hoped for in most instances. The rules of the Interstate Commerce Com- mission in connection with the maintenance of steam railway properties, for example, formerly prescribed that no specific expenditures of less than $200 should be considered as chargeable to additions and betterments. Under this ruHng some small improvements were wrongly charged to expense ; but it was ex- pected that errors in the other direction would approximately offset any such charges. In any industry in which improvements in mechanical tech- nique are taking place very rapidly, and where it is the practice to charge all repairs and renewals in the technical sense to ex- pense, overstatement of expense and understatement of capital is quite hkely to result. This has been the situation in the case of many American railway properties. Old locomotives were scrapped and replaced with more efficient and more costly types, and the entire cost of the new equipment was considered as a replacement. Such a practice results in what are called secret reserves. Such a reserve is an item of proprietorship which repre- sents profits retained in the business, but which does not appear on the balance sheet becsiuse the property is understated by just the amount of the reserve. This practice is entirely illegiti- mate. It may not mean as direct a step toward financial disaster as the opposite error — the overstatement of property and the DETERMINATION OF NET REVENUE 237 understatement of expense — but the individual stocMiolder is misled and often suflers from such a practice. Further, ac- counts which do not represent at least approximately the actual situation cannot serve the purposes of management for which financial statistics are intended. It should be observed that the practice of charging improvements to expense followed by some railroad companies in their early history did not in every case lead to the understatement of total assets ; for in many cases the original property figures were much too large. In such a case an overstatement of expense means that profits are being retained in the business — although this is not recognized as such in the accounts — and are building up a previously overstated property ; or, in other words, overcharges to expense are making good equities which have been only nominal up to this time. It might be said at this point that it is the practice of many banking institutions to understate or to omit entirely from the accounts such assets as real estate and furniture and fixtures, and in this way to create secret reserves. While it is essential that a banking house be conservative in its accounting practices it is doubtful if such a procedure even in the case of banks is in any way justified. Sheer understatement where it is possible to ascertain the actual facts is not conservatism but conceal- ment ; and it hardly seems as if any proper purposes were served by such accounting. Certainly in some cases secret reserves have been built up by those in control for the express purpose of defrauding minority owners. Usually the interests of the various equities involved are best protected if all the assets — in as far as they can be ascertained — are shown in the accounts. If actual assets are charged against revenue, net revenue is not correctly stated, and erroneous conclusions will be drawn by the stockholders and others concerned. If assets are concealed by charges to surplus, the operating sheet may be correct, but an eqaity is misstated in the balance sheet ; and again the situation is misleading to the individual owners. Probably repairs and renewals are more often charged to property than are improvements charged to expense. The desire on the part of the management in a particular case to make a good showing of net revenue is often responsible for 238 PRINCIPLES OF ACCOUNTING such a procedure. Frequently, however, this is done because an error is made in the analysis of expenditures. Expenditures which are made for the purpose of earning the revenue of . a single fiscal period, and which represent no value at the end of that period, must be carefully distinguished from expenditures which mean a relatively permanent improvement. An amuse- ment company, for example, furnishes a skating rink in the winter and a swimming pool in the summer with practically the same property equipment. Each seasonal change, however, requires some expenditures for reconstruction. These outlays, obviously, are not property charges, but represent current ex- penses. If these items were considered as improvements each season the value of the property would soon be seriously inflated. From the standpoint of financial integrity the error of charg- ing repairs and renewals to property is more serious than a prac- tice which leads to secret reserves. Errors in either direction, however, are serious from the standpoint of proper accounting, and should be avoided as far as possible. APPRECIATION AND DEPRECIATION If the net revenue be defined very broadly as the net increase in the equities during a given period (allowing for new invest- ment and capital withdrawals), it is clear that this figure can only be discovered when all value changes are taken into con- sideration. According to this conception of net revenue the accrued depreciation of fixed assets — as well as the expirations due to the consumption (or loss) of specific units of commodities and services — constitutes a part of the total expense for a given period. Similarly all appreciation of the durable equip- ment and other assets during an accounting period — as well as accruals from the sale of product — is a part of total revenue. Not until all these variations in asset values have been recog- nized can the new status of the equities be determined. In so far, as depreciation and appreciation are normal results of business operation within a given period such value changes may be reflected in the expense and gross revenue accounts. If these changes are unusual, however, or apply to several past accounting periods, the Net Revenue and Surplus accounts DETERMINATION OF NET REVENUE 239 may be used to show the necessary equity adjustments. Sup- pose, for example, that a manufacturing company has a building valued at $10,000 destroyed by an unusual storm. The entries might be as follows : Surplus $10,000 Buildings $10,000 If this loss were considered as a current deduction from owner- ship the entries would be : Net Revenue $10,000 Buildings $10,000 Still another procedure would be to charge a special account such as "Storm Loss." If no net revenue or surplus balances were available this account might be carried as a deferred expense as explained in a preceding section. In a sense items of appreciation are always net revenue credits, for no deductions are involved as in the case of ordinary revenues. Suppose a factory site, for example, appreciates to the amount of f S,ooo during an accounting period. The following entries would recognize this occurrence : Real Estate $S,ooo Net Revenue $S,ooo If such an item of appreciation covers several accounting periods before it is recognized in the accounts, it should be credited not to Net Revenue but to Surplus, thus : Real Estate $S,ooo Surplus $5,000 For in this case crediting the amount of appreciation to Net Revenue would distort the current figure. In the meantime some of the individual owners may have retired from the enter- prise without receiving their full rights in property, but this situation cannot, of course, be remedied. The most adequate procedure, then, is to make this adjustment through the surplus accounts. If it seemed desirable to show the above mentioned item of 240 PRINCIPLES OF ACCOUNTING appreciation in distinct net revenue and property accounts, entries somewhat as follows would be made : Appreciation of Real Estate $S,ooo Net Revenue from Appreciation . . f SjOoo Where items of appreciation are large it is no doubt best to adopt this or a similar procedure ; for by the use of such special accounts the nature of the transaction is definitely shown in the accounts. In any case, however, the explanation of the occur- rence may be found in the details of the original Journal entry. It might be objected that the conception of net reveniie here developed is improper in that it apparently obscures the results of actual operation by combining in one figure net operating revenue and accruals due to price changes.^ This objection is not of great importance. As a matter of fact this analysis does not mean that no differentiation is possible in the financial records between the results of actual operation and the results of the speculative opportunities and burdens involved in a business enterprise. It is quite possible to organize the ac- counts and statements in such a way as to reveal both net revenue from operation, so-called, and total net revenue as well. In this connection it should be noted that the figure which the accountant considers as net operating revenue — the result of purchase and sale transactions, and ordinary ac- cruals — is not, in most cases, restricted to the results of opera- tion as distinct from the speculative and accidental possibilities. If a business enterprise purchases raw materials in a falling market and sells the > finished product in a rising market actual appreciation is involved in the revenue from operation. This can be made clear by an illustration. Suppose that a whole- saler buys merchandise for $100,000, and that before he sells again an advance in price occurs which would mean a price of $1 20,000 for this same lot if he were buying now. The merchant will now be able to sell this lot for $120,000 plus his customary • In general accountants object to the recognition in the accounts of the appre- ciation of unsold assets, although the validity of depreciation as a matter of account- ing record is admitted. This opinion is due in part to conservatism, and in part to a misunderstanding of the functions of accounting and the implications involved in valuations. In Chapter XX the general principles of valuation will be fuUy discussed. DETERMINATION OF NET REVENUE 241 advance, or, in other words, gross revenue is increased by $20,000 due to appreciation. The amount of net revenue in such a case is not restricted simply to the results of operation in the narrow sense. Similarly, costs may be unusually heavy in a particular period due to accidents and unfavorable price changes. If such costs are treated as current expense — as is usually done — the net revenue figure will not indicate merely the results for which the manager and the other operating officials are directly responsible. An ideal classification of expense and revenue accounts would undoubtedly be based on the principle that all charges and credits apphcable to technical operation as such should be segregated in the "operating" accounts, and that all accruals due to speculative changes and ancillary operations should be shown in the "non-operating" accounts. This goal is far from realized in any system of accounts now in use, however ; and in view of the complexities of the typical industrial situation it is doubtful if this ideal can ever be more than approximated. In- deed the notion of operation as a mere mechanical process can hardly be said to be justified as an accounting conception. Production is an economic process, and the speculative exigencies of business Kfe are inextricably bound up with physical produc- tion. In some cases production consists entirely in the per- formance of services ; and often it might be said that the taking of risk is an important part of the regular productive function. In such cases, certainly, it would seem reasonable to consider all value accruals as appHcable to the regular expense and revenue accounts. Emphasis has been laid in a preceding section upon the im- portance of preserving in the accounts and statements the integrity of the accounting period. In an important sense it might be said to be the function of accounting to present a classification of business transactions and accruals in terms of fiscal periods. Iii this connection the appreciation of assets — particularly current assets such as materials — has an important bearing. This can best be shown by means of an illustration. A retail merchant, it will be assumed, buys goods in October, 1917, amounting to $25,000. The journal entries at the time of purchase would be ; 242 PRINCIPLES OF ACCOUNTING Merchandise $25,000 Cash $25,000 On December 31st the merchant closes his books and prepares statements. At that time the lot of merchandise purchased in October is still unsold, and it is discovered that it would now cost $30,000 to replace this shipment. On the theory, however, that no revenue is yet realized, the appreciation of merchandise is not recognized in the accounts. During January, 1918, these goods are sold for $40,000, an advance of $5,000 over the price which would have been realized had there been no increase in wholesale prices. The entries — assuming cash sales — would now be as follows : Cash $40,000 Sales $40,000 These entries show that a gross revenue of $40,000 is realized in igi8. But do these entries show the actual situation? Is the 1918 management entirely responsible for this revenue? Or is it not true that a part of this revenue — $S,ooo — accrued in 1917 and should be credited to the revenue accounts for that year? At least there would seem to be some force to this contention. Had the appreciation of merchandise been recognized when the accounts were closed in 191 7 the entries might have been as follows : Merchandise $S,ooo Revenue from Appreciation .... $S,ooo These entries would have served to allocate to the revenue accounts for 1917 the revenue actually reahzed in that year — realized in the form of added value in merchandise. The charge to Merchandise would serve to increase the cost of goods sold in 1918 by $5,000, and hence would reduce the showing of revenue for that year — as far as this shipment of goods is concerned — by that amount. This procedure should not be confused with the illegitimate practice of forecasting profits in the accounts. To forecast profit is to use selling prices in taking inventories. To accrue the revenue due to an increase in the cost of replacing materials DETERMINATION OF NET REVENUE 243 and similar assets is an entirely different matter. Whatever may be decided about the wisdom of recognizing appreciation in the accounts, it at least should be admitted that this is not the same thing as the anticipation of profit. A word should be added in this connection concerning the wisdom or possibiHty of declaring dividends on the strength of a showing of net revenue which is due in part to appreciation of unsold assets. In general it may be said that dividends are based upon the net revenue figure rather than upon the cash balance, and that in any case net revenue is hkely to be repre- sented on the asset side by general assets rather than by cash alone. The current assets received when goods are sold may be shortly invested in additional material, supplies, machines, etc. In general appreciated assets form as sohd a basis for credit and dividends as additional units. On the other hand it should be noted that even in the case of a net revenue figure based entirely upon sales the condition of the money market and other factors ■ may make it unwise to declare dividends. In this section it is intended merely to suggest the way in which asset valuations affect the net change in the status of the equities during a given period. The problems of valuation have many other accounting implications. In Part IV par- ticular attention is given to these problems. The significance and treatment of appreciation will be more fully discussed in this connection. PART TWO THE EQUITY ACCOUNTS XI •Proprietorship — Single-Proprietors' and Partners' Accounts The point has been emphasized repeatedly in the foregoing pages that the accounts of a business enterprise are kept pri- marily from the standpoint of the private equities involved. It is the private owners — the interests that furnish the necessary capital — who have control of business operation in any case. The net revenue figure — the goal of the business struggle from the accounting standpoint — measures the change in the status of these equities. Hence the accounts which represent the equi- ties form in many ways the most important group of accounts. The results of the business process are reflected particularly in these accounts; the financial history of the enterprise can be read, in large measure, from these accounts. Several chapters will now be devoted to a discussion of the nature of the principal types of equities, and to an analysis of the typical transactions affecting the accounts with these interests. As already noted the laborer has a current equity in the business enterprise, but this equity is retired so frequently as seldom to assume impor- tant accounting significance. Similarly the state through its tax power may be said to have an equity in every enterprise ; but the state's claim is also an equity which is currently retired. It is the equity accounts which represent the capital investment in any case which are of particular accounting importance ; and in the following chapters it is these accounts which will receive especial attention. The present chapter begins a discussion of the most important equity from the accounting standpoint, the proprietorship interest, and is devoted primarily to an analysis of the proprietary accounts in single-proprietorships and partner- ships. proprietorship The ownership of property, broadly understood, is a complex fact comprising several elements. The principal burdens as- 247 248 PRINCIPLES OF ACCOUNTllSTG sumed by the investor in a business enterprise are : (i) the bearing of risk; (2) the taking of responsibility and control; (3) the furnishing of capital-service. (Sometimes the proprie- tor furnishes ordinary labor services as well.) These phases of ownership are more or less inseparable : for example, there can be no risk without the furnishing of -capital ; nevertheless these different elements may be subdiAdded and combined in a great variety of ways, as is evidenced by the specialization of securities in the modern business organization. The division of all equities into proprietorship and liabilities is based upon an important general classification of the burdens — and accompanying priv- ileges — of ownership just mentioned. The Hne drawn in accounting between proprietorship and out- side equities or liabihties corresponds roughly to the distinction made in economics between the. entrepreneur and the capitahst proper. The individual or interest that assumes the major ele- ment of risk in a business enterprise and takes the major share of final responsibihty and control is the entrepreneur; the indi- vidual or interest that furiiishes capital, but takes comparatively little risk and has but slight control of financial policies and busi- ness operation is the capitalist proper.^ Similarly the equities which involve the large element of risk and control of operation form proprietorship ; the other equities which carry less risk and less control are the outside equities or liabilities proper. This general distinction may be expressed more concretely. AU equities which have contractual rights to assets as either in- come or principal are liabilities ; the equities which have residual rights to assets constitute proprietorship. In other words the proprietor's equity acts as a buffer for all other equities in the enterprise. All contractual accruals of income must be met before any proprietary income is available; all contractual rights in capital must be met in case of financial disaster, or Uquidation for any reason, before the proprietor's claim may be considered. On the other hand whatever sum is available either as income or principal after other claims are satisfied is proprietorship. The proprietor assumes in large measure the burden of speculative losses ; the proprietor realizes in large measure the benefit of speculative gains. • Cf . Taylor, Principles of Economics, SINGLE-PROPRIETORS' AND PARTNERS' ACCOUNTS 249 On the accounting side the proprietary equity is of particular importance because the proprietor is in control. The proprietor — albeit there are certain important reservations in particular cases — has almost complete ultimate control of business opera- tion and financial poUcies. The proprietor — or his manager — buys materials, hires laborers, decides as to processes, finds a market, extends credits, etc. Naturally the proprietor's in- terest tends to dominate accounting theories, methods and poli- cies. This point of view, however, has been unduly stressed in the case of corporation accounting. The present tendency in corporation finance is toward the restriction of proprietary con- trol in favor of the other important equities.-^ The legal view which practically identifies the business organi- zation with the proprietor's equity in many cases gives added accounting importance to proprietorship. A study of reorgani- zations in the case of large corporations, however, reveals the fact that the courts are now thinking of the business enterprise as a unit with a variety of equities, each of which has certain peculiar rights and privileges. It should also be observed that the legal view is not necessarily the proper standpoint for the accountant. The legal Habihty in the case of a promissory note, for example, is always the par or face of the note. The account- ing liabiHty at the outset is the amount actually realized. As the note matures it "accrues" to par. There are other important general distinctions between pro- prietorship and Habilities. The proprietary equity is normally perpetual — or at least indefinite in length. A liability is gen- erally terminable. Further, a firm does not become bankrupt if proprietary claims are not met ; but if interest or principal is defaulted in the case of a typical liability legal insolvency is likely to ensue. These distinctions will be further considered in the following chapter. In accounting practice proprietorship and the accounts rep- resenting this equity are quite definitely defined. In the pre- 1 All general distinctions between proprietorship and liabilities must be stated with decided qualifications when applied to the most important type of business organization, the corporation. The difference between the proprietary equity and the liabilities is an important one but no hard and fast distinctions can be stated which apply in aU cases. Corporate proprietorship will be discussed in the next chapter. 2SO PRINCIPLES OF ACCOUNTING ceding chapters the important proprietary accounts have been frequently mentioned and briefly explained. It will now be necessary, however, to discuss more elaborately these accounts and the important types of transactions involved, especially from the standpoint of the leading types of business organiza- tion: (i) the single-proprietor enterprise; (2) the partnership; (3) the corporation. The difference between the accounting for one type of organization as compared with another Hes pri- marily in the distinction between the equities and the equity accounts involved. The details of the various legal phases of the different types of organization will be introduced only when necessary for the explanation of the accounts and the trans- actions. THE SINGLE-PROPRIETOR ENTERPRISE The simplest form of proprietorship is found in the case where this equity is vested in a single person. Anyone who is produc- ing for sale a commodity or service requiring for its production the outlay of capital might be called a proprietor.'- If the person directing production, however, owns no capital in the enterprise, he is simply a manager or laborer selling his personal service. It is in this form of organization that the distinction between proprietorship and liabihties can be most clearly drawn. The proprietor in such a case is usually spoken of as the "owner." The Habilities are said to represent the amount due to the "credi- tors" of the business. The "net worth" of the enterprise con- stitutes the proprietor's equity. The liabilities show the amount that he owes. The proprietor usually has almost entire control ; and his equity is likely to represent from seventy-five to ninety- five per cent of the total investment. In all such cases it is easy to identify the proprietor with the enterprise itself, and to con- ceive of proprietorship as representing the actual ownership. This is a more narrow conception of ownership than the one given in the preceding section, however, and it is not an entirely satis- factory view even in the case of a single-proprietorship. For ' As was previously explained the business enterprise is conceived in this text as an establishment producing something for sale. Obviously accounting problems arise in connection with the ownership of consumption goods ; and the owner of such goods might reasonably be considered a proprietor. SINGLE-PROPRIETORS' AND PARTNERS' ACCOUNTS 251 example, can it be legitimately said that a person owns outright mortgaged property? Is it not rather true that the proprietor in such a case shares with another the privileges and burdens of ownership? Certainly there are many cases in which the pro- prietor so-called is_ trading on a "shoestring." The proprietor •in such a case is little more than the manager for the real owners. If absolute control is vested with such a proprietor the interests of the actual owners are jeopardized. The restriction of ultimate control to those who furnish at least a significant part of the capi- tal is a healthy tendency in corporation finance. Even in the case of the single-proprietor business the view which looks upon all the equities as representing aspects of ownership is the more significant conception for the accountant to adopt. If a business enterprise be defined in the broad sense suggested above it must be admitted that there are more single-proprietor- ships than of all other types of organization combined. But this does not mean that this t3^e of enterprise is the most important for the accountant.! The newsboy on the street corner might be thought of as a proprietor ; but his business is so small that he has little need for records of any kind as all the details of his business, financial and otherwise, can be readily kept in mind. The great majority of typical single-proprietorships, however, are of sufficient consequence to require accounting records. In practice many such enterprises do not use the complete double-entry method. Quite commonly a small concern will keep a set of books which contain accounts with properties and habihties, but which omit the proprietary accounts. There are few firms, however, which require accounts of any kind that might not advantageously make use of the complete double-entry system. In most cases this system will prove far simpler in the long run than any possible abbreviation. A concrete illustration will serve as a convenient basis for the discussion of the proprietary accounts and the transactions affecting such accounts in the case of a business where proprie- torship resides in a single individual. It will be assumed that A ' In point of aggregate capital controlled, number of employees, units of output, financial influence, etc., the corporation leads in many important lines of industry. In the case of the corporation the importance of proper accounting for the equities is greatly magnified. 252 PRINCIPLES DF ACCOUNTING is a small manufacturer ; and that the following statement rep- resents the financial status of his business on July ist, 1918 : Assets Real Estate I 7,500 A, Capital Machinery Tools and Supplies Finished Product Materials . . . Cash .... Accounts Receivable Coal .... Insurance Prepaid 8,700 5,600 S,ooo 11,900 6,100 4,200 500 700 $50,200 Equities Mortgage . . . Notes Payable . Accounts Payable $33j°°° 8,500 2,300 6,400 $5°. 2°° The account entitled A, Capital represents proprietorship in this statement. Other terms might be used for the main proprie- tary account such as A, Proprietor or, simply, Proprietor. The nanie of the proprietor without any accompanying explanatory phrase is frequently employed to designate this account. The expense and revenue statement at the end of the month of July, it will be assumed, is as follows (in account form) : Expense Revenue Labor $1,200 Sales $6,600 Depreciation Expense . 150 Materials Consumed . 3.500 Fuel Expense . . . 300 Insurance Expired . . 100 Uncollectible Accounts SO Miscellaneous . . . 200 Decrease in Inventories 500 $6,000 Net Revenue . . . 600 $6,600 \ $6,600 The following represents the net revenue statement at this time: Net Revenue Interest Proprietary Net Income $100 From Expense and Revenue $600 500 $600 $600 SINGLE-PROPRIETORS' AND PARTNERS' ACCOUNTS 253 The balance of this statement, $500, constitutes the increase in proprietorship, or the increase in A's equity. The journal entries (assuming a Net Revenue account is used) which trans- fer this item to A, Capital would be : Net Revenue $500 A, Capital $5°° If now A decided to withdraw this profit the entries would be as follows : A, Capital $500 Cash $500 The first pair of entries simply transfer the item of proprietary net income from an allocation account to the proprietor's regular account and therefore merely represent a transposition of equi- ties. The second pair of entries recognize the withdrawal of cash and an equal decHne in proprietorship as stated. Frequently such an account as A, Capital is used to show only the permanent investment that it is expected will be left in the business. This account in such a case is credited with the amount of all investments and is charged with all retirements of original capital. Another account is then introduced called (for example) A, Drawing, which is credited with all items of income and debited with all withdrawals of income from the business. In accounting practice an allocation account such as Net Revenue is seldom used in the case of a single-proprietorship. Items of interest and proprietary income, together with all ex- penses, are charged to a summary account, Profit and Loss. In the case of a simple business this procedure may be considered expedient, but such confusion of unlike classes, as was emphasized in a preceding chapter, should be avoided as a rule. There are few cases in which a clear-cut division in the accounts of gross and net revenue charges and credits is not advisable. In the case of actual losses and extraordinary gains entries might be made directly in the main proprietary accounts to re- flect such happenings. Suppose, for example, that a storm dam- ages A's building (referring to above illustration) to the extent of $1,500. This occurrence would be journalized as follows : A, Capital $1,500 Real Estate |i,Soo 254 PRINCIPLES OF ACCOUNTING Similarly an extraordinary gain would require a credit to A, Capital. A customer's account amounting to $500, for example, which has been considered worthless and has been written from the books, is paid in full. The entries would be : Cash,. $500 A, Capital $500 In case the proprietor allows himself a salary as an expense (see page 224) in order that net income may be restricted to a return to capital as such, but does not withdraw the sum allowed, it is necessary to credit a proprietary account for the amount of the expense charge. Suppose A, for example, allows a salary of $150 per month for his own services, but makes no immediate withdrawal of this amount. The entries would be : A's Salary $150 A, Drawing $150 If A decides to leave this amount in the business permanently as investment the item may be transferred to A, Capital, thus : A, Drawing $150 A, Capital $150 These entries have exactly the same final effect upon the accounts as would be the case if A withdrew the amount of his salary in cash and immediately reinvested the same amount. The entries in this event would be: (i) A's Salary $150 Cash $150 and, (2). Cash $150 A, Capital $150 This discussion shows the simplicity of the proprietary accounts and the transactions affecting these accounts in the case of a single-proprietor enterprise. The need for keeping accounts with proprietorship in such cases is not as great as in enterprises having a more complex form of organization. If accounts are kept with all asset items and with all liabilities, proprietorship — the difference between assets and HabiHties — can be readily SINGLE-PROPRIETORS' AND PARTNERS' ACCOUNTS 255 ascertained from these accounts provided the other items are correctly exhibited. This is an indirect method, but might be feasible in the case of a very simple business. In such a case, however, the advantage of the complete double-entry method in furnishing a test for numerical accuracy would be lost. Fur- ther, unless subsidiary equity accounts (or at least a general expense and revenue account) were kept, there would be httle information in the records concerning the process whereby the changes in the proprietor's equity had been brought about. The various "single-entry" and incomplete systems in use by so many firms are not to be commended. COPARTNERSHIP PROPRIETARY ACCOUNTS A partnership, or copartnership, is an association by contract of two or more persons who have combined their capital and skill in a business venture for the purpose of joint profit. The part- nership agreement or contract may be either written or oral — aside from special statutes to the contrary ; but as a matter of business expediency carefully constructed articles of copartner- ship should always be prepared which state in detail the relations of the partners in regard to investments, division of income, participation in management, drawings, rights at dissolution, etc. It is even desirable to have the contract go so far as to specify the accounting methods which shall be used ; and detail direc- tions relating to methods of production and other questions of management may well be stated in writing. At least authority to settle such matters should be specifically delegated ; other- wise there are certain to be endless disputes and consequent in- efficiency. The accountant's work in connection with partner- ships is very much simplified if the articles of agreement give definite instructions concerning the important contingencies which may arise. A carefully stated contract minimizes the possibiHty of legal disputes and obviates, in large measure, the need for special audits. Certain general peculiarities of the firm ' or partnership should 1 The term firm is usually restricted in law to the partnership. An established single-proprietorship making use of a firm name, however, may also be called a firm or "house" with propriety. 256 PRINCIPLES OF ACCOUNTING be mentioned. The ordinary partnership, unless formed for a specified time, is a partnership "at will," and may be dissolved at any time by any partner. That is, a partner may usually withdraw at any time even against the wishes of his associates, and by such a withdrawal the firm is thereby dissolved. This is an important general characteristic of the partnership as com- pared with the corporation. Further, every member of an or- dinary partnership is liable to the entire amount of his private estate for the debts and engagements of the firm. In other words a partner risks not only the loss of his entire investment in the firm but the loss of any other property he may own should the partnership become insolvent (and its HabiHties exceed its assets). This fact of "unHmited liability" accounts in some measure for the inadequacy of the partnership form to meet the needs of large scale production. Where a large aggregate of capital is needed it would usually be very difficult to induce a sufficient number of investors to combine their interests on this basis. There may, of course, be any number of partners, although in actual business there are very few partnerships with more than four or five members. The several partners may be asso- ciated on an equaUty as regards investments, management, draw- ings, etc. ; but very commonly there are differences in the rights of the partners in one or more of these respects. The law rec- ognizes several kinds of partners with which the accountant should be famihar. A "silent" or dormant partner is one who takes little if any active part in the transaction or control of the partnership business. A "secret" partner is one who is not known as a partner, although he may be active in the manage- ment of the affairs of the firm. A "nominal" partner is not a partner by contract or agreement, but may be considered a part- ner legally if he has knowingly permitted himself to be "held out" as a partner to the public. The "limited" partnership and the joint stock association are special t)^es of partnerships. Limited partnerships are authorized by statutes in most of our states. In such firms the liability of certain members called "special" partners is limited to the amount of capital contributed in any case. Other members, called "general " partners, are liable to the creditors ■ — or outside equities — for all the obligations of the firm as in SINGLE-PROPRIETORS' AND PARTNERS' ACCOUNTS 257 the ordinary partnership. The joint stock association is usually nothing more than a large partnership having transferable shares which represent the partners' equities. The unlimited hability feature pertains to such companies as in the case of regular part- nerships. In this country the joint stock company is not at present a popular form of organization, and has almost entirely given way to the corporation. In a partnership the equities of the partners constitute proprie- torship. The partners' accounts are the proprietary accounts. All other equities represent the Uabilities of the fiirm. In the absence of special agreement to the contrary the assets of the partnership are joint property. No specific asset belongs ex- clusively to any partner. A partner's interest is simply a right to share in the general assets of the firm after all liabiHties have been met. Although the law makes a rather sharp distinction between the equities of the partners and the liabiUties or debts of the firm it is important that the accountant keep in mind a conception of the firm as an entity. The balance sheet of a partnership is prepared in the same way as the balance sheet of a corporation — all assets on one side, all equities on the other. The balance sheet is the groundwork of partnership accounting as it is of single-proprietorship or corporation accounting. Hence the various transactions occurring should be viewed from the stand- point of the enterprise as a whole rather than in terms of the part- ners' equities alone. An individual partner, for example, may borrow from or loan to the firm in much the same manner as an outsider. This is one illustration of the type of situation arising which requires the accountant to think of the entire enterprise as a unit. In the partnership the proprietary accounts are more numerous than in a single-proprietor enterprise, and some complexities arise. For an illustration it will be assumed that in the balance sheet shown in the preceding section pro'prietorship is repre- sented by the capital accounts of two equal partners, A and B, instead of the single proprietary account. The expense and revenue statement at the end of one month will be assumed to be the same as for the single-proprietorship. Hence, as far as expense and revenue and other subsidiary equity accounts are 2S8 PRINCIPLES OF ACCOUNTING concerned, there would be exactly the same records required for the partnership as in the simpler organization. The entries closmg the item of net income into the proprietary accounts would differ only in that more accounts would be involved, thus : Net Revenue $500 A, Capital $250 B, Capital 250 In distributing profits or making other withdrawals the part- ner's capital account is debited and Cash is credited as in the case of the single-proprietorship. The other types' of proprie- tary transactions illustrated in the preceding section would be handled in the same manner on the books of the equal partner- ship except that two proprietors would be involved instead of one. There is hkely to be little regularity about the distribution of income, or withdrawals of investment, by the partners unless there is specific stipulation in regard to this point in the articles of agreement. This is one reason why the capital accounts of partners frequently show such disproportionate balances. Usually the investments at the outset are equal or represent simple frac- tions of total proprietorship, but the irregularity of withdrawals may soon disturb this relation. Such a situation often makes the computation of a partner's share in income, or in assets at dissolution, somewhat cumbersome. Drawing or "personal" accounts are especially useful in the case of a partnership to show current increases and decreases in the partners' equities. When income is not divided among the partners in proportion to investments, interest may be allowed on each partner's equity, and then a distribution of the residual income made. A varia- tion of the above case will serve as an illustration. Suppose that of the partners mentioned A is the only one actively interested in the business, while B is a silent partner, investing capital and assuming risk but taking only slight interest in actual manage- ment. The articles of copartnership, it may be assumed, stipu- late that after each partner is allowed six per cent on his invest- ment the balance of the income is to be divided, two-thirds to A and one-third to B. In this case the situation may be shown on the books by making two distinct distributions of income among SINGLE-PROPRIETORS' AND PARTNERS' ACCOUNTS 259 the partners. The entries (using drawing accounts) would be somewhat as follows : (i) Net Revenue $165 A, Drawing $82.50 B, Drawing 82.50 which credits each partner with one month's interest on $16,500 at six per cent ; and, (2) Net Revenue $335 A, Drawing $223.33 B, Drawing 111.67 which distributes the balance of net income, two-thirds to A and one- third to B. In computing total proprietorship in the case of a partnership any credit balances in the drawing accounts must be added to investment as shown by the capital accounts. For even if such accounts show equity balances that are to be withdrawn, as long as such items remain in the business they form a part of total proprietorship. The equity of an individual partner would be similarly determined. In winding up the affairs of a partnership, however, the drawing account balances would not always be settled on the same basis as the capital account balances. The articles of agreement may require, for example, a division of the assets between partners in proportion to original investments. If such an agreement obtains provision should also be made to insure the maintenance of each partner's equity, at least approxi- mately. Otherwise serious disputes concerning the distribution of assets at time of dissolution are likely to arise. The need for an adequate system of proprietary and subsidiary accounts in the case of the partnership is evidently imperative. The amount of each partner's original investment may appear in the articles, but these amounts soon become obscured by withdrawals and accretions. Wherever proprietorship resides in more than one individual it is essential that careful accounting methods be observed. In such cases there is always a possible clash of interests, and the equity of one or more of the firm mem- bers may be jeopardized if complete proprietary accounts are 26o PRINCIPLES OF ACCOUNTING not kept. This matter is of still greater importance in the case of the corporation, where in addition to numerous individual owners may be found different classes of proprietors and other investors. Many special legal and accounting problems arise in connec- tion with the relations between partners as regards interest charges, loans, distribution of assets, etc. Some simple illus- trations will be considered in the following section. SPECIAL PROBLEMS IN PARTNERSHIP ACCOUNTING In certain cases questions arise as to the correct presentation of the partners' accounts at the time of organization. The transition from a single-proprietorship to a partnership will serve as an illustration. A, it will be assumed, is a proprietor engaged in the retail trade. The balance sheet of his business, in summary form, appears as follows : Assets (at book value) . $40,000 A, Capital $40,000 A now agrees with B to form a partnership. No new assets are contributed to the business, but B pays A personally $15,000 for a half-interest in the enterprise. Since A and B are now equal partners the proprietary accounts should show equal balances. The following balance sheet would be consistent with this situa- tion: Assets $40,000 A, Capital $20,000 B, Capital 20,000 $40,000 $40,000 If the price which B pays for an equity, however, be considered as a reasonable criterion of the value of the assets of the business, it is evident that the book value of these assets is overstated by |io,ooo. If certain of these assets, merchandise, for example, were written down by this amount the first balance sheet would appear as follows : Assets $30,000 A, Capital $15,000 B, Capital 15,000 $30,000 $30,000 SINGLE-PROPRIETORS' AND PARTNERS' ACCOUNTS 261 A somewhat different situation arises if it be assumed that B purchases an equal interest with A by contributing to the business cash to the amount of $50,000. If the old assets be considered as worth $40,000, the first partnership balance sheet would ap- pear as follows : Sundry Assets .... $40,000 A, Capital $45,000 Cash So,ooo B, Capital 45, 000 $90,000 $90,000 It might be assumed that the premium which B pays for his equity in this case is due to goodwill, an intangible asset belong- ing to the original business but not appearing in the accounts. A more reasonable procedure, according to this assumption, would be to set up the assets and partners' accounts as shown in the following balance sheet : Sundry Assets .... $40,000 A, Capital $50,000 Goodwill 10,000 B, Capital ,50,000 Cash 50,000 $100,000 It is evident from the foregoing simple illustrations that the original investment of a partner, as shown by his capital account, may not coincide with the actual amount contributed. In other words the purchase price of a definite fraction of the proprietary interest may not be consistent with the asset values as stated. This is particularly likely to be the case where one partner, with the consent of the other members of the firm, sells a part or all of his equity to an outside party who brings in no new capital. As long as the proper proportions are maintained in the part- ners' accounts, however, a revision of the asset values is not an imperative matter. The purchase and sale price of a share in proprietorship in the case of a partnership is little more likely to indicate the actual value of the firm's assets than is the price of a share of stock in the case of a corporation a reUable index at all times of the value of the corporation's assets. As stated in the preceding section a partner may have debtor and creditor relations with thie firm as an outsider as well as in the capacity of a proprietor. A partner may loan funds to the firm or borrow from the firm. Such transactions should be kept 262 PRINCIPLES OF ACCOUNTING carefully distinct from the regular proprietary transactions. The rights of the partner as an outsider have a different legal status in the event of dissolution as compared with his rights as a proprietor. Further, since the division of profits is often based directly upon the proportions which the amounts appearing in the individual proprietary accounts respectively bear to total proprietorship, it is essential that actual proprietary transactions be segregated. Suppose, for example, that A, a partner, loans $5,000 to the firm on the firm's promissory note (of which A himself may be a signer). This sum should be credited to Notes Payable rather than to A, Capital. Similarly if A borrows $5,000 in cash from the firm on his personal note the transaction would be viewed as an exchange of assets and not a subtraction from A's invest- ment. The entries in this case would be : Notes Receivable $S,ooo Cash $5,000 It should be observed that in certain extreme cases rather artificial accounting situations may arise if there is a strict ad- herence to the distinction between transactions with the part- ners as outside individuals and transactions with the partners as proprietors. The following balance sheet illustrates such a situation : Loans to A $20,000 A, Capital $20,000 Loans to B 20,000 B, Capital 20,000 $40,000 $40,000 Obviously the partnership whose condition is represented by this statement has virtually ceased to exist as a business enterprise. It really has no assets and no equities. The loans to partners are essentially withdrawals of proprietary investment. The business has been Kquidated. Although this statement rep- resents a very unlikely situation, it serves to suggest a certain aspect of these internal relationships. The entity of the busi- ness enterprise should not be insisted upon too rigidly. One must be careful not to allow formal accounting entries to obscure the realities of a situation. Similarly in connection with interest on loans to partners SINGLE-PROPRIETORS' AND PARTNERS' ACCOUNTS 263 pecuKar situations may appear. Suppose, for example, that A, a partner, has borrowed $5,000 from the firm on a six per cent note. At the end of a year it is agreed among the partners that the amount of interest due on A's note, $300, shall be charged to A's proprietary account since A is not in a position to make a cash payment. The entries recognizing this transaction would be: A, Capital $300 Interest $300 The credit to Interest is apparently a revenue item, and it would in practice be handled in the accounts as would any interest revenue. It should be recognized, however, that this item is not actual revenue, but should be used to adjust original pro- prietorship between the partners. This may be made clear by an examination of supposititious balance sheets as affected by this single transaction. The balance sheet at the time the loan is made, it will be assumed, appears as follows : Sxmdry Assets . . . $25,000 A, Capital $15,000 A's Note S,ooo B, Capital 15,000 $30,000 $30,000 Assuming that the partners share in all income in proportion to their capital account balances — or equally in this case — the interest revenue shown in the above entry would be distributed between the partners by the following entries : Interest I300 A, Capital $150 B, Capital 150 The net result of this transaction, therefore, is a decrease in A's equity of $150 and an increase in B's ownership of the same amount. The resulting balance sheet would show the following condition : Sundry Assets .... $25,000 A, Capital $14)850 A's Note 5,000 B, Capital 15,150 $30,000 $30,000 There has been no increase in total assets or in total equities. Obviously, therefore, no revenue has been realized. This il- 264 PRINCIPLES OF ACCOUNTING lustrates the importance of keeping out of the ordinary interest accounts interest transactions which result simply in adjust- ments between partners. If such interest debits and credits are included in one account with ordinary interest entries erro- neous conclusions are Hkely to be drawn. An appropriate pro- cedure in the above case, for example, would be to omit the entries in the Interest account. In this event the transaction would be journalized as follows : (i) A, Capital $300 A, Capital $150 B, Capital 150 or, simply, A, Capital $150 B, Capital $150 In some cases the articles of agreement specify that interest shall be charged on deficiencies and credited on excesses as shown by the partners' capital accounts. In other words if a par- ticular partner's drawings are excessive and reduce his equity below the original capital contribution, his capital account may be charged with interest at a specified rate on the amount of the deficiency ; and if another partner allows his equity to accumu- late above the stipulated investment his capital account may be credited with interest on the amount of the excess. Such items of interest are likewise adjustments in proprietorship between partners, and neither represent deductions from net revenue nor actual additions to revenue earned as the case may be. It is sometimes said that such items should be carried to the or- dinary interest account and should be treated as interest on regular loans. This fallacious opinion is due to a too rigid em- phasis upon the distinction between the partner as an outsider and as a proprietor. As was explained in the preceding section the computation of interest on the partners' equities is sometimes required by the particular provisions in the agreement concerning the distribu- tion of net income. In such a case residual income (after in- SINGLE-PROPRIETORS' AND PARTNERS' ACCOUNTS 265 terest allowances are distributed) is usually divided upon some other basis. Such agreements are common in cases where the functions of the several partners are quite different. A managing "junior" partner, for example, who invests very httle capital, may be entitled according to the partnership contract to a Uberal percentage of residual profits after the other partners have been allowed a certain rate upon their investments. Such a partner is essentially a manager, and the profit he receives is really the wages of management. Sometimes the more active partner is allowed a definite salary before any distribution of profit is made. Such a salary is a part of the earnings of the partnership, as a business unit, and if charged to expense simply restricts the stated net proprietary income to a return on capital (pure interest and profit). As was stated in a preceding chapter, however, such charges may be considered legitimate revenue deductions when for tax purposes the net income of the partnership is as- sessed on the same basis as the net income of a corporation which buys the services of management from outsiders. Where interest adjustments are involved the distribution of proprietary income may require rather cumbersome calculations. A further example will serve to suggest the nature of such com- putations, and to illustrate certain other complexities which may arise. Suppose that A and B form a partnership, January ist, each investing $12,000. According to the agreement income is to be divided equally. On February ist it is decided to take in another partner, C, who invests |6,ooo. The articles of copart- nership are amended in such a way as to require that the account of each partner be credited at the close of the current year with interest at a six per cent rate on his net investment from February ist to the end of the year. The agreement stipulates that all residual income shall be divided in proportion to the actual equities of the partners as they appear on the books at the end of the year, before any distribution of income has been made. It is further agreed that the income for the month of January shall be considered as one-twelfth of the total for the year, and is to be divided equally between A and B according to the terms of the original contract. During the year B's drawings are as follows : May ist, $350 ; August 15th, $450; December ist, $200. A and C make no 266 PRINCIPLES OF ACCOUNTING withdrawals whatever. On December 31st, accordingly, the partners' equities stand on the books as follows: A, $12,000; B, $11,000; C, $6,000. Net proprietary income, it will be as- sumed, amounts to $3,600. The first step in distributing this amount according to the above stipulations is to divide one- twelfth of the total equally between A and B. The entries would be as follows : Net Revenue $300 A, Capital $150 B, Capital 150 Interest must now be computed at six per cent on each partner's net investment for eleven months. The equities of A and C have remained unchanged at $12,000 and $6,000, respectively. The interest on $12,000 for eleven months is $660, and on $6,000 for the same period, $330. B, however, has withdrawn $1,000 at various times. A convenient way to compute the interest allowance of this partner is to subtract from $660 — the amount of interest had his investment remained unchanged from Feb- ruary ist — the interest on $350 for eight months (from May ist to December 31st) plus the interest on $450 for four and one- half months plus the interest on $200 for one month. This computation gives $635.88, B's interest allowance. The entries recognizing these allowances would be as follows : Net Revenue . $1,625.88 A, Capital $660.00 B, Capital 635.88 C, Capital 330.00 The balance of the net income, $1,674.12, is to be distributed in proportion to the partners' equities as they appear on the books before any income distributions are made. This sum will then be divided as follows : twelve twenty-ninths to A ; eleven twenty-ninths to B ; and six twenty-ninths to C. The entries recognizing this residual income distribution would be : Net Revenue $1,674.12 A, Capital $692.74 B, Capital 635.01 C, Capital 346.37 SINGLE-PROPRIETORS' AND PARTNERS' ACCOUNTS 267 The partnership balance sheet, it may be assumed, now ap- pears as follows : Sundry Assets .... $32,600 A, Capital .... $13,502.74 B, Capital .... 12,420.89 C, Capital .... 6,676.37 $32,600 $32,600.00 Although the above case illustrates a purely hypothetical situation, it should be recognized that a great variety of agree- ments and arrangements are found in partnership contracts; and where the partners' account balances are irregular some rather elaborate calculations may be necessary in distributing income. As was impHed in the preceding section any change in the personnel of a partnership virtually causes the dissolution of the firm. Where a partner voluntarily retires and sells his interest the change may not mean an actual liquidation of the business. Such a change from the accounting standpoint may be largely of nominal significaiice. But in the case of bank- ruptcy, or dissolution by court decree- for other reason, the firm as a business enterprise usually ceases to exist. In such a case the assets are appHed first to the payment of the liabilities, and any balance is then available for distribution among the part- ners. Any advances made by a partner to the firm must be met before the capital shares are distributed. Unless the articles contain specific provisions in regard to dis- solution some question may arise as to how the residual assets should be divided in certain cases. Should the proportions shown by the original capital contributions of the partners be used, or should the distribution be based upon the balances finally appear- ing in the partners' accounts? The partnership agreement should cover this point. In some cases the articles specify that losses shall be borne equally by all partners, although the in- vestments are unequal and some other basis is used in distribut- ing income. As an illustration of a dissolution on this basis it will be convenient to refer to the case discussed above. Suppose that after three years it is decided to dissolve the partnership because of serious losses and poor business prospects. The balance sheet at this time, it will be assumed, stands as follows : 268 PRINCIPLES OF ACCOUNTING Sundry Assets .... $21,000 A, Capital $12,000 Deficit 9,000 B, Capital 12,000 C, Capital 6,000 $30,000 $30,000 Suppose further that the agreement provides that all losses are to be borne equally. The account of each partner, then, would be charged with one-third of $9,000, or $3,000. The entries would be : A, Capital $3,000 B, Capital 3,000 C, Capital 3,000 Deficit $9,000 The resulting balance sheet would now show the following condition : ^ Sundry Assets .... $21,000 A, Capital $ 9,000 B, Capital 9,000 C, Capital 3,000 $21,000 $21,000 The assets may now be distributed according to the amounts appearing in the partners' accounts. The transition from the partnership to the corporate form of organization is often a complex accounting transaction. This situation will be discussed in the following chapter on corporate proprietorship. XII Corporate Proprietorship — Capital Stock It has been noted several times in the preceding chapters that the corporation is the most important form of business organi- zation with which the accountant has to deal. The large scale enterprise which may be said to be typical of modern industry is usually organized under the corporate form, and it is in connec- tion with the complex equipment of such large enterprises that the more difficult problems of valuation arise. Further, a cor- rect periodic presentation of the status of the rights of owner- ship is a matter of particular importance in the case of the cor- poration because of the large number of individual investors involved in the typical case, and also because of the different classes of equities represented. The detachment of the investor from the immediate management of the affairs of the corpora- tion, and the transient character of many of the individual owners, are other factors contributing to the need for adequate corporation accounting. In this chapter and the next the nature of corporate proprietorship and proprietary accounts will be discussed. In the present chapter typical transactions affecting Capital Stock and related accounts will be explained. Some attention will be given to the peculiar features of the corporate form of organization, and to the special books and records required. Chapter XIII will be devoted to a discussi,on of the surplus accounts. corporate proprietorship The private business corporation (to which the discussion in this text will be largely confined) is Kke the partnership an associ- ation of persons formed primarily for the pecuniary profit of its members. The corporation, however, differs from the partner- 26g 270 PRINCIPLES OF ACCOUNTING ship in several marked respects. Whether created by special act or charter or by general law the corporation is endowed by the state or government with the power of acting in many re- spects as a single individual. In fact, from a legal point of view, the corporation is an artificial being possessing an existence separate and distinct from that of its individual members. The universal recognition by the courts of the reahty of this corporate entity is a matter of very considerable importance. It means that a corporation, having a legal existence distinct from that of its members, is not dissolved by changes in the personnel of its membership, as is the partnership, due to the death or withdrawal of individi;al members and the substitution of others. The entire membership of a corporation might be changed any num- ber of times and still the legal existence of the organization would not be disturbed. It follows that the legal title to the corporate property resides in the corporation itself, and not in its mem- bers as individuals, either separately or collectively. In general, moreover, the Habihties incurred and the engagements made in the corporate name are the obligations of the corporation alone, and bind only its assets or property and not the assets of indi- vidual members,^ while in the case of the partnership — as was explained in the preceding chapter — the law regards the rela- tion of the members as a purely contractual one, and each part- ner is held personally responsible for all of the liabiHties and contracts of the partnership. This fact of limited liability is one of the chief advantages of the corporate form as a means of attracting the capital of the investor. A corporation is most commonly incorporated under a general law authorizing such organizations. The original promoters and other parties interested meet and agree upon a plan of action. Usually at this first meeting a part of the authorized capital stock is subscribed for, and an organization is effected by the election of a board of directors and other officers. Articles of association are then prepared and the other necessary legal steps to initiate the enterprise are taken. 1 In certain special cases there are exceptions to the rule that a corporate member is liable only for the amount of his investment. The stockholders of national bank- ing companies are liable for twice the par value of their stock. Some states also have laws restricting the limited liability privilege in general. CORPORATE PROPRIETORSHIP — CAPITAL STOCK 271 I'he members of the ordinary stock corporation are the stock- holders, and it is the equity of the stockholders which constitutes corporate proprietorship. It is therefore the proprietary equity in the corporation as well as in other types of organization which, in law, represents ownership par excellence. The authorized capital stock is the amount fixed by the charter or articles of incorporation as a basis for the contributions of the stockholders. The total capital stock is divided into ahquot parts called shares. The equity of each stockholder is evidenced by the number of shares he holds. A share of stock, as was impHed above, does not constitute a title to any specific asset of the corporation, but it represents a certain fraction of total proprietorship, and thus carries with it certain rights in management, income, and ulti- mate assets. The number of shares which each stockholder has in the cor- poration is represented by a stock certificate, signed by the proper officers of the company. The nature of such a certificate is suggested by the following illustration. INTERNATIONAL STEEL COMPANY Number Shares This certifies that A. W. Rollins is the owner of one hundred shares (par value ten dollars) of the capital stock of the INTERNATIONAL STEEL C0MPA2SrY a corporation duly organized under the laws of the state of Delaware. This stock is transferable on the books of the Company only in person or by attorney, upon the return of this certificate properly endorsed. In Witness Whereof, the said company has caused this certificate to be signed by its President and Secretary, and its corporate seal to be affixed, at the office of the company at WUmington, Delaware, this 15th day of August, 1918. James B. Harley, President. (seal) S. R. Wilson, Secretary-Treasurer rULLY PAID AND non-assessable The legal holder of such a certificate is one of the corporate pro- prietors. Such a certificate may be acquired either by means of a contract entered into directly with the corporation or by 272 PRINCIPLES OF ACCOUNTING purchasing or otherwise securing the equity of someone previously a shareholder. The stockholders as a rule are not active in the management of the corporation, while the proprietors in partnerships and single-proprietorships usually are. The ultimate authority resides in the stockholders but active management is vested in a board of directors elected by the stockholders in a manner prescribed by law. The directors are usually shareholders, but not always large shareholders. A set of rules or by-laws approved by the stockholders governs in a general way the conduct of the corporation's business. Thus far in the discussion of corporate organization and pro- prietorship it has been assumed that the membership of a cor- poration is a congruous body of stockholders ; or, in other words, corporate ownership has been identified with corporate proprie- torship — the stockholder's equity. This is essentially the legal view ; but there are certain important developments in corpora- tion finance which make it essential that the accountant conceive of the corporation as a business enterprise on a somewhat broader basis. In the first place there may be more than one kind of capital stock. The most important general distinction is between common and preferred stocks. This distinction simply carries one step further the important division of the elements of owner- ship explained at the beginning of the preceding chapter. The common stock represents the more speculative phase of prpprie- torship, carrying more risk and frequently greater control. In some cases the common stock is given as a bonus with preferred stock or bonds, and in such a case its value is purely speculative. The preferred stock may be preferred either as to income or as to capital in case of liquidation; and in many cases both provisions obtain. Usually a preferred stock carries a definite dividend or interest rate. The stated dividend rate applies to the par or face value of the stock. A seven per cent preferred stock, for example, is entitled to an annual dividend of seven per cent on par before any dividends are declared on the out- standing common stock. In some cases the dividend privileges on preferred stock lapse at the end of each year provided earn- ings are insufficient to meet them. In other cases the stock is "cumulative," and all unpaid dividends constitute a potential CORPORATE PROPRIETORSHIP — CAPITAL STOCK 273 charge against net revenue prior to the common stockholders' claims. In fact there is almost an indefinite variety of preferred stocks to be found in practice. It is not intended here to dwell in detail upon the many pos- sible plans which may be followed in dividing among different classes of stockholders the important aspects of proprietorship as regards income, control, etc. The fact that this division of rights, however, is not only a possibiUty but a widespread and growing practice, is a consideration which has an important bearing ■ upon the accountant's conception of the torporation balance sheet. This point will be further emphasized in a moment. A corporate organization commonly makes use of other securi- ties than stocks in securing the capital necessary to the success- ful initiation of the enterprise as a business unit. Various kinds of bonds are the most familiar examples. These other securities, together with the current or floating indebtedness, constitute the liabilities of the corporation.^ According to the conception of the balanc.e sheet stressed in the foregoing pages these lia- bilities also represent equities in the enterprise. The economic distinction between entrepreneur and capitalist proper already referred to corresponds roughly to the distinction between stock- holder and bondholder. The stockholder assumes the larger element of risk in the enterprise and has the larger element of control. The stockholder profits most if the business is very successful; and he suffers first if the enterprise is disastrous. Accordingly the stockholder, as was stated above, is the pro- prietor and his equity constitutes proprietorship. The bond- holder's equity is classed among the Habilities proper. It should be emphasized, however, that the distinction between pro- prietorship and liabiUties is in general much less sharp in the corporation than in the case of the simpler forms of organization. In reaUty the strictly legal view which looks upon the stockholders as forming the membership of a corporation is a somewhat narrow conception for the accountant. From the accounting standpoint there is at least some reason for thinking of all the individuals who furnish capital to the corporation as constituting the cor- porate membership. ' The corporate liabilities will be more fully discussed in Chapter XIV. 274 PRINCIPLES OF ACCOUNTING This view seems the more reasonable when the tendency toward the further specialization of securities, both stocks and bonds, is recognized. This tendency makes it difficult to main- tain in the case of the corporation the sharp distinction drawn between proprietorship and liabilities, which is fairly applicable to the simpler forms of organization. It cannot be said, for example, that the fact that bonds have definite repayment dates places such securities in an altogether distinct category. Pre- ferred stocks are often callable under specific conditions and at specific dates, and are liquidated in cash or exchanged for other securities. Again, perpetuities, which are virtually bonds with- out payment dates, are sometimes issued. The use of such instruments in the United States will probably increase as the country becomes older and the opportunities for speculative investment become less numerous. Further, a large bond issue is usually paid by refunding, and although the personnel of the investors may change this in a sense makes the issue perpetual. Still further, it is quite possible to finance an entire terminable project with stock issues. The stock of a wasting asset enterprise, such as a lumbering company, may be liquidated in a definite manner according to stipulations in the articles of incorporation. Incorporated philanthropic societies and similar organizations also frequently terminate after a specified number of years and the capital stock is retired at that time by definite arrangement. A general legal distinction between stocks and bonds of con- siderable importance lies in the fact that legal bankruptcy ensues if bond interest is defaulted, whereas in the case of stocks such a thing is not possible. This distinction again, however, is not as sharp as the division between proprietorship and habiUties in the case of the small firm. The vast property of a modern corporation cannot be sold under the hammer. Bankruptcy in such cases means primarily reorganization ; and in such a reorganization all of the equities involved in the capitalization of the business play parts according to their particular privileges and burdens. Further it might be noted that a consistent fail- ure to pay cumulative preferred dividends may force a reorgani- zation.-^ Finally it should be remembered that any individual ' For an example see the history of the United States Leather Company in Dew- ing, Corporate Promotions and Reorganizations, Chapter II. CORPORATE PROPRIETORSHIP — CAPITAL STOCK 275 stockholder has definite legal rights of procedure against the cor- poration in which he has an equity provided his privileges are being impaired ; and because of the importance of the corporate entity such rights are of much greater significance than the similar rights of a partner. In the matter of control it should be observed that the bond- holder frequently has considerable direct and indirect influence upon the management of the corporation. Stipulations in regard to sinking fund appropriations, new security issues, general financial policies, etc., are of common occurrence in the bond contract. The bondholder sometimes has voting and veto powers in regard to important measures. Another point of importance in this connection is the fact that the bondholders come into direct control in receiverships and reorganizations. Further, in reorganizations wholesale exchanges of bonds for stocks (the reverse operation is also common) occur. Stock- holders pass into the bondholder class, and bondholders become stockholders. This is also a fairly common kind of financial operation outside of reorganizations. Some issues of bonds give the holder the privilege of exchanging his security for stock under certain specified conditions. This feature is particularly common in the bond issues of mining corporations. The convertibiHty of bonds sometimes means that interests represented for a time at least among the bondholders have a potential majority control of the corporation. In fact if all existing varieties of corporate securities were ar- ranged in a series beginning with the speculative kinds of common stocks, and ending with the conservative types of bonds and similar securities, it would be impossible to group these equities between proprietorship and liabilities on any hard and fast basis. Certainly it would be somewhat unreasonable to classify the series into two divisions, one representing ownership and the other debts. It must be remembered, however, that the unit with which accounting deals is the specific enterprise, rather than corporations or securities in general, and that in the specific case the distinction between corporate proprietorship and cor- porate HabiHties is usually a matter of considerable practical significance. It is evident that the need for complete proprietary and other 276 PRINCIPLES OF ACCOUNTING equity accounts in the case of the corporation is imperative. It is not enough to be able to ascertain total proprietorship at any moment by subtracting the amount of the liabilities from the total of property. If the rights of the different classes of stock- holders and other interests are to be preserved specific accounts must be kept which show the status of each equity. Further, an elaborate system of expense and revenue and other subsidiary equity accounts is a matter of particular importance in the case of the large scale enterprise where several interests are concerned. The accounts representing corporate proprietorship are af- fected primarily at times of organization, merger, dissolution, etc., and by the process of distributing net revenue, subdividing surplus, and the Hke. The transactions requiring entries in Capital Stock and related accounts arise for the most part at the time of organization. Such transactions will be discussed in the following sections. THE TRANSITION FROM PARTNERSHIP TO CORPORATION The organization o! a corporation frequently represents a change from the partnership form. A simple illustration of such a situation will be considered. The balance sheet of A and B, partners, it will be assumed, shows the following condition : Assets Equities Plant $50,000 A, Capital Account . . $22,000 Machinery 10,000 B, Capital Account . . 38,000 Supplies 2,500 Notes Payable .... 6,500 Patents 2,700 Accounts Payable . . . 2,600 Accounts Receivable . . 1,800 Notes Receivable . . . 600 Cash 1,500 $69,100 $69,100 The A. B. Co., a corporation, is organized for the purpose of taking over the assets of the old partnership and expanding the business. According to the terms of the purchase, all the assets of the partnership are to be taken over at their book value, and all the Habilities are to be assumed by the new concern as they stand. Capital stock is authorized for |ioo,ooo, par value $100 CORPORATE PROPRIETORSHIP — CAPITAL STOCK 277 per share. The partners are to receive $75,000 in stock for their equities in the partnership. It will be assumed that this agree- ment is consummated. What would be the closing entries on the books of the partnership? This agreement involves the recognition of goodwill. The partners' equities stand on the books at $60,000. They are to receive $75,000 in the stock of the new enterprise. This situation almost invariably arises when a partnership is taken over by a corporation. The par value of the securities received by the partners usually exceeds the book value of the assets of the firm. The goodwill may, of course, be entirely legitimate, due to a trade name, superior selHng organization, etc. ; on the other hand it is very frequently illegitimate.'^ In such a situation the value of the stock received must be tested on a cash, or an equivalent, basis. Assuming in this case that the goodwill is authentic,then preHminary entries will be necessary on the books of the part- nership to recognize this item. The amount of the goodwill, it will be assumed, is to be credited to the partners' capital ac- counts in proportion to their investments. The entries, accord- ingly, would be as follows : Goodwill $15,000 A, Capital Account .... . $S,Soo B, Capital Account 9)Soo All of the partnership assets, including goodwill, are now trans- ferred to the A. B. Co., and the habihties are assumed by that company. The entries covering these transactions on the books of the partnership would be : (i) A. B. Co $84,100 Plant $50,000 Machinery 10,000 Supplies 2,500 Patents 2,700 Accounts Receivable 1,800 Notes Receivable 600 Cash 1,500 Goodwill 15,000 1 See Chapter XXTV for a discussion of goodwill. 278 PRINCIPLES OF ACCOUNTING which recognizes the transfer of the assets to the corpora- tion ; and, t (2) Notes Payable $6,500 Accounts Payable 2,600 A. B. Co $9,100 which recognizes the assumption of the partnership liabilities by the A. B. Co. The balance of the A. B. Co. account repre- sents the claim which the partners have against the newly organized corporation. The partners receive $75,000 in the capital stock of the A. B. Co. in full settlement of their claim against the corporation. The entries at this time would be : Stock — A. B. Co ■. . $7S,ooo A. B. Co $7S,ooo The partnership balance sheet would now show this condi- tion: Stock — A. B. Co. . . $75,000 A, Capital Account . . $27,500 B, Capital Account . . 47,500 $75,000 $75,000 The final step in liquidating the partnership will be the divi- sion of the capital stock received between the partners in pro- portion to their investments, and the closing of the partnership accounts. In this case the partners' capital accounts are such that the stock can be divided in exact proportion to the balances shown by these accounts. Since a share of stock cannot be divided, it frequently happens that one partner will have to take an extra share, paying the difference in cash. In this case A would receive 275 shares, and B, 475 shares ; and the final closing entries would be : A, Capital Account $27,500 B, Capital Account 47, 500 Stock — A. B. Co $75,000 CORPORATE PROPRIETORSHIP — CAPITAL STOCK 279 In summary form the opening entries on the books of the A. B. Co. covering the transfer of the partnership assets and lia- bilities would be as follows : (i) Plant $50,000 Machinery 10,000 Supplies 2,500 Patents 2,700 Accounts Receivable 1,800 Notes Receivable 600 Cash 1,500 Goodwill 15,000 A and B $84,100 which Tecognizes the transfer of the assets and the claims of A and B ; and, (2) AandB $9,100 Notes Payable $6,500 Accounts Payable 2,600 which recognizes the transfer of the liabilities. The balance of the A and B account shows the amount of stock due the partners. The stock is now issued to A and B. The entries would be : A and B $7S,ooo Capital Stock $75,000 The opening entries are evidently essentially the reverse of the partnership closing entries. The more detailed corporate or- ganization entries usually necessary will be illustrated in the next section. If the balance of the stock authorized were now sold for cash, the opening entries, in summary form, would be : Cash $25,000 Capital Stock $25,000 28o PRINCIPLES OF ACCOUNTING A balance sheet of the corporation at this point would show this condition : Assets Plant $So,ooo Machinery 10,000 Supplies 2,500 Patents 2,700 Accounts Receivable . . 1,800 Notes Receivable . . 600 Cash 26,500 Goodwill 15,000 $109,100 Equities Capital Stock . Notes Payable Accounts Payable $100,000 6,500 2,600 $109,100 A comparison of this balance sheet and the original partnership statement shows that the important change that has occurred is in the proprietary accounts. The property accounts stand as they did before (except for the introduction of Goodwill and the increase in the amount appearing in Cash), only now they are on the ledger of the corporation. The outside equity accounts show no change ; but in place of the partners' capital accounts there appears the Capital Stock account to represent proprietor- ship. This illustrates the fact that the type of organization adopted in any case affects the character of the accounting records primarily in the equity accounts. ORGANIZATION — STOCK ISSUED FOR CASH The opening entries in the case of the organization of a cor- poration are usually much more detailed than as shown in the preceding section. Another illustration will be discussed at this point. The Blank Company is incorporated under the laws of Michigan, July i, 19 18. The company plans to do a general manufacturing business. The authorized capital is $175,000, divided into 1000 shares of common stock, par $100, and 750 shares of preferred stock, par $100. At the time of incorpora- tion $50,000 of common stock is subscribed, and $25,000 of pre- ferred. There are various methods of making the journal en- CORPORATE PROPRIETORSHIP — CAPITAL STOCK 281 tries necessary to recognize this situation. The entries might have this form : ^ Subscriptions (Common) $50,000 Subscriptions (Preferred) 25)0°° Stock Subscribed (Common) . . $50,000 Stock Subscribed (Preferred) . . 25,000 A subscription for capital stock is of the nature of a promissory note and hence is an asset of the corporation. The balance of the Stock Subscribed account represents the promise of the cor- poration to issue the stock when the subscriptions are paid. At the time the subscriptions are paid the journal entries would be : Cash $75,000 Subscriptions (Cornmon) .... $50,000 Subscriptions (Preferred) .... 25,000 After the subscriptions have been paid in cash the corporation is required to issue and deliver the stock. The following entries would cover this transaction : Stock Subscribed (Common) $50,000 Stock Subscribed (Preferred) 25,000 Capital Stock (Common) . .' . $50,000 Capital Stock (Preferred) . . . 25,000 The balance of stock authorized (both common and preferred) is now sold immediately for cash. The entries would be : Cash ... ........ $100,000 Capital Stock (Common) . . . $50,000 Capital Stock (Preferred) ... ^ 50,000 If the balance of the stock authorized had been subscribed, and an interval had elapsed before the subscriptions were paid, then the additional entries involving Subscriptions and Stock Sub- scribed would be necessary. This is practically always the case. The balance sheet of the Blank Company after the consumma- 1 The entries given in these cases show the effect of the various transactions only upon the controlling proprietary accounts appearing in the general ledger of the corporation. The subsidiary accounts and books required will be described in a later section of the chapter. 282 PRINCIPLES ar ACCOUNTING tion of the foregoing transactions would show the following condition : Cash ... . . $175,000 Capital Stock (Common) $100,000 Capital Stock (Preferred) 75, 000 $175,000 $175,000 It has been assumed in this and in the preceding illustration that the entire authorization of the capital stock was issued at one price — par value. Very frequently, however, capital stock is subscribed at some price other than par ; and in the case of the flotation of a large issue several different prices may be involved. In such cases it is not the par value of the securities issued that represents the stockholders' equity but the amount of the actual investment. Par value is then largely a nominal fact ; and the significance which the investor commonly attaches to this fact is unwarranted. Some states now permit the is- suance of capital stock without a par value. This seems an entirely proper practice. Undoubtedly the investor is often misled by par value and formal capitalization. These facts give Httle clue to the amount of the actual investment and the consequent value of the company's property. It would be quite possible to enter capital stock without a nominal value in the accounting records. No difficulty arises in the treatment of partnership proprietary accounts because of the absence of a par value for proprietorship ; and none need arise in the case of capital stock. In fact a number of concerns have recently or- ganized whose stock issues have no stated par values. It is universal practice to enter capital stock in the accounts at par, when a par value is stated. The Capital Stock account, therefore, shows only a certain formal amount. If the stock is sold' either below or above par it is then necessary to make use of the subsidiary accounts, Discount on Stock or Premium on Stock, as the case may be, to show the difference between par and actual investment. The nature and treatment of such accounts will be further discussed in the next chapter. In some cases the stock of a corporation* is underwritten by an investment or brokerage house. This usually amounts to the sale of the stock for the corporation on a commission basis. In such a case the contractual relations represented by such CORPORATE PROPRIETORSHIP — CAPITAL STOCK 283 accounts as Subscriptions and Stock Subscribed may exist directly between the issuing corporation and the underwriters. The opening entries in this event may differ somewhat in form from the case in which the corporation itself sells the stock to the individual investors ; but the final result is the same in either case. There is no particular advantage to be gained from opening accounts with unissued stock and capital stock authorized. This information is contained in such records as the minutes of the directors' meetings ; or it usually may be found in the articles of incorporation and in the stock certificates. It is sufficient for practical purposes if the first entries in the books proper are made when subscriptions are actually received, and cover only the amount of stock actually subscribed. In fact erroneous conclusions are likely to be drawn by the stockholders and others if such accounts as Unissued Stock and Capital Stock Authorized are opened. This may be best shown by first giving illustrative entries involving these accounts. In the case of the organization of the Blank Company (refer- ring to the above illustration), for example, entries might have been made before subscriptions were taken as follows : Unissued Stock (Common) . . . . $100,000 Unissued Stock (Preferred) . . . 75,000 Capital Stock Authorized (Common) . . . Capital Stock Authorized (Preferred) . . . . . $100,000 75,000 It is important to note that such entries represent no asset or equity facts. Unissued stock is not an asset. It represents simply a decision of the incorporators; and it may never be issued. Similarly capital stock authorized is only another ex- pression for unissued stock and is not in any sense an equity. In fact the left-hand accounts involved in the above entries are simply offsets to the right-hand accounts, and vice versa. There- fore no corporate balance sheet could be prepared at this point. There are various ways of making the later entries when the above fictitious accounts are opened. Subscriptions may be charged and Stock Subscribed credited as was shown before. 284 PRINCIPLES OF ACCOUNTING When the subscribers pay their subscriptions and the stock is issued the entries may be as follows : (i) Cash $75,000 Subscriptions (Common) . . . $50,000 Subscriptions (^Preferred) . . . 25,000 and, (2) Stock Subscribed (Common) $50,000 Stock Subscribed (Preferred) 25,000 Unissued Stock (Common) . . . $50,000 Unissued Stock (Preferred) . . . 25,000 The resulting balance sheet (before the balance of the stock is sold) would now appear as follows : Cash $75,000 Capital Stock Authorized $100,000 Unissued Stock (Common) 50,000 (Common) Unissued Stock (Preferred) 50,000 Capital Stock Authorized 7S,ooo (Preferred) $175,000 $175,000 An item of unissued stock may never be sold. Many corpora- tions at the time of organization authorize stock far in excess of the amount ever issued. In case further issues are necessary it is convenient to have such an authorization available so that no change in the formal capitalization (which may necessitate a revision of the corporate charter) is required. Unissued stock, if carried on the balance sheet in such a case, is simply a valua- tion item — a deduction from the authorized capital stock ap- pearing on the other side. Valuation items of this type — which serve no purpose whatever — should not appear in the accounts. They are often confused with the asset items ; and in any case they serve to inflate totals and consequently lead to erroneous general impressions. A great many companies always show stock outstanding on the balance sheet rather than stock authorized ; and this is a commendable practice. If the author- ized stock is shown the balance sheet might well be prepared in the following form : CORPORATE PROPRIETORSHIP — CAPITAL STOCK 285 Sundry Assets .... $500,000 Capital Stock Authorized $600,000 Less Unissued Stock . . 100,000 $500,000 $500,000 $500,000 If shown as a deduction in this way there is less objection to the recognition of unissued stock. DONATED AND TREASURY STOCK Capital Stock may be issued for property other than cash. This type of transaction arises very commonly in connection with reorganizations and mergers, and the taking over of partner- ships. The original promoters and incorporators also often turn over services and other valuable considerations to the corpora- tion in exchange for stock. The owner of a patent right, for example, may be instrumental in organizing a corporation for the purpose of exploiting the patent, and he may receive a large block of stock as a payment for relinquishing his patent privileges to the corporation. Similarly the owner of a mineral tract, or other natural resource, may find it necessary to take an equity in a corporation in exchange for his property in order that the mine or other asset may be properly developed. In some of these cases interesting and complex situations arise. In particular the treatment of "donated" and "treasury" stock raises some questions of importance. A modification of the illustration discussed in the preceding section will serve to suggest the nature of these questions. Mr. Blank, it will be assumed, who is a prominent figure in the organ- ization of the Blank Company, has subscribed for common stock to the amount of $75,000 and preferred stock to the amount of $25,000. He agrees to pay for his stock by turning over to the company a factory which he owns. It is further agreed that he is to donate back to the company common stock to the amount of $50,000 which is to be sold to provide working capital. The securing of working capital is a matter of necessity. A corpo- 286 PRINCIPLES OF ACCOUNTING ration, obviously, cannot operate without having a fund avail- able to invest in working and trading assets. The advantage of donated stock lies in the fact that such stock may be con- veniently sold on the market to provide the necessary current funds. But, it may be asked, why does not the corporation sell the original stock to outsiders in the first place? The purpose of such an arrangement as the above is to make possible the use of the phrase "fully paid and non-assessable" on the stock cer- tificates. A stockholder, as was stated in a preceding section, is usually liable for the par value of his stock. If the amount paid in at the time the stock is originally issued is less than par, any subsequent holder of the stock, no matter at what price he makes his purchase, may be called upon by the corporation at any time to make good the difference. In other words, he may be required to pay an assessment or assessments equal to the difference between the original issuing price and par. Further, in case the corporation becomes insolvent the holder of "partly- paid" shares is usually liable to the creditors for the unpaid balance. Thus non-assessable stocks can be sold more readily to the investing public than the assessable issues. It is considered in the case of donated stock that the stock is first issued at par for property. Any stock donated to the corporation may then be "resold" at the market price to secure working capital. In those states where statutes prohibit the issue of capital stock at less than par stocks are also often issued for property with the understanding that a part of the stock issued is to be returned to the corporation. The purpose of such arrangements, again, is to make the stock fully paid in order to facilitate the raising of additional capital. In most cases the law can be complied with by such a formal transaction as the one mentioned above. At the time Mr. Blank actually turns over his factory to the Blank Company and receives stock in payment the entries would be as follows : Factory fioo,ooo Subscriptions (Common) . . . $7S,ooo Subscriptions (Preferred) . . . 25,000 CORPORATE PROPRIETORSHIP — CAPITAL STOCK 287 and, (2) Stock Subscribed (Common) .... $75,000 Stock Subscribed (Preferred) .... 25,000 Capital Stock (Common) . . . $75,000 Capital Stock (Preferred) . . . 25,000 When Mr. Blank, donates the stock to the corporation the journal entries would be : Donated Stock (Common) $50,000 Reserve for Donated Stock . . $50,000 The account Treasury Stock might be used here instead of Donated Stock. The term treasury stock, however, may well be restricted to stock once issued for value received and actually bought back by the corporation on a cash or an equivalent basis. The exact nature of the accounts involved in the last pair of entries given depends upon the actual value of the factory turned over to the corporation. If Blank is willing to return to the cor- poration stock with a par value of $50,000 it would seem reason- able to conclude that the factory is not worth more than $50,000. If such is the case Donated Stock is a valuation account of the nature of Unissued Stock, and Reserve for Donated Stock is another valuation account — an offset to the value of the fac- tory. A conclusion on such a question should be conditioned by the special circumstances involved in each case. The donated stock is now sold for cash at $75 per share. The entries (in summary form) would be : Cash I37.S00 Discount on Donated Stock 12,500 Donated Stock $50,000 If the factory is worth but $50,000, the balance of Reserve for Donated Stock should be written off against the Factory account. The entries would be as follows : Reserve for Donated Stock $50,000 Factory $50,000 288 PRINCIPLES OF ACCOUNTING A balance sheet of the corporation covering these transactions would now show the following condition : Factory $50,000 Capital Stock (Common) $75,000 Discount on Donated Capital Stock (Preferred) 25,000 Stock .... 12,500 Cash 37.50° $100,000 $100,000 Since the outstanding common stock is worth apparently but $75 per share, or $56,250, the outstanding preferred stock evidently has a value of $87,500 (the total value of the assets) less $56,250, or $31,250 — a value of $125 per share. If it be assumed that the factory is reaUy worth $100,000, and that Mr. Blank is willing to make this arrangement because of his interest in the success of the enterprise, this virtually means that he pays a premium of $50,000 for his stock. This assump- tion would modify the above entries. Instead of using the ac- count Reserve for Donated Stock, it would be proper to use Donated Surplus. The factory would be allowed to remain at $100,000. The balance of Discount on Donated Stock would be closed against Donated Surplus. The resulting balance sheet would be : Factory $100,000 Capital Stock (Common) $75,000 Cash 37,5°° Capital Stock (Preferred) . 25,000 Donated Surplus . . . 37,500 $137.50° $137.500 In such a case the donated stock would, of course, be likely to sell at a higher price. In this connection might be considered the significance of treasury stock which arises from purchases by the corporation of its own stock for cash or an equivalent. Quite commonly accountants consider such stock as an asset of the corporation, making a sharp distinction between unissued and treasury stock. As a matter of fact there is only a superficial distinction between authorized but unissued stock and stock which has been repur- chased by (or donated to) the issuing corporation. Treasury stock is never a bona fide asset. The contrary opinion arises from a too rigid insistence upon the corporate entity. This can CORPORATE PROPRIETORSHIP — CAPITAL STOCK 289 be made clear by a consideration of illustrative journal entries and balance sheets. Suppose the balance sheet of a certain corporation appears as follows : Sundry Assets . . . $200,000 Capital Stock .... $300,000 Cash 100,000 $300,000 $300,000 The directors now decide to retire a portion of the capital stock by buying it on the open market. The reasons for such a decision are various. Conditions may be favorable to a curtailment of the activities of the corporation and" hence the available cash may well be returned to the stockholders. Such transactions also frequently occur when to attain certain purposes the "in- siders" wish to intrench themselves more firmly in the control of the company. Whatever the reason for the transaction, the effect upon the balance sherit is essentially the same in every case. The directors in this case, it will be assumed, buy 750 shares on the open market at par ($100). The journal entries (in summary form) would be : Treasury Stock $75,000 Cash $75,000 The resulting balance sheet would appear as follows : Sundry Assets . . $200,000 Capital Stock .... $300,000 Cash 25,000 Treasury Stock . . . 7S,ooo $300,000 $300,000 Should this transaction be viewed as an exchange of assets or as a retirement of capital with an equal reduction in equities? The latter view would certainly seem to be the correct one from the accounting standpoint. A corporation cannot maintain its assets by buying its own stock from its own members. Treasury stock cancelled or not is essentially the same as unissued stock, — a deduction from the apparent outstanding capital stock. (Treasury stock can, of course, be issued below par labelled fully paid and non-assessable.) It is no more an asset than bank notes in the hands of the issuing bank. Indeed in the above entries V 290 PRINCIPLES OF ACCOUNTING the charge might well have been made to Capital Stock instead of to Treasury Stock, in which case treasury stock would not appear on the balance sheet at all and outstanding capital stock would appear at $225,000, the correct figure. If it is desired to reissue the stock later on the same or another basis this can be conveniently done without recognizing treasury stock in the accounts. , In any case it will be necessary to cancel the old cer- tificates and issue new. It may be that stock once issued can be resold to greater advantage than stock authorized but not previously issued. This fact, however, would not at all justify the recognition of treasury stock as an asset. If treasury stock appears on the balance sheet it should be viewed as unissued stock, and might well be listed as a deduction from capital stock in the manner illustrated in the preceding section. The recognition of treasury stock as an asset is a fiction similar to certain partnership transactions discussed in the preceding chapter. The accountant must at certain points brush aside the fiction of the business enterprise in order to get at the realities of the case. Obviously if a corporation purchased all of its capital stock, and paid a price based upon the actual value of the assets, the equity of the stockholders would be completely retired. (Such a situation would, of course, usually be impossible or il- legal.) SUBSIDIARY PROPRIETARY RECORDS Thus far in discussing the transactions affecting corporate proprietary accounts only the general ledger accounts have been shown. There has been no description of the records which take care of the relations between the individual subscribers and stock- holders, and the corporation. Where proprietorship is vested in a numerous and shifting personnel, however, it is evident that the keeping of records which show the status of each individual owner is an important and complex task. The usual subsidiary proprietary books and transactions involved in the case of the corporation will be briefly discussed in this section. When a corporation is organized a subscription ledger is opened in which are recorded the details in connection with each sub- scription. The general ledger account "Subscriptions" controls this subsidiary ledger. (If the corporation is small, and the in- CORPORATE PROPRIETORSHIP — CAPITAL STOCK 291 dividual subscribers few in number, each subscriber's account might be carried in the general ledger and the subscription ledger dispensed with.) When Subscriptions is charged each subscriber's account involved in the subscription ledger is also debited with the proper amount. When subscriptions are paid the controlHng account is credited and the proper individual accounts as well. The balance of the controlUng account at any time shows the amount still due the corporation on all its sub- scription contracts, and the individual subscribers' accounts show how this amount is divided among the various subscribers. In some cases where the subscriptions are to be paid in installments a separate installment hook is used and the controlling account. Subscriptions, is divided into several accounts corresponding to the number of installments. A subscription is a legal claim of the nature of a promissory note, and if the subscriber fails to meet the regular calls for pay- ment he may be sued by the corporation. If payment is de- faulted and the amount is found to be uncollectible it is neces- sary to reverse the original entries by debiting Stock Subscribed and crediting Subscriptions for the amount involved. The de- faulting subscriber's account should also be credited. In some cases the subscription contract contains a provision to the effect that any sums paid on the subscription will be forfeited to the corporation provided the subscriber fails to meet his obHgations. The amount realized in such a case is a kind of gain and may be credited to Capital Surplus. (See Chapter XIII.) There may be statutes, however, which invalidate such contracts, and re- quire the reimbursement of the subscriber for the amount he has invested. The stock ledger is a subsidiary book containing an account with each stockholder which shows the par value of the stock owned by him and other details. The stockholder's individual account is credited with the par value of stock purchased by or issued to him, and is debited with the par value of any stock which is ordered transferred to other parties. Capital Stock (outstanding) is the controlling account for this ledger. When Capital Stock is credited the special stockholders' accounts are also credited with the proper amounts. The balance of each individual account shows the par value of the stock then owned 2g2 PRINCIPLES OF ACCOUNTING by the stockholder; and the total of all balances in the stock ledger should agree with the balance of the Capital Stock account appearing in the general ledger. In form the individual stockholder's account appears somewhat as follows : J. B. Hawley, Birmingham, Michigan Date Cert. No. No. Shares Names and Other Details Dr. Cr. 1918 Aug. 3 127 100 Subscribed and Paid S.J. 8 2,500 IS 47 10 Transferred from A. R. Watson S.J. 13 250 30 19s 40 Transferred to W. S. Bailey Balance Balance (New S. J. 20 1,000 1,75° 2,75° 2>7So Sept. I 214 70 Certificate) 1,750 Shares of stock, like other kinds of personal property, may be disposed of without restriction, at the pleasure of the lawful owner. "Active" stocks are bought and sold freely on the stock exchanges and the keeping of the record of the individual stock- holders is a task of some magnitude. In many cases large cor- porations whose stocks are frequently dealt in on the market employ a transfer agent to make all transfers and keep the sub- sidiary books. For dividend and other purposes the current list of stockholders is then secured from the books kept by the transfer company. Since the total of outstanding stock is not affected by transfers from one person to another, the controlling account. Capital Stock, is an inactive account, showing few changes through a period of years. In some cases stocks are assigned from person to person and the transfers are not registered on the books of the company. The records of the corporation, in other words, may not show an up to date list of the actual stockholders. The corporation, however, recognizes as voting shareholders the list from its own records, and makes up its dividend schedules from the roll of stockholders as it appears in its stock ledger. CORPORATE PROPRIETORSHIP — CAPITAL STOCK 293 The stock certificate book contains blank stock certificates and stubs. When a certificate is issued the data written in the stock certificate is also entered on the stub. Postings to the stock ledger may be made from these stubs, but where the transfers are numerous it is desirable to make use of a special stock journal. Cancelled certificates are sometimes attached to the appropriate stubs and kept as a permanent record. There are many other cases of corporate proprietary trans- actions than those discussed in this chapter. The conversion of securities from one type to another and the retirement of serial stocks have already been referred to. Increases and decreases of capital stock in connection with mergers, business expansion, dissolution, etc., are of common occurrence under modern finan- cial conditions. Such transactions are often very complex but no important general pecuHarities in accounting for capital stock not already discussed arise in such cases. The corporate surplus and related accounts will be discussed in the next chapter. XIII Corporate Proprietorship — Surplus Accounts It has been stated that proprietorship in the case of the cor- poration is represented by the capital stock and surplus or deficit accounts. In the broadest sense, therefore, surplus represents the excess of actual proprietorship in a given case over the par value of the capital stock outstanding, and deficit — or negative surplus — represents the amount by which the par of the capital stock exceeds proprietorship. In accounting practice, however, surplus so defined may appear under a number of special heads. The accounts representing surplus and deficit form an important ^roup of corporate accounts ; and the numerous transactions affecting these accounts often involve difficult questions of an- alysis. Probably no other accounting concept is so commonly misunderstood as that of the surplus, and consequently the sur- plus accounts are very frequently misinterpreted. This makes the study of these accounts a matter of considerable importance. In this chapter the t5^ical surplus accounts will be discussed and the important types of transactions affecting these accounts will be illustrated. A sharp distinction will be drawn at the outset between the two main types of surplus (and deficit) : (i) that which originates at the time of organization and in con- nection with any subsequent sale of securities ; and (2) accumu- lated profit or loss resulting from business operation and the accidents of the industrial situation. CAPITAL surplus AND DEFICIT Very frequently when a corporation is organized the par value of the stocks issued exceeds the value of all the property acquired. This simply means that securities such as stocks are usually sold for the first time at a discount. It is common practice to write 294 CORPORATE PROPRIETORSHIP — SURPLUS ACCOUNTS 295 up the property to the point at which securities are apparently vaUdated. This is sometimes done by using "real estate, patents, machinery, etc. " — or some similar caption — on the balance sheet. This practice is decidedly illegitimate. If goodwill or other intangibles are involved in any case it is proper to put these items on the books, but they should be isolated in the balance sheet and should be listed at the actual amounts carried in the appropriate accounts. The use of general balance sheet captions, and the indiscriminate writing up of property to make an apparent vaKdation of securities issued, should be avoided. The item discount on stock should appear frankly on the balance sheet as an offset to stocks entered at par but issued at a discount. Both Discount on Stock and Deficit are offset or valuation proprietorship accounts. It is desirable, however, to distinguish between the two, and to restrict the use of Discount on Stock to cases where the par value of the stock at the time of issue exceeds the value of the assets acquired by the corporation in exchange. The Deficit account may then be used to indicate an offset to original proprietorship caused by losses in business operation. A capital surplus at the time of organization is of comparatively rare occurrence in the case of American corporations. One pos- sibility, the donated surplus, has already been discussed, but the most important case of capital surplus arises in connection with the sale of stocks at a premium. The excess of the issuing or selling price over the par value of the stock is premium. The sale of stocks at a premium is quite common in those states which prohibit the issuance of stocks at a discount by statute. In many such cases, however, where the stock is issued for property other than cash, the premium is only nominal due to the fact that inflated valuations are set upon the properties involved. An- other important illustration of stock premium occurs in connec- tion with the organization of banking corporations. Because of the actual and traditional advantages of investments in such companies their stocks are often issued at a price considerably above par. Since stocks are always entered in the capital stock accounts at par it is necessary to open a special account in which to record the amount of the premium in any case. Suppose, for example, 296 PRINCIPLES OF ACCOUNTING that a trust company issues stock with a par value of $ioo,ooc at $115 per share. The journal entries (summarized) would be somewhat as follows: Cash $115,000 Capital Stock $100,000 Capital Surplus iS,ooo Such a surplus account should have some distinctive title such as the one used here. In railroad accounting the Interstate Commerce Commission prescribes the use of the accounts Pre- mium on Stock and Discount on Stock, for the recording of capital surplus and deficit respectively. This is a commendable prac- tice. One source of confusion in accounting is the loose and non-standardized nomenclature. The names of accounts should give at least some clue to what they contain even if it is neces- sary to use rather long titles. The later treatment of stock discounts and premiums in the accounts is a matter of considerable importance. It is usually conceded to be good practice to charge the amount of stock dis- count in any case against annual or accumulated profits. In fact some accountants urge that proprietary discounts be written off as rapidly as possible, so that such valuation items may be removed from the balance sheet. There is some question as to the propriety of such a procedure, however, for if capital stock has been issued at a discount the original investment is less than the par of the stock and the two accounts, Capital Stock and Discount on Stock, taken together, show the amount of original proprietorship. The Discount on Stock account is therefore really a section of the Capital Stock account. It would seem desirable to use one group of proprietary accounts (the capital stock accounts) to show investments, and another group (the accumulated surplus accounts) to reflect the amount of income retained in the business. If, however, discount on stock is ex- tinguished by charges against net revenue or surplus the amount of the original investment is obscured, and the amount of accumu- lated income as well. It is perfectly proper to allow surplus to accumulate, but it is advantageous to have the amount of such accumulation segregated in the accounts. In other words, since stock discount and surplus are not exact opposites, it would be a CORPORATE PROPRIETORSHIP — SURPLUS ACCOUNTS 297 rational procedure to maintain Discount on Stock indefinitely on the books even though a Surplus account also appears. The amount of accumulated corporate surplus is an important fact in connection with the relations of the pubHc to the enterprise, as well as in connection with the relations between different classes of equities within the enterprise. Any practice, therefore, which tends to disturb the integrity of the accumulated surplus figure, is questionable. Similarly (as is generally admitted). Premium on Stock may well be considered as a permanent account — a section of the Capital Stock account. The two accounts, taken together, show again the amount of original investment. If the amount of the premium in any case is credited to a regular surplus or net rev- enue account either at the time of organization or later, both surplus and investment figures are obscured. Further, since dividends are often appropriated from surplus, the amount of stock premium, if added to general surplus, might appear to be available for dividend purposes. If dividends are declared from a stock premium, this simply meins that a portion of the stock- holders' original capital investment is being returned. While such a practice might not be considered illegal, it would usually be an unwise poHcy; and in any case the nature of the trans- action should be clearly recognized. Premium on Stock, then, should remain in the ledger as a permanent account, until such time as a part or all of the capital stock is retired. ACCUMULATED PROFIT AND LOSS As was emphasized above it is desirable to restrict the terms surplus and deficit to their most common usage, namely, accumu- lated profit and loss. If a " surplus " account is used to represent any other fact, qualifying terms should be added to the account title so that there can be no doubt as to the meaning intended. Surplus, then, is the resultant of net proprietary income balances which have not been distributed as dividends. An illustration will serve to make the origin of surplus in the accounts entirely clear. Suppose that the Net Revenue account of a certain cor- poration shows a net revenue figure of $40,000 available for partition among the various equities. The interest accrued on 298 PRINCIPLES OF ACCOUNTING outstanding bonds, it will be assumed, amounts to $10,000. The directors order a dividend posted of $15,000, and allow the balance of Net Revenue to be carried to Surplus. The entries giving effect to this situation would be as follows : (i) Net Revenue $10,000 Interest Payable |io,ooo (2) Net Revenue $15,000 Dividends Payable $15,000 (3) Net Revenue $15,000 Surplus $15,000 Thus it is evident that the final incidence of all undistributed net proprietary income is in the Surplus account. Accumulated surplus, in other words, is the sum of the annual surpluses. Ac- cumulated deficit, on the other hand, represents the sum of all the annual deficits (offset, of course, by any surpluses). A pro- prietary deficit may arise if expenses exceed revenues, if net revenue is insufficient to meet interest and tax obligations, or if dividends are paid in excess of net proprietary income. A deficit in the last case simply represents the deduction from orig- inal proprietorship due to the return of capital to the stockholders and on the balance sheet has a significance somewhat similar to stock discount. In practice an intermediate surplus account, Undivided Profits, is sometimes used. Such an account receives any income bal- ances which are not to be withdrawn at the end of the current fiscal period, but which may become the basis of dividends in later years. Such an account can be used as a convenient buffer to stabilize the dividend rate without necessitating an encroach- ment upon capital. A stable dividend rate is a great convenience to the stockholders who are depending upon their dividends to meet current personal obligations. A fixed rate also is of ad- vantage in that it tends to promote the credit and general finan- cial standing of the corporation. Since, however, net revenue will fluctuate year by year according to the exigencies of the CORPORATE PROPRIETORSHIP — SURPLUS ACCOUNTS 299 business situation, net revenue balances cannot be followed in declaring dividends if a constant rate is to be established. Ac- cordingly in lean years the Undivided Profits account may be drawn upon, and in boom years the balance of Net Revenue after dividends are declared may be transferred to Undivided Profits. It is a mistake to suppose that a stable dividend rate depends upon a constant net revenue figure. When an Undivided Profits account is used the Surplus account may be restricted to those items of net proprietary income which have been specifically recognized as a part of the permanent pro- prietorship. In the case of rapidly expanding enterprises it may be necessary to use the earnings to buy new equipment, and such a process, of course, builds up a surplus. The distinc- tion between Undivided Profits and Surplus is not, however, a matter of very great importance. These account titles may be used interchangeably without confusion ; and as a rule it is not necessary to make use of two such accounts in a single enterprise. A surplus account might be used in the case of a single-pro- prietorship or partnership as well as in the case of a corporation. In fact the individual proprietor's personal or drawing account serves much the same purpose as the Undivided Profits account. Since there is no par value for proprietorship in these cases, however, it is customary to transfer income balances directly to the main proprietary accounts. Yet this process obscures original investment and accumulated income figures, and hence accounts analogous to Surplus might well be used in all enter- prises. Surplus is accumulated for various purposes, some of which have already been suggested. In general it seems to be desirable for a corporation to adopt a conservative policy in regard to dividend distributions, and to build up a buffer account which will serve to absorb, in a measure, the shock of financial strin- gency or other business hardship or disaster. The individual stockholder would often prefer to have larger dividends paid ; but the accumulation of surplus, within reasonable limits, is usually regarded as a sound financial policy. Unless the business in any case may be conveniently expanded, however, it may be unwise to withhold any large amount of profit from the stock- holders, for this would require the investment of the current 300 PRINCIPLES OF ACCOUNTING assets which are concurrently accumulating in property such as securities and similar assets. This would mean a change in the character of the stockholders' investment, and hence might not be in accord with the best interests of the shareholders. It needs to be emphasized that the surplus accounts are equity accounts. The term surplus is often used in business practice in the sense of cash and other Uquid funds available. In ac- counting, however Surplus (or any of its subdivisions) is a pro- prietary equity account, representing as already explained the excess of present proprietorship over formal capitalization (less any organization discounts if used as advised above), and not representing any specific assets. Surplus, as is the case with any equity item, is balanced by assets on the opposite side of the balance sheet; but no specific asset can be tied definitely to this or any other equity. The only inevitable relation between assets and equities is the equality of totals. Surplus, then, may be considered as offset among the assets by equipment, cash, accounts receivable, materials or any other it6m. Turning now from the discussion of the origin and general nature of surplus, it will be necessary to consider the principal subdivisions of surplus and the process of setting up these ac- counts. A large number of the resolutions of the board of direc- tors affect the surplus accounts. The process of subdividing surplus is sometimes spoken of as the making of "appropriations " from surplus. In itself it is a purely formal process and can go on indefinitely without affecting the property accounts. Making appropriations from surplus simply means the putting of different labels on portions of surplus ; and this process should never be confused with the setting up of assets in special funds. These appropriations may express the financial policies and intentions of the directors, however, and in this way indirectly affect the asset accounts. In the following sections typical examples of surplus appropriations will be considered. DIVIDEND APPROPRIATIONS Dividends are frequently appropriated from the Surplus account. A dividend in ordinary usage is a distribution to the stockholder of net proprietary income. As already explained, CORPORATE PROPRIETORSHIP — SURPLUS ACCOUNTS 301 however, the term "dividend" is sometimes applied to distribu- tions which contain an element at least of original capital. This is particularly true in the case of wasting asset enterprises such as mining companies.^ But as a rule dividends are appropriated and paid from current or accumulated profits; and except in special circumstances it is a general principle of corporation law that dividends must not be paid out of capital. As stated above, dividends are usually assumed to be profits ; and were disburse- ments of capital made under this guise allowed to rank as profits the stockholders in general and other parties interested would be misled, and certain classes of stockholders and creditors might be defrauded. The most common type of dividend appropriation (or declara- tion) is the cash dividend. Such a dividend may be appropriated from the Net Revenue (or Profit and Loss Allocation) account, from an account called Undivided Profits as explained in the preceding section, or from any general surplus account. If a corporation has adopted a stable dividend policy it is a convenient accounting procedure to transfer all proprietary net income from Net Revenue to Surplus, and to make all dividend appro- priations from the latter account. To illustrate this procedure it will be assumed that a certain corporation has a proprietary income after interest charges are met of $50,000. The entries transferring this balance to Surplus would be : Net Revenue $50,000 Surplus $50,000 The entries covering the declaration of a dividend of $25,000 would now be as follows : Surplus $25,000 Dividend Payable . . ... $25,000 These last entries involve a withdrawal of $25,000 from Sur- plus, and the setting up of the same amount in a special account. In a sense the Dividend Payable account represents a part of the general surplus, labeled for a particular purpose. It is true • It is noticeable that several such companies have recently adopted the policy of apportioning disbursements to the stockholders between actual dividends and capital return. 302 PRINCIPLES OF ACCOUNTING that a declared dividend must be paid like any debt, and that a stockholder can sue the corporation for the amount of any un- paid dividends once posted, yet it seems a misnomer to call such an item a Kabihty in the accounting sense. It represents an equity of the proprietors and hence is clearly a part of total proprietorship. Until the dividend is paid there is no change in total assets or in total equities. In the analysis of the balance sheet how should a dividend declaration be viewed ? Is it not simply a special part of the corporate surplus? At any rate a dividend payable is a part of the stockholders' equity, and since the stockholders are usually considered as representing the corporate proprietors there is some reason at least for this view. At the time the above dividend is paid the following entries would be made : Dividends Payable $25,000 Cash $25,000 These entries represent the actual payment of cash and an equal deduction from the stockholders' equity. The preceding entries represent simply transpositions of equity items. In some cases a small balance may appear in the Dividends Payable account for a long period. It is not always possible to locate all the stockholders in the case of a corporation with a large and widely scattered membership. A small part of a divi- dend declaration may, therefore, remain unpaid for years, but after such items have legally lapsed the unpaid balance of the Dividends Payable account may be transferred again to the Sur- plus account. Various names are applied to dividend accounts. Dividends Payable, Dividends Declared, and Dividends Posted are common examples. It is usually advisable to number each dividend declaration, and the account may be labeled correspondingly, as, for example, Dividend #1. When a dividend is declared a schedule of stockholders' names must be prepared, and the amount of dividend due each stock- holder must be computed and entered on this schedule. Such a schedule virtually amounts to an accounts payable ledger. Each individual account may be closed when a check for the proper CORPORATE PROPRIETORSHIP — SURPLUS ACCOUNTS 303 amount is mailed to the shareholder. All matters of procedure involved in the payment of dividends are, of course, the same whether the dividend be appropriated from current or accumu- lated income. An appropriation and distribution of proprietary income to the members of a partnership may also be called a dividend. Because of the nature of the partnership as previously explained, however, a distribution of income to the partners is not as formal or important a transaction as a dividend appropriation and pay- ment in the case of a corporation. In common usage the ex- pression "dividend" usually has reference to the declarations of corporations. Surplus may be appropriated as "stock" dividends. If there is an accumulated surplus a dividend may be declared even if there is insufficient cash available to pay the dividend. If income has been invested in equipment and merchandise this does not affect the showing of net revenue or the amount of accumulated surplus. The actual payment of a dividend, how- ever, requires cash or an equivalent. Sometimes cash is bor- rowed for dividend purposes although the corporate treasury is temporarily empty. An alternative procedure in such a case is the issuance of either "scrip"" or stock dividends. A scrip dividend may be used when it is expected that cash will be avail- able shortly with which to redeem the corporation's formal promises to pay which have been issued to the stockholders. A stock dividend may be declared if it be decided to retain the available assets indefinitely. A great deal of confusion exists in popular discussions of stock dividends. A stock dividend in a sense is no dividend at all. The payment of such a dividend involves no withdrawal of cash or other assets. It is purely a formal process as far as the balance sheet totals are concerned. The directors decide to issue stock certificates covering a part or all of the accumulated surplus. This is simply a formal recognition of their intention to allow this surplus to remain permanently as investment. Once represented by stock certificates it is no longer available for other appro- priations. A stock dividend is really simply a portion of the surplus, renamed. This is clearly shown by an examination of the journal entries. Suppose a corporation, with an unappro- 304 PRINCIPLES OF ACCOUNTING priated surplus of $75,000, decides to issue a stock dividend of $50,000. The entries would be : Surplus $50,000 Capital Stock $50,000 These entries transfer a credit balance of $50,000 from the Sur- plus to the Capital Stock account. (It would also be necessary to credit the individual stockholders' accounts at this time with the distribution of the new stock, pro rata.) The actual ad- justment is usually made by calling in the old stock certificates and issuing new ones for a proportionally greater number of shares in each case. The action of the stock market when a stock dividend is dis- tributed (a "melon-cutting") is somewhat irrational. Usually the market price of the total of the stockholders' equity advances after such a distribution. There seems to be Httle real founda- tion for this situation. Total proprietorship is neither increased nor decreased by the payment of a stock dividend. This may be made clear by an examination of the balance sheets of a hy- pothetical company before and after the distribution of such a dividend. The balance' sheet of ^the A Company (in summary form) appears as follows : Sundry Assets .... $500,000 Capital Stock .... $300,000 Surplus 100,000 Liabilities 100,000 $500,000 $500,000 The amount of proprietorship as- shown by this statement is evi- dently the sum of the capital stock and surplus items or $400,000. A stock dividend of $100,000 is now declared and distributed. The balance sheet after the consummation of this transaction would appear as follows : Sundry Assets . . . $500,000 Capital Stock .... $400,000 Liabilities 100,000 $500,000 $500,000 In this statement proprietorship still stands at $400,000, the balance of the Capital Stock account. The Capital Stock and CORPORATE PROPRIETORSHIP — SURPLUS ACCOUNTS 305 Surplus accounts have been combined. Since the assets are unchanged and total proprietorship is the same as before there seems to be no vaHd reason for an advance in the market value of the total capital stock. If this stock has a par of $100 one would naturally expect the price of the stock before the new issue was made to be about $133 per share, and after the stock divi- dend is issued about $100 per share. This assumes, of course, that the balance sheet given shows the actual value of the assets. It is, however, a familiar fact that security prices do not always closely conform to what one would expect in view of the informa- tion shown by the accounts. The issue of a stock dividend, evidently, obscures the amount of accumulated surplus and the amount of original investment. This statement suggests a common reason for such dividends. Corporations which are making huge profits, and which wish to pay but an ordinary rate of dividends on formal capitalization wUl often gradually transfer their accumulated earnings from the Surplus to the Capital Stock account. It is then possible to declare much larger aggregate cash dividends at the same normal rate on formal capital. In connection with public utilities this practice may also be made the basis of an argument for the main- tenance of rates. A corporation, it is urged, should be allowed a fair rate on its outstanding securities. Evidently such an ac- counting practice gives the corporation an opportunity to beg the real question as to what rate per cent is being earned, or should be allowed, on actual investment. Corporate surplus is a red flag to certain rather noisy elements in public opinion. Undoubtedly this has something to do With the practice of issuing stock dividends in certain lines of industry. These dividends " cover up "• surplus. This is hardly a sufficient basis, however, for a general condemnation of the practice in the case of the ordinary competitive enterprise. SINKING FUND APPROPRIATIONS An important illustration of a type of surplus account arises in connection with the setting up of sinking funds for special purposes. A sinking fund is simply a special fund of assets (usually liquid) which is created in anticipation of some event 3o6 PRINCIPLES OF ACCOUNTING such as the replacement of an important unit of the plant or the maturity of a large obligation or equity. Suppose, for example, that the bond contract in the case of a corporation having out- standing $1,000,000 of twenty-year bonds requires that each year until the bonds mature liquid assets to the amount of $50,000 must be set aside in the hands of a trustee. (The directors might, of course, decide to adopt the sinking fund method of their own volition. This illustration ignores interest. Sinking fund calculations and entries will be fully explained in Chapter XVIII.) The entries recognizing this requirement each year would be : Sinking Fund Assets $50,000 Cash fSOjOoo r These entries involve simply a transposition of assets and do not affect any of the equity accounts. But suppose, further, that the bond contract requires an appropriation of $50,000 each year from net income or surplus under the title of "sinking fund reserve." (Various terms- such as "reserve for sinking fund," "sinking fund" or "sinking fund surplus," may be ap- plied to this appropriation.). The reason for such a requirement is that the bondholder is better protected if profits are being re- tained in the business. The entries setting up such a surplus should be carefully considered. The appropriation might be made directly from Net Revenue. In this case the entries would be: - ' Net Revenue $50,000 Sinking Fund Reserve $50,000 The balance of Net Revenue ($75,000, it may be assumed) might first be carried to Surplus, and the appropriation made from the latter account. The entries in this case would be as follows : (i) Net Revenue $75,000 Surplus $75,000 and, (2) ^Surplus $50,000 Sinking Fund Reserve $50,000 CORPORATE PROPRIETORSHIP — SURPLUS ACCOUNTS 307 These appropriations from annual or accumulated surplus as a matter of accounting are entirely independent of the property accounts. Yet there is very common confusion on this point. Special funds, it is true, are often set up concurrently with sur- plus appropriations as was shown in the above illustration. But the point should be emphasized' that there is no necessary connec- tion between the appropriating of income or surplus and the setting up of special funds. Either transaction may occur without the other (subject, of course, to contractual provisions), and if both transactions arise simultaneously there is no inevitable coincidence between the amounts appearing in the special asset and equity accounts. From the standpoint of protection to the bondholder the appropriating of surplus as a special sinking fund reserve is probably more important than the setting up of special funds. If surplus is specifically appropriated, or labeled, so that it cannot become the basis for cash dividend declarations, this means that the stockholders' equity is being increased with a corresponding accumulation of assets. It is this process which insures the widening of the margin that protects the bondholders' equity. Sinking. Fund Reserve is not affected by the repayment of the bonds. This can be clearly shown by an examination of the balance sheets. It will be assumed that the balance sheet of the corporation mentioned above at the date the bonds were issued is as follows : Property $2,000,000 Capital Stock . . . $1,000,000 Bonds 1,000,000 $2,000,000 $2,000,000 At the date the bonds mature the balance sheet stands as fol- lows: Property ..... $3,000,000 Capital Stock . . $1,000,000 Bonds 1,000,000 Sinking Fund Reserve 1,000,000 $3,000,000 $3,000,000 The following entries would be made when the bonds are paid : Bonds , $1,000,000 Cash $1,000,000 3o8 PRINCIPLES OF ACCOUNTING Sinking Fund Reserve can now be transferred to surplus, thus : Sinking Fund Reserve $1,000,000 Surplus $1,000,000 The resulting balance sheet would show the following condition : Property $2,000,000 Capital Stock .... $1,000,000 Surplus 1,000,000 $2,000,000 $2,000,000 The final result shows simply that |i, 000,000 in profits has been retained in the business during twenty years. In other words the stockholders have accumulated surplus sufficient to buy out the bondholders. (This illustration assumes that cash is avail- able at the proper time with which to retire the bonds. In the case of an expanding business the bonds would probably be paid by refunding.) Inexact terminology is in part responsible for the tendency to confuse property transactions and the formal process of sub- dividing surplus. The term "sinking fund" is fraquently found in practice on both sides of the balance sheet. On the left-hand side it represents special assets, on the opposite side it represents a part of general surplus. Sinking Fund Assets is the proper name for the property account, and Sinking Fund Reserve for the proprietary equity account. MISCELLANEOUS SURPLUS TRANSACTIONS AND APPROPRIATIONS A peculiar case of surplus arises when contingencies which have been anticipated do not materialize. A shipping company, for example, decides to carry its own fire insurance by charging against revenue each year the amount ($10,000) which expe- rience has shown to be the average annual fire loss in this type of business, and crediting this amount to an account entitled Reserve for Fire Insurance, thus : Expense and Revenue $10,000 Reserve for Fire Insurance . . . $10,000 CORPORATE PROPRIETORSHIP — SURPLUS ACCOUNTS 309 If safety devices and more efl&cient management by the end of the first year cut down the fire loss to one-half of the previous estimate a part of this valuation reserve may become a real sur- plus ; and in such a case it could properly be transferred to the general surplus account, thus : Reserve for Fire Insurance $S,ooo Surplus $S,ooo In certain cases, a management, desiring to present an ultra- conservative showing, will transfer a portion of surplus to an account called "Reserve for Contingencies," or some similar name, to cover possible but unlikely losses. If the loss is very unlikely there is Uttle to be said in favor of the creation of such reserves. Such a reserve is part of the general surplus and should be so considered in computing total proprietorship. For, obviously, the proprietor's entire equity is subject to loss under unusual conditions. Such a reserve might be specifically labeled to indicate the nature of the contingency, as, for example, "Re- serve for Flood Loss," or "Reserve for Contingent Deprecia- tion." Contingent reserves do not, of course, remove risks or lessen the burden of unusual losses to the stockholders. The use of such accounts, however, serves to suggest to those inter- ested the nature of possible risks inherent in the business, and it reveals the conservative policies of the management. These illustrations serve to suggest the relation between valua- tion and surplus reserves. As was explained in another con- nection, asset valuation accounts are often called "reserves" in practice. This is a confusing practice and, as was suggested, the term "allowance" might well be substituted for reserve in the valuation account. The two types of reserve are seldom carefully distinguished on the corporate balasnce sheet, and since the accountant has to deal with this situation it is important that the relation between these different groups of accounts be clearly understood. In general- the distinction between a surplus and a valuation reserve is clear. Valuation reserves are supposed to measure the expiration of certain assets which are left on the books for various reasons at original figures. The concurrent charge when such an account is credited is to some expense account. Suppose, 3IO PRINCIPLES OF ACCOUNTING for example, that in a certain case the estimated depreciation of a company's buildings is $10,000. The entries recognizing this accrual would be as follows : Depreciation Expense $10,000 Reserve for Depreciation .... $10,000 The charge in this case represents an expense, a deduction from gross revenue which must be made before net revenue can be correctly stated. Suppose now that the management of this company further decides to appropriate a part of the surplus ($10,000) as a reserve for contingent losses which are possible but are so unhkely that it is not possible to make adequate pro- vision for them by means of insurance as in the case of ordinary risks. The entries recognizing such an appropriation would be : Surplus (or Net Revenue) $10,000 Reserve for Contingencies . . . $ro,ooo The Reserve for Depreciation account shows an offset to over- stated assets while the Reserve for Contingencies account repre- sents a part of the proprietor's equity, labeled in a particular way. , Where a contingent reserve simply covers the average accrual of an expiration which is capable of reasonably accurate estima- tion it becomes an "accrued" reserve, or valuation item. So- called contingent reserves are often of this tj^e. The Reserve for Fire Insurance mentioned above is an illustration of such an account. In all such cases the conditions leading to such a re- serve must be carefully investigated in determining its real character. If depreciation charges have been excessive, then a part of the depreciation reserve is really a surplus item and may be trans- ferred to the Surplus account. If the depreciation charges have been insufl&cient to cover actual property expirp,tions, then a por- tion of surplus as stated (if there is any surplus) is a valuation item. Surplus may be charged and Reserve for Depreciation credited for the amount. Due to the dif&culty of estimating depreciation exactly there is always likely to be some small overlapping between valu^tioii and actual reserves. This does CORPORATE PROPRIETORSHIP — SURPLUS ACCOUNTS 311 not mean, however, that these types of accounts should not be very carefully distinguished. The term reserve is also sometimes applied to accrued liability items. The Reserve for Taxes mentioned in a preceding chapter illustrates an account with such an item. Such a reserve, evi- dently, is not a part of proprietorship, but is an actual HabiUty. Since a contingency, properly defined, is an unlikely or accidental, but possible occurrence, however, a reserve which covers a contingent Hability is an item of proprietorship until the con- tingency materializes. The nature of a "secret" reserve was suggested in Chapter X. Such a reserve is an item of proprietorship which exists but which is not booked. Secret reserves may be built up by charg- ing improvements to expense, by excessive depreciation charges, by unreasonable allowances for bad accounts, by ignoring ap- preciation, by omitting certain assets entirely, or by overstating liabiHties. As already explained such practices are not legitimate if the real situation is known. While conservatism in accounting is to be commended, the actual understatement of proprietor- ship is illegitimate. The insiders may know the facts, but the other interests in the enterprise who also have a right to the facts are not informed as to the actual state of affairs. All known surplus should appear on the books. Certainly it is one purpose of corporation accounting to follow and present the actual status of the stockholders' equity. There are many other cases of surplus accounts and surplus transactions. In railroad accounting a common illustration of an account representing a special surplus appropriation is Re- serve for Additions and Betterments. The journal entries setting up an appropriation of $50,000 in such an account are as follows : Surplus $50,000 Reserve for Additions and Betterments f 50,000 Such an appropriation is simply a formal recognition of the fact that income has been retained in the business for a particular purpose. The special surplus account involved is sometimes called "Reserve for Improvements." Surplus also arises where appreciation is recognized, as was 312 PRINCIPLES OF ACCOUNTING explained in a preceding chapter. Gifts present still another case. If a gift of real estate, for example, is made to the cor- poration either at the time of organization or later, the concur- rent credit when Real Estate is charged should be made to a special surplus account. A Donated Surplus account might well be used in this case. Such a surplus should be distinguished from accumulated income. Surplus'may be increased if the cor- poration buys a portion of its own stock at less than book value. Surplus is correspondingly diminished if such stock is bought at a price above book value. No attention has been given thus far to special accounts in- volved under the general head of accumulated loss or negative surplus. The possibilities here are far less numerous. The Deficit account should be used to show such a deduction from proprietorship. Sometimes a deficit which the company is un- willing to recognize as such is set up as a deferred expense as explained in Chapter X. Such an account may appear on a balance sheet even if the company involved is having fair success. Usually, however, if surplus is available any large loss should be charged against surplus rather than being set up under a special head. Sometimes the available surplus is largely appropriated in special accounts, and the directors, not wishing to reverse an established accounting policy, will allow a deficit to appear con- currently with such special surplus accounts. The propriety of any considerable extension of such a procedure is doubtful. Many further illustrations might be given of particular sur- plus accounts. The cases described, however, are among the most important. Some of the situations mentioned will be dealt with further in later chapters. In Part Five particular atten- tion will be given to the interpretation of such special proprietary accounts in the corporate balance sheet. It should be em- phasized, in conclusion, that an important part of the accounting entries in the case of the corporation are of the formal type, con- cerned with changes in. the current proprietary accounts which are made for the most part Upon authorizations by the board of directors. XIV The Liabilities The distinction between proprietorship and liabilities has already been emphasized in some detail in preceding chapters. In general the proprietors carry the greater burden of risk, are vested with the larger element of control or management, and (as is implied in the risk burden assumed) have residual rights to assets as either income or principal. The "creditors" (whose equities constitute the Habilities) assume less risk and have less direct control, and have prior or contractual rights to assets as income or principal. Several chapters have now been devoted to a consideration of proprietorship and the proprietary accounts. In the present chapter — to complete the discussion of the equi- ties — the important types of liabilities will be described, and the nature of some of the accounting problems that arise in connec- tion with such items will be suggested. The more important and difficult questions that concern the treatment of the liabilities in the accounts have to do with the problem of interest calcu- lation and the analysis of interest transactions. These questions will be considered in detail in Part Three of the text. This chapter, therefore, will be confined primarily to a more complete descrip- tion of the various kinds of contractual equities than has been possible heretofore. Particular attention will be given to the important classes of corporate contractual securities. ACCOtnSTTS AND NOTES PAYABLE The importance of the division between fixed and current items in the case of both assets and equities has been emphasized re- peatedly in the preceding chapters. Similarly it should be noted at the outset that the liabilities may be conveniently grouped 313 314 PRINCIPLES OF ACCOUNTING into fixed and current items. Such a classification in any case is not only an important matter of principle but has a very practical significance in the determination of the financial status of a given enterprise. A division of the liabilities of a company into funded or long-term indebtedness and floating or short-term obligations would serve to throw considerable light upon the immediate financial status of the enterprise. Typical Habilities may be settled or retired only with cash or an equivalent, and the position of an enterprise showing a satisfactory relation between total proprietorship and total UabiUties might as a matter of fact be precarious if an undue proportion of the outside equities were of the short-term t5^e. In the preparation of a balance sheet, therefore, the classification of the liabilities into groups is a matter of importance, and in the case of an enterprise with a complex capitalization such classification may be carried very far — much beyond a simple division into fixed and current items. If a management is to adopt at all times a financial program which will meet the exigencies of the capital market and the general industrial situation, it is necessary that the accounts and state- ments present an intelligible analysis of the Habihties. Among the current liabilities an equity which is of almost universal occurrence is that represented by the accounts payable. An account payable is usually based on a verbal or informal promise to pay. Such habilities originate most commonly when a company buys merchandise, materials, supplies or other assets on credit, or, in other words, postpones payment. Accounts payable usually run from ten to ninety days. The accounting problems arising in connection with accounts payable are not very complex. When goods are purchased on credit the asset account involved is charged and Accounts Pay- able is credited. If the account involves alternative terms of settlement special valuation accounts may be needed, for accounts payable are entered on the books at the gross figure and this gross figure in one way or another must be accounted for. If a discount is allowed for prompt payment, for instance, the amount of the allowance is credited to an account such as Purchase Dis- counts. As previously explained such discounts are in effect deductions from the cost of goods purchased. In this connec- tion there is a sense in which it might be said that an account THE LIABILITIES 315 payable depreciates. If an account appearing on the books at $500 is settled in full for $490 in cash, the account is virtually written down. ' This is a revaluation only in a fictitious sense, however, as the account was really overstated to the amount of $10 in the first instance. When the account is paid the amount of this overstatement is transferred to a valuation account. The interests represented by the accounts payable are usually equities in the enterprise only in a limited sense. When one mer- chant sells another merchant goods the relation between the two is essentially a buyer and seller relationship, and the seller does not invest his capital in the enterprise of the buyer. Yet if the buyer postpones payment the vendor has a claim against the vendee equivalent to the price of the goods involved — a claim enforceable by regular legal procedure if payment is not iriade as stipulated or within a reasonable time. In some in- stances title to the specific assets involved may rest for a time in the seller, but this is not usually the case. Instead of a title to the specific assets sold the vendor usually has a general claim against the assets of the buyer and is said to have an " unsecured " claim because he has no Hen on specific assets and his rights are subsidiary to any such liens and other prior claims. Although as will be explained in the next chapter interest is involved in all time transactions there are usually no expKcit distributions of income to the creditors whose claims are repre- sented by the accounts payable. The question of income, how- ever, is in part responsible for the usual alternative terms of settlement referred to above. The seller of a bill of merchandise, for example, offers a cash discount of two per cent if the bill is paid in ten days. If the buyer allows the discount privilege to lapse he is in effect making a distribution of income to the ac- countholder. Suppose the bill is for $1,000. The entries at the time of purchase might be : Merchandise $i,cx30 Accounts Payable $1,000 If the bill is paid after the discount lapses the entries would be : Accounts Payable $1,000 Cash $1,000 3i6 PRINCIPLES OF ACCOUNTING It may be said that of this charge to Accounts Payable the amount of $20 is a distribution of net revenue to an outside interest. The entries at the outset, it might be urged, should be as follows : Merchandise $980 Accounts Payable I980 and at the time of payment, Accounts Payable $980 Net Revenue (Interest, etc.) 20 Cash $1,000 While as a matter of theory there is some force to this analysis it would probably be fantastic to attempt to present it in the accounts. As a matter of fact, moreover, many factors contrib- ute to the amount of discount allowed in any case besides the matter of interest or other phases of income. Still it must be remembered that there is an important sense in which the creditors represented by the open book accounts constitute an equity in the ownership of the enterprise. In some cases accounts draw interest according to the terms of the sale if unpaid after a certain date. In such a case contractual income is explicitly involved. Further it should be noted that although the specific items which make up the accounts payable of a particular company are highly current in character the total of such accounts may be a relatively stable amount, and may also form a considerable part of what might be called the com- pany's capitaUzation. In other words the floating debt repre- sented by the accounts payable may be constantly a significant part of total ownership. Occasionally the accounts payable are - largely in the hands of one company and virtually constitute a silent partner's equity from the accounting standpoint. In some cases the claims of the merchandise creditors mount into millions of dollars ; and there are instances in which such creditors have played very prominent parts in the reorganization of finan- cially embarrassed corporations, and have taken stock and other securities in the reorganized company in settlement of their claims.^ 1 A notable example is found in the reorganization of the Westinghouse Company in 1891-92. See Dewing, Corporate Promotions and Reorganizations, Chapter VII. THE LIABILITIES 317 Promissory notes constitute an important type of liability. Such notes may be either current or long-term in character. Short-term notes arise primarily in connection with commercial transactions similar to those involving accounts payable. An enterprise buys goods and postpones payment but gives a prom- issory note, or written promise to pay. Such a liability is suffi- ciently distinct from an open book account that it is considered necessary to set it up in a separate account. The note itself is sometimes looked upon as the liability rather than the claim of some specific person or company and the highly negotiable nature of such instruments makes this view the more reasonable as the noteholder, whoever he may be, has the claim against the maker. Such notes may be drawn with or without interest. The fol- lowing illustration shows the form of a promissory note : Ann Arbor, Mich. April 17, 1918. fSoo Sixty days after date I promise to pay to the order of W. W. Stavin five hundred doUars, for value received, with interest at six per cent per annum. A. B. Powers. Transactions involving the making and paying of promissory notes, and the payment and accrual of interest on such notes, have already been explained, and some further illustrations will be given in the next chapter. It is generally true of notes payable and other HabiHties that the problems of valuation do not arise as in the case of the assets. Yet though liabilities do not depre- ciate or appreciate in the ordinary sense, the accountant must recognize the possibility of book changes in the liabilities which arise outside of actual transactions. The book value of a lia- bility may increase, for example, because of the accrual of in- terest. In Part Three the variations in the values of HabiHties in both directions due to interest accruals will be fully discussed. There are many different kinds of notes and similar formal evidences of indebtedness. Accepted bills of exchange, or thirty, sixty or ninety-day "sight" drafts, are in effect promissory notes and may be treated as such in the accounts. Bank "notes" are a somewhat similar type of liabiUty. Notes of this kind are usually made payable to the bearer on demand and are so highly 3i8 PRINCIPLES OP ACCOUNTING standardized and safeguarded that they constitute a regular part of the currency. These notes are non-interest bearing and yet circulate freely at par. The noteholders in this case are a rapidly changing body of whom the bank has no record. Al- though the notes are payable on demand they may wander far from the point of issue and may circulate indefinitely. The present issue of war-savings st^imps is an example of a kind of long-term non-interest bearing government note. Interest is, however, involved in such an instrument in that the note accrues to par during its life. The equity of the noteholders, also, may constitute in a given case an important element in total ownership ; and the interest accrued on notes payable may represent a significant distribu- tion of net revenue. Corporations make use of special kinds of notes in many cases as an important means of raising capital. Such notes may run for several years and may constitute an im- portant equity on the balance sheet. In some cases the note- holder also may be virtually a kind of silent partner, for although promissory notes usually run for a year or less a particular note may be renewed at successive maturity dates and hence may become a permanent equity. More commonly, however, specific notes and accounts payable are liabilities which must be actually paid in cash within a comparatively short period. If the note- holder does not contemplate an actual investment in the enter- prise of the maker of the note, he will usually insist -upon with- drawing his capital upon the termination of the contract. ACCRUED, DEFERRED AND CONTINGENT LIABILITIES Accrued liabilities are current claims which are recognized at the time of closing the books. Common examples are wages payable, taxes payable, rent payable and interest payable. These liabilities are recognized in the accounts in order to pre- serve the integrity of the accounting period and to present a correct exhibit of a company's financial condition in any case. Such items are usually retired within a few days or weeks after the books are closed. Liabilities of this kind usually do not assume significance in amount, and hence do not represent an important element in the ownership of an enterprise. The THE LIABILITIES 319 laborer, for example, does not make an investment in the enter- prise in the ordinary sense. He rather sells his service at a price. As in the case of accounts payable, however, the postponement of payment virtually gives him an equity. Further, it might be noted that in waiting for his wages the laborer actually carries a part of the capital burden of production. A small part of his wage, therefore, is really pure interest. The accountant, how- ever, is not interested in the division of wages into its ultimate economic elements. But he is interested in seeing to it that aU accruals of expense are charged against current revenue and that all claims which must be met are shown in the balance sheet. The accrued liabilities, as in the case of notes and accounts pay- able, must be retired shortly with cash or an equivalent ; and unless such items are exhibited the accounts do not present the actual financial status of the enterprise. Occasionally such accrued items may accumulate to a considerable amount. Methods of accounting for accrued liabilities were explained in Chapter VIII. Corporate dividends declared and payable represent a special kind of current liability. As was explained in the preceding chapter a dividend payable is a part of the stockholders' equity in a sense ; yet at the same time such an item is a liability in that it constitutes an obligation of the enterprise as an entity which must be met. Cumulative preferred dividends unpaid some- times come to represent a large figure on the books. If there is small prospect of payment such a Hability, it should be recog- nized, stands on an entirely different level from the regular lia- bilities. It is interesting to note at this point the legal positions of some of these different classes of liabihties in point of risk. In general accrued wages and taxes occupy a prior position to all other claims, not excluding mortgage hens. Other current liabilities as a rule, however, are not in as favorable a situation in this respect. The claims of noteholders and accountholders are usually subject to the interests represented by the funded debt. Between the capital liabihties in turn many differences in this connection arise. In Hquidation or reorganization securities such as mortgage bonds take precedence over debentures and similar equities. As a rule all other HabiHties rank prior to 320 PRINCIPLES OF ACCOUNTING dividends payable. All proprietary equities, of course, follow the liabilities as a class in rights to assets. There are certain liabilities which are finally paid not in cash but in commodities or services. These items are sometimes called " deferred " liabiUties. Suppose, for example, that a newly organized fire insurance company inaugurates a big selling cam- paign and writes insurance during the first year of business which yields premiums amounting to $800,000. The entries covering the payment of premiums, it may be assumed, are as follows : Cash $8oOjOoo Premiums $800,000 At the end of the year it is found that of this amount $450,000 represents premiums applicable to unexpired insurance. This means that the company is obligated to furnish during future periods an amount of its service, risk-taking, with a selling value of $450,000. At this time the following entries might be made : Premiums $350,000 Revenue $350,000 The balance of the Premiums account should appear on the bal- ance sheet as a deferred liability. This is simply another illustration of the deferred credits to income discussed in Chapter X. Prepayments in connection with leases and similar contracts give rise to such items on the books of the party receiving payment. Such a liability is sufli- ciently distinctive to be set up under a special head in the ac- counts and statements. In some cases (as in the above illustra- tion) such an equity may be one of the most important items on the balance sheet. No income explicitly accrues to such an equity, and the item is extinguished by the furnishing of a ser- vice rather than by being retired with cash payments. A contingent liability is not an existing obligation or equity but a possible one. Certain contractual conditions exist in the case of nearly every enterprise which may give rise to liabilities not appearing on the books. The most common case arises where a company endorses and discounts its notes receivable. This THE LIABILITIES 321 case and a possible accounting treatment for it was explained in a preceding chapter. Another illustration may be taken from corporation finance. A company may guarantee the dividends on the stock of a subsidiary company, or the principal and in- terest of the subsidiary's bonds. Such guarantees imply con- tingent liabilities as the company may be called upon to make good its guarantee from its own assets. A terminal company sometimes furnishes a similar illustration. Several railroad cor- porations, for example, combine to organize a company to build Joint terminal facilities. Each company agrees to pay a certain percentage of the operating expenses, and of the principal and interest of the securities of the terminal company. If each com- pany is jointly as well as severally Uable this means that if any of the parties to the undertaking should default on the agree- ment, the other companies would be responsible for the amount defaulted. A contingent liability in the case of each company is evidently involved in such a situation. There are many other illustrations of contingent liabilities. A corporation owning assessable securities in another company is contingently liable for the amount of such possible assessment. Analogously the company issuing the security has a contingent asset for the same amount. In fact, wherever guarantees in- volving a possible loss are undertaken there is a contingent liability. In general it may be said that it seems to be the better prac- tice to omit contingent liabilities from the books proper alto- gether for it is the function of the accounts to present the actual situation rather than the contingent situation. Obviously the entire status of the assets and equities in any enterprise might be radically altered by contingent circumstances easily conceiv- able. Where a definite possibility exists it might be recognized by a footnote on the balance sheet. Indeed the use of supple- mentary forms and statements to present certain facts which do not directly affect either the assets or the equities but neverthe- less have an important bearing upon the general financial status and prospects of the enterprise might well be extended. From the auditor's viewpoint contingencies of a definite kind cannot be entirely ignored in the financial statements. 322 PRINCIPLES OF ACCOUNTING MORTGAGES AND BONDS A mortgage is a liability consisting essentially in a lien upon some specific asset or assets or upon the general assets of some enterprise. Such instruments as mortgages, particularly real estate mortgages, may run for a long period of years. A mort- gage normally carries an interest rate corresponding roughly to the prevailing rate on promissory notes (sometimes a little lower). The typical mortgage carries rights to income and principal which are prior to the claims of the unsecured general creditors. There are many kinds of mortgages. The mere name mort- gage does not always carry with it the degree of security which the investor in mortgages traditionally attaches to such instru- ments. Mortgages may be placed upon real estate, equipment, or almost any other kind of asset. Mortgages may be first, second, third, etc. In the distribution of income or in the liquida- tion of capital assets in any case the mortgage holders stand in order according to the kind of mortgage held by each class. A first mortgage, as the name implies, is in general a much more substantial equity than a second or any subsequent mortgage. A first mortgage on the plant of a manufacturing company which amounts to but ten per cent of the value of the property, is but little safer, however, than a second mortgage on the same prop- erty for an additional ten per cent. The accounting for mortgages payable is similar to that for notes payable. The amount of the mortgage is credited to the Mortgages Payable account, and the amount of cash or other assets received is debited to the appropriate property account. Discounts on ordinary mortgages seldom arise. The amount invested is equal to the face of the mortgage. In other words the stated interest rate is usually the effective market rate for the particular type of equity involved. Arrangements are com- monly made by which a mortgage may be paid in installments ; in other cases the entire amount may be paid only at maturity. Interest is usually paid either once or twice per year. The holder of the typical real estate or chattel mortgage has little control of the operation of the enterprise involved.^ If 1 Mortgages are also a common tjrpe of indebtedness involved in the ownership of assets such as dwelling houses, which are not used in production. THE LIABILITIES 323 interest or principal is defaulted the mortgagee may foreclose and possibly force the sale of the incumbered assets to satisfy his equity. The mortgage contract sometimes contains a pro- vision empowering the mortgagee to sell the mortgaged property upon the non-payment of the debt, and to apply the proceeds to the liquidation of the mortgage. Such special mortgages may eliminate the need for foreclosure proceedings. As was stated in a preceding chapter the most common type of Hability arising in American corporation finance is the bond. A bond is a formal instrument of indebtedness widely used by incorporated companies in raising capital. As an illustration of the extent to which such securities are issued it might be noted that of the total capitaHzation of American railway companies over fifty per cent is represented by various types of bonds. Bonds are also commonly issued by manufacturing companies and other industrials. In fact comparatively few large corpora- tions are financed entirely by stock issues. The general distinction between stocks and bonds has already been explained. The point should be reiterated that the investor in a corporation whose equity is evidenced by a bond must be thought of as an owner and not merely as a creditor — an out- sider. In financing a corporation the bond issues constitute as much a part of the original capitalization as the stock issues. The capital furnished by the bondholder is essentially a part of the permanent investment, and is furnished to the corporation as an entity, not to the stockholder. In a sense all of the in- vestors, bondholders as weU as stockholders, constitute the membership of the corporation. A bond consists in a formal contract which contains a promise to pay a certain definite simi ($1,000, for example), the par of the bond, at the date of maturity, and certain smaller periodic pay- ments, the bond interest. A bond is a long-term security. The different issues run from ten to fifty years, or even longer. The bond interest is usually paid twice a year. Bonds may be either coupon or registered. A coupon bond is not made out in the name of any particular person and hence is readily negotiable. The principal is made payable to the bearer, and the interest is paid to whoever presents the detached interest coupons. A registered bond is registered on the books of the company in the 324 PRINCIPLES OF ACCOUNTING name of a particular party, and interest and principal are then payable only to the registered holder. Such a security may be transferred, however, in much the same maimer as a stock cer- tificate. Bond issues are often based upon mortgages. A corporation desiring to raise capital may place ajnortgage on its properties somewhat similar to the ordinary mortgage. The corporation would have difficulty, however, in raising the necessary capital directly on the basis of a single mortgage contract. The mort- gage is therefore deposited with a trustee, and an issue of bonds, secured by the mortgage, is emitted. The individual bonds can then be written in convenient denominations and can be readily sold to investors. The mortgage contract is often an elaborate document giving to the bondholder a considerable degree of indirect control over the general business and financial policies of the corporation. If interest or principal is defaulted the bondholder comes into almost complete control of the affairs of the corporation under the mortgage right of foreclosure. The tendency in corpora- tion finance seems to be more and more toward the placing of limitations upon the absolute control of the stockholder. There are many types of mortgage bonds. In the first place a bond may be issued on the basis of a mortgage covering only a part of the corporation's property, or the mortgage may con- stitute a hen upon all of the present assets and any assets that may be acquired in the future as well. Further, a succession of mortgages, and corresponding bond issues, may be issued against the same property. All kinds of combination mortgages are used. A particular bond issue, for example, may be based upon a first mortgage upon some assets and a third mortgage upon other assets. The name used in the prospectus is often not a reUable index of the nature of the security back of the bond issue. A careful inquiry into the nature of the mortgage contract upon which the security rests might well be made by the prospective investor. "Debenture" bonds and "income" bonds represent other types of corporate equities. The debenture bondholder, in the absence of special stipulations, is in much the same position as the general creditor. Debenture bonds are often issued by a THE LIABILITIES 325 corporation which already has outstanding mortgage bonds. In other cases a corporation will issue this t5^e of security and make no use of mortgages. Although debentures do not carry the privileges of mortgage bonds a particular issue may represent a very conservative investment. In general the character of cor- porate liabilities is determined in large measure by the nature of the particular enterprise involved in any case as well as by the special contractual privileges which obtain. Income bonds have not proved to be a desirable form of secur- ity. The income bondholder has very little control, either direct or contingent. The interest is paid only if earned. There are so many possibilities of manipulating the accounting treatment of transactions affecting net revenue in such a case to the ad- vantage of the common stockholder that it is very difficult to protect the interests of the bondholders adequately. The stock- holder is content to see income retained in the business so that a dividend may be earned on this property in the future. The methods of building up secret reserves referred to in the last chapter may be employed to the bondholder's disadvantage. In the absence of a very complete governmental or contractual control of the accounting procedure it is difficult to prevent such practices, or to secure redress for the bondholder. There are stiU more highly specialized kinds of bonds than any yet mentioned. "Equipment" bonds may be secured by liens upon specific units of equipment such as railway cars or vessels. "Collateral" bonds are based upon a subsidiary issue of stock or bonds held by a trustee. Such bonds are often used in con- nection with a combination of two or more enterprises by means other than an actual merger. A company, for example, may borrow sufficient funds on promissory notes to buy a large or controlling interest in the stock of another company. This stock may then be deposited with a trustee and be made the basis of an issue of the holding company's own bonds, the proceeds from the sale of which may be used to retire the outstanding notes. "Serial" and "convertible" bonds are often issued, par- ticularly in the case of mining and similar companies. A serial bond issue is one in which the bonds mature in regular install- ments. Convertible bonds may be exchanged for stocks under certain conditions. 326 PRINCIPLES OF ACCOUNTING The corporate form of organization is indeed marvelously well adapted to the specialization of equities. There is prac- tically no limit to the possible variations in corporate securities which may be devised by ingenious financiers. By means of different kinds of stocks and bonds the tastes of practically every type of investor may be suited. All of the important sources of capital in the community may thus be tapped in the organiza- tion of a single large corporation. In this respect the simple partnership or single-proprietorship is comparatively very much handicapped. The more important accounting questions arising in connec- tion with such liabilities as bonds have to do with the calculation of interest and principal and the treatment of these items in the accounts. As was stated above this subject will be fully discussed in Part Three but some questions arising in connection with the retirement of bonds will be briefly considered at this point. The length of time a bond is to run should bear some relation to the length of life of the property upon which the security is based. The amortization of equipment bonds, and the bonds of wasting asset enterprises such as mines and timber companies, should be provided for in some regular way. One method of providing for the maturity of such liabihties is to accumulate a sinking fund out of revenues sufhcient to meet the obligation at the due date. The chief disadvantage of such a fund hes in the fact that it will usually earn a rather low rate of interest since it must be invested in high-grade securities in order to serve its purpose. Another method is to issue the bonds with serial re- tirement dates, though such a bond issue has certain disad- vantages. If emitted at a discount serial bonds cannot be priced evenly on the market and this makes the security unattractive to the investor. Those bonds which have the shortest time to run will sell for higher prices than the blocks with a longer life.^ Still another way to reduce the liability is to buy an amount of bonds on the market each year equivalent approximately to the amount of an appropriate sinking fund installment plus the ac- cumulation on such a fund. Bonds called or bought back by the issuing corporation present 1 The reason for such a pricing will become evident as the chapters on interest transactions are studied. THE LIABILITIES 327 essentially the same accounting problem as treasury stock. Such bonds may be kept "alive" in the treasury or may be cancelled. As in the case of treasury stock, however, the bond of a corpora- tion in its own treasury is always virtually "dead." It could not be issued again as it stands. Such bonds are not an asset but a deduction from the amount of the outstanding HabiKties. The claim which a corporation holds against itself can hardly be considered an asset. If listed among the assets redeemed bonds should be considered as a valuation item. In conclusion certain special tj^jes of securities somewhat akin to bonds should be mentioned. Perpetual liabilities, or per- petuities, are not common in American finance, but there are a few cases of such equities. A perpetuity is essentially a bond having no due date. The bond does not mature, hence there is no provision made for the repayment of the principal investment. In this respect such a security is similar to a stock issue. In- come, however, accrues on a contractual basis and the holder of the perpetuity usually has little or no control. The Enghsh consols are an example of a government security of this t3^e. Insurance companies sometimes secure capital from a certain tj^je of investors on the basis of annuities. The annuity as a security is an instrument containing the promise to pay to the investor a certain number of annual sums, though a series of semiannual or quarterly payments may also be called an annuity. In the case of Hf e annuities the number of payments depends upon the length of Hfe of the investor or beneficiary. The investor in an annuity furnishes a certain amount of capital and receives a series of contractual sums. Income and principal are botJi involved in these payments. The calculations and accounting problems arising in connection with annuities will be fully dis- cussed in Chapters XVI and XVII. PART THREE THE INTEREST PROBLEM XV A General Analysis of the Interest Problem Frequent reference has been made in preceding chapters to transactions involving interest. Particularly in Part Two, in con- nection with the equity accounts, it has been necessary to mention the importance of interest in the accounting records, and to stress the fact that the distribution of net revenue to the various classes of equities is largely based on the interest contract. In the suc- ceeding chapters, moreover, especially in Part Four, on the valua- tion of assets, this question will arise repeatedly. In all cases where it has been necessary to recognize interest, the question of its computation has been deferred to this part of the text as many purely technical questions are presented in connection with the computation of interest and the analysis of transactions in- volving the interest phenomenon. Several chapters of the book will now be concerned with the more important of these questions. Many of the topics discussed here have already been mentioned in connection with the equity accounts, and some will again be taken up in connection with the asset accounts. This part will therefore serve as a technical basis for the other problems men- tioned. the interest phenomenon The interest phenomenon presents itself in two different forms in connection with business transactions. In economic discus- sions these are called "explicit" and "implicit" interest trans- actions, and the accountant needs to understand the distinction thoroughly. ExpHcit interest is the type of interest explicitly mentioned in definite credit relations expressed by some form of contract such as promissory notes, mortgages, bonds, etc. Im- plicit interest refers to the interest involved in the ownership of any durable asset and is an important accounting consideration 331 332 PRINCIPLES OF ACCOUNTING because the difference between the immediate purchase price of such an asset item and the sum totals of the revenues which it will produce in the future represents in part at least implicit interest. This is what is meant when the manager says that in addition to providing for other items, the selling price of his product must be high enough to pay interest on his investment. Explicit interest as was stated above arises in connection with contractual loans. A large part of the capital invested in the average business enterprise is obtained through what is commonly termed borrowing. The firm issues some form of promissory obligation in exchange for present funds to be used in obtaining various asset items. The amount of the funds received is less than the amount which the firm promises to repay in the future. This difference is explicit interest. It is convenient, however, to classify the forms of loans of this type into two classes on the basis of the length of time involved in each case. From the ac- countant's point of view the first class, called short-term notes, are all such obligations which run for periods less than a year. The banker is incHned to call all such obligations which run for over ninety days " long-term," but the accountant classifies as long- term securities only those which run for a year or longer periods. Short-term notes are given usually for the purpose of raising current funds to meet current Habilities. Bankers speak of this form of loan as a merchandising loan. The manufacturer bor- rows on his sixty-day note to enable him to make immediate payment for his materials and labor while waiting for payment from his customer the jobber. The jobber in turn, on receipt of goods from the manufacturer, borrows on his sixty-day note in order to make prompt payment while waiting for receipts from his own customers, for example, the retailers. These are all short- term loans made for the purpose of financing immediate pur- chases. The assets obtained are listed among the current assets and the notes are listed among the current liabilities. Likewise the interest involved is usually placed in the Commercial Interest account. The compHcations which arise in connection with this class of loans will be discussed more fully in the next section. Long-term securities are issued primarily for the raising of capital to be invested in fixed assets and hence usually run for a much longer period than promissory notes. Bonds, long-term ANALYSIS OF THE INTEREST PROBLEM 333 notes, annuities, etc., characteristic of this class, run for periods of from one to one hundred years. Most bonds, however, run for less than one hundred years though some securities, such as the British consols, run in perpetuity. The assets obtained from these security issues therefore will largely be represented in the fixed asset accounts while the securities themselves will be placed among the capital equities. Moreover, the interest involved is placed in special interest accounts ; in fact it is often deemed ad- visable to keep a special interest account for each security out- standing, and this class of interest transactions will therefore be discussed further in a later section. It is unnecessary at this point to go into a lengthy discussion of the nature and origin of interest, but it is essential for the ac- countant to realize that interest, either explicit or impHcit, enters into every transaction where time is an essential element. The fact that it exists in every computation involving time is very generally recognized, and two types of characteristic calculations commonly made by business men show further that computations involving impHcit interest are consciously made. In the first place if a bid is to be made for the purchase of an asset the future revenues of which are definitely known, the business man will discount the revenues, thus making the purchase price consider- ably less than the sum of the revenues. This difference is interest. The amount of revenue received each year in such a case .con- sists of, (i) a return of part of the purchase price, and (2) interest on the investment. The second general type of impHcit interest is made evident when the manager of a plant is about to state a price for his product ; for he adds a certain amount to the regular expenses to "cover the interest" on his investment. These two types of calculations, of course, are just two different methods of computing impHcit interest. The first recognizes that money due in the future must be discounted to find its present value, and the second that interest is an economic cost of production. In commercial accounting the impHcit interest item is seldom calculated separately but is included with the profits in the net revenue figure. For instance, the net revenue figure which is carried from the expense and revenue statement down to the credit side of the net revenue statement includes interest on the investment. If the firm is prosperous it also includes a con- 334 PRINCIPLES OF ACCOUNTING siderable profit, if poorly managed even interest will not be earned although this situation cannot continue without leading to bankruptcy. The operating net revenue, then, includes the interest return on the investment. Additions are made to this figure in the net revenue statement through receipts of explicit interest and deductions through distributions of explicit interest. The final net balance is therefore made up of interest on the pro- prietary investment and pure profit. There is a very close relation between the interest element in operating net revenue and the value of the assets used in pro- ducing the revenue. In the purchase of assets having definite future revenues this value may be obtained by a mathematical computation. The relation between the revenue and the value of the asset is fixed at the date of investment by a discounting process. In determining the price of a product the relation is somewhat more obscure but is nevertheless present. The man- ager invests in a machine which will last ten years because, in view of all the conditions which he can foresee, the revenue at- tributable to the machine will be in excess of the purchase price. Or, stated in another way, he will fix the price of his own product at a point which will enable him to obtain the market rate of interest on the investment. In any case, if he is successful, net revenue will jdeld a reasonable interest return on the investment. There is then a relation between the value of the asset and the interest return which should as far as possible be recognized in the accounts. Its bearing on the problem of valuation will be discussed at some length in Part Four, but some of the questions dealing with interest in valuations will be mentioned in the last section of this chapter. COMMERCIAL INTEREST Commercial interest is the term generally applied to interest paid or received on short-term notes. No fixed rule can be laid down as to what constitutes a short-term note but usually it is assumed that one year may be taken as the limit of this class, as the normal purpose of loans of this t)rpe is to aid in the mer- chandising of goods. Such loans are made in order that the pur- ANALYSIS OF THE INTEREST PROBLEM 335 chaser of raw materials or merchandise can make prompt pay- ment to his creditor awaiting the sale of his own product and are therefore practically always closely connected with the purchase price of the raw materials or merchandise involved. That is, the loan is obtained by the purchaser so that he can "take his discount" and thus obtain the goods at a lower total cost than would be the case if he accepted the credit terms of the seller. The question as to whether a short-term loan should be obtained usually arises in somewhat this way. X purchases goods from Y at an invoice price of $1,000.00. A discount of 2 per cent will be allowed if the bill is paid within ten days, but if it is not paid within that time the net must be paid within sixty days. X has not the ready funds to make payment immediately but his credit at the bank is good for a 6 per cent rate per year. He can borrow $980.00 at 6 per cent from the bank and immediately pay Y for the goods. Then at the end of sixty days he pays the bank the $980.00 plus interest, $9.80, or a total of $989.80. He then says that his goods cost him $989.80 instead of $1,000.00 as they would have if he had waited sixty days to pay Y. He has evi- dently saved $10.20 by this operation. It was shown in Chapter VIII that all commercial interest, both interest paid and interest received, can be entered in one account. This account then shows the excess of interest paid on merchandising operations over interest received or vice versa, and in the ordinary industrial enterprise this net figure is of more significance than the total of the interest on either notes payable or notes receivable. This account represents the results of oper- ations of a commercial banking character. Interest received on notes receivable might with reason be considered as a deduction from the total interest paid on notes payable. A note received from a customer can be and usually is endorsed and used for obtaining current funds from a bank. If it is held a few days before it is taken to the bank for discount, the interest earned in those few days might properly be taken as an offset to the interest paid on notes originating with the firm. There are certain cases, however, where it would be of service to the manager to separate the accounts so as to show the commercial interest paid in one and the amount received in another, but the two methods of keeping the commercial interest were explained and illustrated 336 PRINCIPLES OF ACCOUNTING quite fully in Chapter VIII.^ (At closing dates interest accrued in both directions is, of course, taken into consideration.) Another question of considerable importance in connection with the Commercial Interest account is whether the account should be closed into expense and revenue or into net revenue accounts. To be logically consistent with the theories thus far developed in this text, interest should be considered as a dis- tribution of net revenue to the equities represented by the Notes Payable account. In the average enterprise a not inconsiderable part of the working capital is supplied through this medium, and this is good policy. Should not interest on these notes then be considered in the same category with interest on bonds as a dis- tribution of net revenue? There are, however, good practical reasons for charging this form of interest to expense (or crediting it to gross revenue in the case of a credit balance) . The borrowing operation as was shown above is directly connected with the price of goods purchased (or sold). By obtaining the loan the purchase price of goods is less even after interest is paid on the loan than it would be if the alternative terms of settlement were accepted. As it is customary to charge the Materials account with the invoice price and to credit a valuation account, Merchandise Discount, for the dis- counts actually taken, there is some reason for charging interest on commercial loans against the operating accounts. That is, since the whole matter is tied up with the purchase transaction and the merchandise discount, the statements for practical purposes will be as significant with this kind of interest in the expense and revenue statement as through the more logical method of treating it as a distribution of net revenue. The location of such items, in other words, may be based entirely on practical considerations. In a bank the case is clear ; commercial interest is gross rev- enue. Expenses of conducting the bank are met out of the com- m^ercial interest received. The bank organization is maintained primarily for the purpose of furnishing this service and of course expenses incurred in furnishing such services must be deducted from the revenue received from the sale before obtaining net '■ It is suggested that the student at this point review the section on closing of interest accounts (pages 188-189) ii order to have clearly in mind the diEEerent elements entering into such an account. ANALYSIS OF THE INTEREST PROBLEM 337 revenue. This does not necessarily, mean that the debit on the borrower's books must also be entered in the Expense and Revenue account but it lends considerable weight to that contention. A consideration of a few of the t3^ical transactions involving commercial interest will lend concreteness to the discussion. The most common case has already been mentioned, namely the borrowing or loaning on an interest bearing promissory note. The X Company borrows $1,000.00 from a bank on a sixty-day 6 per cent note. On the date of borrowing, the entries are. Cash fijOoo.oo Notes Payable $1,000.00 Then at the end of sixty days, when the note is paid, the entries wiU be. Notes Payable $1,000.00 Commercial Interest 10.00 Cash $1,010.00 Another form of borrowing frequently used is through a non- interest bearing note. That is, the X Company brings to the bank its promise to pay $1,000.00 at the end of sixty days without interest. In this case the payment to be made by X at the end of sixty days is just $1,000.00 and no more. The bank then will discount this note at the bank rate of discount and give X the proceeds. Six per cent of $1,000.00 for sixty days is $10.00. The net proceeds of the note therefore are $990.00 and the en- tries on X's books are. Cash $990.00 Discoimt on Notes Payable 10.00 Notes Payable $1,000.00 The amount of the discount is, of course, interest but this in- terest accrues during the ensuing sixty days. As Discount on Notes Payable stands on the books at present it is a valuation account offsetting the overstatement of the liability on notes payable. At the end of sixty days the full $1,000.00 is paid and the entries would be, Notes Payable $1,000.00 Cash $1,000.00 z 338 PRINCIPLES OF ACCOUNTING By this time the interest of $10.00 has accrued and should be charged to Commercial Interest, Commercial Interest $10.00 Discount on Notes Payable .... $10.00 Because of the short time which elapses between the date of issue and date of payment of such a note, it is considered good poUcy to charge the discount to Commercial Interest at the time the loan is made. In this way the necessity for making this last entry is avoided. If all of the interest on such a note has not accrued at the time of closing the books, the accrued amount can be taken into account through the inventories . Commercial Interest, then, could have been charged originally instead of Discount on Notes Payable. The point to be emphasized, however, is that the interest accrues during the ensuing period. While interest and discount as they appeared in the last two illustrations are fundamentally the same thing, attention should be called to a difference between the rate of interest and the rate of discount. The rate of interest is applied to the present sum to obtain the amount to be added for interest. The rate of dis- count is applied to the sum due in the future to obtain the amount to be deducted for discount. It is obvious that a certain rate of discount would give a higher rate of interest on the present value of a sum. To illustrate, the non-interest bearing note for $1,000.00 which was discounted at 6 per cent for sixty days brought $990.00. The item of $10.00 is interest. The rate of interest involved in the transaction is greater than 6 per cent however, as the in- terest on $990.00 at 6 per cent for sixty days is only $9.90. The borrower then pays a higher rate of interest than the stated rate of discount if he has a non-interest bearing note discounted at the bank. The relation between the two rates is given in a mathematical formula in the next chapter. Minor questions sometimes arise in matters regarding interest where custom is primarily the guide. In computing interest on short-term notes, for instance, the student may be in doubt as to whether to figure 360 or 365 days to the year. There is no absolute uniformity in practice in this matter but certain customs are general enough in extent to warrant a statement of them in the form of rules. The year is generally taken as 360 ANALYSIS OF THE INTEREST PROBLEM 339 days for computations involving the use of odd days. Sixty days, for example, is one-sixth of a year. The note itself, how- ever, may specify that 365 days shall be used as a basis. The next shorter unit of time than the year is the month. The month is always considered to be the period between the dates of equal number including the second number. That is one month from January 15th is February 15th. A note due one month from the former date must be paid on the latter. One month from Jan- uary 31st, however, is February 28th (or 2gth in a leap year). Thirty days and one month are usually considered as synony- mous terms although in some cases the actual number of days is counted. In other words, one-twelfth of a year is either thirty days or one month. Other forms of paper which are classed as notes payable, or notes receivable, are time drafts, trade acceptances, bills of ex- change, etc. Each of these forms of paper is somewhat dis- tinctive as to legal form but in accounting all are properly treated as commercial notes. If X sells a bill of goods to Y and then draws a draft on Y which is properly accepted, the draft becomes a promissory note. It is a note payable on Y's books and a note receivable on X's books. The same would be true of other forms of commercial paper of this general character. An industrial concern may receive a large number of promissory notes from its customers in the ordinary conduct of its business. If these are retained until maturity, the entries would be the reverse of those made on the books of the customer, except that Notes Receivable would be the title of the account representing the notes instead of Notes Payable. The notes are usually ob- tained, however, in order to use them for immediate discounting purposes. The Notes Receivable account then is credited, Cash debited for the proceeds, and the Commercial Interest account debited if the proceeds are less than the face of the note or credited if the proceeds are more than the face of the note. LONG-TERM SECtTRITIES Interest on long-term securities is unquestionably a deduction from net revenue. Such securities are issued for the purpose of raising the capital to be retained permanently in the enterprise. 340 PRINCIPLES OF ACCOUNTING and accruals of interest are therefore contractual distributions of net revenue. Being contractual it is essential that the accrual on each class of securities be kept in a distinct account. In- terest on first mortgage bonds, for example, must be met before arty net revenue is apportioned to second mortgage bonds, and interest on these must in turn be met before a further appor- tionment to the less secured equities such as income bonds, de- benture bonds, etc. Interest on each class of security therefore has a significance of its own. Further, interest received from securities owned should not be placed in the same accounts with interest on outstanding securities. The net revenue statement of a corporation having several classes of securities outstanding, for example, might have interest accounts as shown by the following statement. Net Revenue Statement Interest on First Mtg. Balance from Expense 4's $585,490 and Revenue $2,356,200 Interest on Second Mtg. Interest on Securities > S's 495,380 Owned 15,365 Interest on Income 6's 298,300 * Interest on Debentures 7's 185,275 Balance (Stockholders' Equity) 807,120 12,371,565 $2,371,565 The order of the interest accounts on the debit side is of con- siderable importance. They should be listed in the order of claims to net revenue as specified in the security contracts. The balance carried from net revenue is available, after taxes have been deducted, for the private equities. Interest on first mortgages must of course be met before the second mortgage bondholders may present their claims, and so on ; and in case of a deficiency in net revenue the loss of interest is placed on the security holders whose claims are placed low in the list. This matter can always be definitely settled by an examination of the text of the security contract. The determination of the amount to be entered in each interest account, however, is not such an easy matter. The fact that 4 per ANALYSIS OF THE INTEREST PROBLEM 341 cent bonds with a par value of $1,000,000.00 are outstanding and that $40,000.00 is paid over to the bondholders each year does not necessarily mean that $40,000.00 should be charged to the ap- propriate bond interest account. In fact the charge would be equal to the annual payment of bond interest only in cases which rarely exist in actual practice, namely in case the bonds are sold at par. If the $1,000,000.00 issue of 4 per cent bonds due in twenty years were sold to investors for only $934,516.19, for example, and this would be the case if the market rate of interest were 4^ per cent, the interest accrual on the bonds would be greater than $40,000.00. The detailed explanation of this fact will be deferred to the next chapter where the mathematical com- putations are given, but the principle involved can perhaps be explained in a few words at this point. In the preceding section two illustrations of short-time notes were given. In the second one a non-interest bearing note was discounted at a bank. It was said that this discount is in fact interest that accrues in the ensuing period before it becomes due. Now even if the note had been interest bearing as the first one was but the amount of interest were not as much as the market dictated should be given, the note would again be dis- counted and this discount would be part of the interest. The case of the twenty-year bonds under consideration is analogous to this situation. The main difference is that more time elapses between the date of issue and final payment and that the interest on the bonds is paid periodically throughout the Hfe of the bonds. But the rate of interest stated in the bonds is not as high as the market requires for this type of security ; therefore, the security will be discounted and the discount is part of the interest. Fur- ther it was stated in the preceding section that after the interest had accrued, the Discount account should be credited and In- terest charged, but that inasmuch as the period involved was short. Interest might be charged in the original entry. In the case at hand, however. Discount on Bonds should be credited and Interest on Bonds charged only as the interest accrues, as the interest account cannot be charged directly for the whole discount at the date of issue because the integrity of a great many succeeding net revenue statements is at stake. At the date of issue then entries must be made recognizing this discount. 342 PRINCIPLES OF ACCOUNTING Cash $934,516.19 Discount on Bonds .... 65,483.81 First Mortgage Bonds . $i,cx30,ooo.oo The Discount on Bonds is a valuation account to be written off as the interest actually accrues. During the first six months, the interest accruing would amount to 2^ per cent of $934,516.19 (if interest were payable semiannually, see next chapter), or $21,026.61. At this time bond interest to the amount of $20,000.00 is paid on this accrual so this payment is short just $1,026.61. Interest on Bonds is charged with the total ac- crual, Cash credited with the payment, and Discount on Bonds with the balance. Interest on Bonds $21,026.61 Cash $20,000.00 Discount on Bonds .... 1,026.61 When this $1,026.61 is subtracted from $65,483.81 a balance is left in the valuation account. Discount on Bonds, of only $64,- 457.20. The bondholders' net investment then is $1,000,000.00 less $64,457.20 or $935,542.80, and the interest accrual for the next six months is 2^ per cent of this amount or $21,049.71. The same form of interest entry would now be made with this amount charged to interest. The total interest for the year then is $42,076.32 instead of $40,000.00, the amount of the pay- ments. Continuing this policy for the twenty years the Interest on Bonds account for each period would be charged with its due share of interest and the Discount on Bonds account closed. On the other hand if the $1,000,000.00 of bonds had carried a 5 per cent rate and were sold to investors on a 4^ per cent market basis, the price would be $1,065,483.81. The bonds are said to be sold at a premium of $65,483.81. This premium is simply part of the investment which is returned in the bond interest payments. In this case, that is, the interest charge for each year would be less than $50,000.00, the amount of the payment. The corporation pays $50,000.00 each year, but this is more than the market demands in the form of interest, therefore the in- vestor makes a payment at the date of issue for the privilege of receiving these additional sums. The corporation at the date of issue makes these entries, ANALYSIS OF THE INTEREST PROBLEM 343 Cash $1,065,483.81 First Mortgage Bonds . $1,000,000.00 Premium on Bonds . 65,483.81 The Premium on Bonds account represents part of the bond- holder's equity and will remain on the books until written down at subsequent interest payment dates. At the end of six months, the interest accrual on the market rate is 2-j per cent of the orig- inal investment, $1,065,483.81, or $23,973.39. But the corpora- tion actually pays $25,000.00 in bond interest. The difference between these two quantities is a return of part of the original investment originally credited to Premium on Bonds. The entries are, Interest on Bonds $23,973.39 Premium on Bonds 1,026.61 Cash $25,000.00 The investment now remaining in the bonds is only $1,064,- 457.20 and it is on this figure that interest really accrues at 2-J- per cent for the next six months. This accrual amounts to $23,- 950.29 and the payment of $25,000.00 leaves $1,049.71 as another return of premium. The total interest charge for the year, there- fore, is $47,923.68 instead of $50,000.00, the cash payment. The continued use of this method for the twenty years would reduce the Premium on Bonds account to zero and would charge the proper amount of interest against each year's net revenue state- ment. Accumulation of discount and amortization of premium tables may easily be prepared to serve as a basis for the interest entries for bonds at a discount or premium respectively. In the next- chapter a rather detailed explanation of such tables is given together with the necessary mathematical formulae for bond valuations. The purpose of raising the question at this point is to show the necessity for making an accurate computation of the interest item. Obviously an error in stating the accrual. of interest on one class of security in the net revenue statement might cause an unjust distribution to other classes of security holders. Many complicated computations arise in placing the proper figure in the interest accounts, but the security con- tracts must be carefully investigated together with the quoted 344 PRINCIPLES OF ACCOUNTING price as affected by the market conditions. With these facts at hand, proper entries can be made with the aid of mathematical computations or various interest tables based upon the same. INTEREST IN VALUATIONS The fact that interest enters into every transaction where time is an element is of particular significance in the valuation of the fixed assets. Ideally there is a rather definite relation between the revenue attributable to an asset item and the value of that item at any time. In fact if the revenue is definitely known or can with any degree of accuracy be estimated, the valuation of the asset even for sale purposes is obtained by a dis- counting process. On the other hand where there is no reason- able basis for estimating the future revenues obtainable, interest is a factor which must be taken into account on the production side. That is, interest always enters into the situation though sometimes the computation is made by looking at the revenues and applying a discounting process, while at other times the com- putation is made by looking at the cost or investment side and applying the interest computation to that figure. It is partially because of these different ways of looking at the asset items that it is convenient to classify the fixed assets into the ordinary intangible items, tangible items, and claims against others (securities). A brief statement of the way in which interest enters into the valuation of each of these classes of assets will be made in this section, and a more detailed discussion of each class will be found in later chapters. The valuation of securities owned presents the simplest case as the purchaser of a security consciously makes his bid on the basis of the amounts to be received in the future. The future sums due are all definitely stated in the security contract (except in the case of capital stock) and the market rate of interest then determines the purchase price. The reason that a $1,000.00, twenty-year, 4 per cent bond is purchased for $934.52, is that if the market rate of interest is 4I per cent this sum is the dis- counted value of all the amounts which the bond entitles the purchaser to obtain. The entries which are made on the issuing company's books covering such situations were illustrated in ANALYSIS OF THE INTEREST PROBLEM 345 the preceding section, and the purchaser of the bond is simply looking at the same transaction from another point of view. In his case the bond is an asset and the interest actually accruing on the bond is a credit to net revenue. For example, at the time of acquiring the bond just mentioned, the purchaser would make these entries, Bonds Owned ' $934-52 Cash $934-52 At the end of six months when the $20.00 bond interest payment is received a revaluation of the bond should be made. The holder now owns a 19I year bond and if the market rate is still 4I per cent this will give a value of $935.54. The journal entries are, Bonds Owned $ 1.02 Cash 20.00 Interest on Bonds Owned .... $21.02 The interest earning consists of an increment in the value of the bond owned of $1.02 plus the $20.00 cash received from the cor- poration. If the bond had decreased in value instead of increas- ing the entries would have shown credits to the Bonds Owned account and to Interest equal to the debit to Cash. Changes in value either way are caused by a change in the present value of the sums due in the future. In Chapter XVIII the details of the valuation of securities on the books of the purchaser are explained. Enough has been said here to show that in the case of securities owned interest is an important factor in valua- tion, and to show the necessity for a knowledge of the mathe- matics of interest calculations in this connection. In the valuation of the general class of intangible assets such as goodwill, franchises, patents, leases, etc., the discounting process is used. In some of these cases the amounts of revenue to be received due to the existence of the property right are def- initely known. The valuation in such cases follows the same pro- cedure as for securities. The value of the lease-hold which brings ^ There is something to be said in favor of listing the bonds owned in this account at par and using a valuation account Discount on Bonds Owned as an ofiEset. For the purpose of this illustration, however, the net valuation may properly be carried into the Bonds Owned account. 346 PRINCIPLES OF ACCOUNTING in $10,000.00 per year but which expires at the end of fifteen years is, if the market rate of interest for such an investment is 6 percent, $97,122.49. This figure represents the discounted value of the fifteen payments of $10,000.00 each on a 6 per cent interest basis. Further this would be the sale price if it were placed on the market with the buyer and seller having the same informa- tion. In the case of other intangibles where the definite amount of revenue to be obtained is unknown, the revenue items are estimated. In the valuation of goodwill, for example, a judg- ment is made of the amount of revenue attributable to this factor and the number of years it will be effective. With this estimate as a basis, the value is obtained through the discounting process. The same may be said of franchise values and of all intangibles when the revenue is fixed by contract or otherwise definitely known. There are many practical questions which arise in the valuation of intangibles, and which must be settled before the discount process is employed, and these will be taken up quite fully in Chapter XXIV. In all these cases, however, after the revenue figures have been obtained, either by definite contract or estimate, the interest calculation is the final determining factor. In the case of tangible assets, the case for interest is not quite so clear. Here it may be said with reason that the original val- uation at the date of purchase at least is not immediately de- pendent upon the revenue attributable to the item. The man- ager of a factory decides that in view of the conditions in his plant, the labor market and all other factors to be considered, it would pay him to invest in a certain machine. He pays just $15,000.00 for the machine desired, not because that figure rep- resents the present value of the revenues attributable to the machine but because the market price of that machine at that time is $15,000.00. He might be willing to pay more but this is unnecessary so long as it can be obtained on the market for that price. Of course, he would have convinced himself that the machine was capable of aiding sufficiently in the production of his product to yield a net return at least equal to the market rate of interest in addition to replacing the original investment, but the final definite basis for the original valuation in each in- dividual purchase is the market price of the item purchased. ANALYSIS OF TH3 INTEREST PROBLEM 347 Here the asset is being viewed from a different standpoint than that applicable to intangibles. Cost, or at least the market price of the specific item as viewed from the cost side, seems to be decisive. How then does the interest problem enter into this situation? This is a much mooted question in connection with valuation in general and requires some care in answering. One purpose in revaluing physical property items is, as it is for any asset, to restate the book value and make it correspond to the present value. Now in the assets comprising the other classes, i.e. intangibles and securities, the market can be relied upon to furnish the information. That is, a rather definite figure can be obtained for valuation purposes on the basis of mar- ket information. This figure is obtained, as was stated in the discussion above, through the use of the market rate of interest in discounting revenues which are known. The market is not available, however, for this purpose in the revaluation of the ordinary tangible assets. The revenues are uncertain to say the least and a discounting process cannot be used. Since cost is the basis of the original valuation, it is but natural to expect future valuations of the same asset to be in some way based on cost, but the market cannot be relied upon here, either, as there is no market for second-hand machinery, build- ings, and the hke which can be used for valuing such items in use. The estimate or appraisal of the engineer is, therefore, substituted for the market test, and this practice has given rise to the basis of valuation on cost of reproduction less deprecia- tion or, in some cases, original cost less depreciation. That is, a judgment as to cost and accrued depreciation is substituted for a market test. The judgment of the engineer or of the manager cannot be relied upon to furnish accurate measurements of depreciation on the basis of inspection or mere physical measurement. A pair of calipers cannot be used for measuring the extent to which a machine which is still being operated in its entirety has depreci- ated. Physical measurements can be used for revising estimates of the probable service life, but value expiration cannot be ob- tained in such a way. The only way left open for making such revaluations is by spreading the depreciation charge in the ex- pense accounts over the life of the property item. At any time 348 PRINCIPLES OF ACCOUNTING ,the book value is the difference between the original cost and the amount charged to expense for depreciation. It is not the purpose of this chapter to discuss the methods of measuring depreciation and the resultant valuing of tangible property on this basis. This question is discussed in Chapter XXIII. Enough will have been said here by mentioning the fact that in the more approved methods of accounting for de- preciation interest is usually considered as a factor. At least in the sinking fund, compound interest, and annuity methods, in- terest is indeed one of the most important factors. These methods all recognize to some extent at least that interest is an element which must be shown in the accounts wherever a durable property item is used. The methods by which this factor is brought into the calculation are highly technical and hence can- not be discussed without a considerable knowledge of interest computations such as are given in the next chapter. Finally, it may be said, in summarizing this discussion, that interest calculations enter into the accounting computations at some point or other in every case where time is an important element in the process of production. In some cases it enters as an explicit payment for the service rendered based on con- tract. In other cases there is no explicit recognition by con- tract but it is involved in a discounting process. Again it may enter as an addition to or adjustment of cost figures for purposes of valuation. In fact so important is the question that the next chapter will be given over entirely to the technical computations which commonly present themselves. XVI Interest Calculations There are several reasons for a rather detailed discussion of the formula which are most frequently needed in the solution of accounting problems involving interest. It cannot safely be assumed that the student of accounting either remembers or understands the fundamental interest situations treated in the ordinary arithmetic. Moreover interest computations m^y be very complicated, as in the case of the determination of principal and interest in connection with such securities as bonds ; and the accountant who is to be thoroughly at home in dealing with theories must be thoroughly competent to deal with the mathe- matical principles involved. Bond interest payments, annuity installments, sinking fund contributions, and many other similar items can be properly entered in the accounts only on the basis of mathematicaj computations. Similarly, as was stated in the last chapter, interest calculations are necessary in connection with the valua- tion of certain classes of property such as leases, patents, and other wasting assets and are involved in certain general methods of estimating depreciation. The fact that these situations arise is therefore ample justification for a rather lengthy discussion of the mathematics of interest computations. In fact so important are these calculations that it has seemed best to defer to the next two chapters the discussion of purely accounting aspects of the situations involving the use of these formulae in order that this chapter might be confined to the explicit mathematics of in- terest. the accumulation of principal Perhaps the computation used most frequently in business transactions is that of determining the amount to which a prin- cipal will accumulate in a given period at a certain rate of in- terest. While most of such computations are made at compound 349 35° PRINCIPLES OF ACCOUNTING interest rates, the fact that occasionally a contract is made at the simple rate makes necessary an analysis of the two kinds of computations. At the risk of attempting to explain the obvious, therefore, the following elementary definitions are given as a basis for the discussion in this and succeeding sections of the present chapter. The unit of time used in interest calculations is the year. The total interest accruing on one unit of principal (the dollar) in one year is the rate of interest. Compound interest results from adding interest to the principal at stated intervals, and allowing interest to accrue on the sum for the succeeding periods. Simple interest accrues if no interest is added to the principal in this manner. The number of periods per year at which interest is added to the principal for compounding is called the frequency of conversion. If a principal of $100.00 were invested at 6 per cent simple interest for five years, it would accumulate according to definition as shown by the following table. (I) (2) (3) (4) Year Principal on which Interest is Computed Interest during Year Sum at End of Year I $100.00 $6.00 $106.00 2 100.00 6.00 112.00 3 100.00 6.00 118.00 4 100.00 6.00 124.00 S 100.00 6.00 130.00 The total interest for the five years is five times the interest for one year or $30.00. A formula may easily be developed on the basis of such a schedule. Using the symbol P to represent the principal ; S, the sum to which the principal will accumulate ; i, the rate of interest ; and n, the number of years ; the following equation is evidently true, S = P-{-Pni or, (i)i 5 = P(i + ni) ' The more important formulae will be numbered in order that reference may easily be made to them. INTEREST CALCULATIONS 351 This is the standard equation for the accumulation of a principal at simple interest. Thus, in the above illustration, P is $100.00 ; w, 5 ; and i, .06 (or 6 per cent). The substitution of these quantities in formula (i) gives the following, 5 = 100(1 + -30) = 130.00 If, now, a principal of $100.00 were invested at 6 per cent com- pound interest convertible annually, the corresponding amounts would be as follows : (I) (2) (3) (4) Yeak Peincipai, on which Interest is Computed Interest during Year Sum at End or Year 1 $100.00 $6.00 $106.00 2 106.00 6.36 112.36 3 112.36 6.74 119.10 4 119. 10 7-iS 126.25 S 126.25 7-S7 133.82 The formula which expresses the accumulation for one year is the same in this case as for simple interest because the compound- ing process is not performed until the end of the first year. There- fore the formula for the first year is 5 = P(i + i) (from formula (i) when w is i). Now the sum for the second year is obtained in a hke manner except that the principal at the beginning of this year is the sum from the preceding year. Then S = P(i -|- j)(i + i) = P(i + tf- Again, the sum at the end of the third year would be equivalent to P(i -|- f)^(i -\-'i), or P(i + if. Generalizing from this reasoning it may easily be seen that the sum to which the principal P would accumulate in n years would be expressed by the formula. (2) 5 = P(i + if This formula may be used for finding the amount to which a principal will accumulate in any number of years at a given rate 352 PRINCIPLES OF ACCOUNTING of interest, convertible annually. Thus, in the illustration just given, the principal (P) is loo, the interest (i) is .06, and the number of years (n) is 5. Substituting these figures in equation (2) gives, S = 100(1.06)' = 133-82 which is the same result as shown by the table. The term (i + i)" in the right-hand member of equation (2) expresses the accumulation of one dollar at rate i for n years. This can be shown very clearly by assuming that the principal (P) is one. The formula then becomes, (3) s = (i + ir Now this expression contains but two variables, i and n, which makes it very convenient to construct a table for values of S. Such a table is of a great deal of service in finding the accumula- tion of principal sums since the S in equation (3) multiplied by the principal gives the value of 5 in equation (2). For an il- lustration of such a table see Table I in Appendix B. Here the different rates of interest are shown at the heads of the various columns while the numbers of years are shown in the columns at the sides of the page. Thus to find the accumulation of one dol- lar at 6 per cent convertible annually for five years refer to the column headed "6 %" and opposite the figure 5 in the column headed "w." The required quantity is 1.3382256, the value of 5 in equation (3) for the conditions assumed. Now if the prin- cipal were $100.00, the sum could be found by substituting for (i -|- i)" in formula (2), the quantity found in the table. 5 = 100(1.3382256) = 133-82 This result is identical with the accumulations shown in the two preceding computations. The saving in computation effected through the use of the interest tables is evident. Of course whenever a computation involves a rate of interest not given in the tables equation (2) must be solved in detail. Interest is compounded more frequently than once a year in a great many transactions. The accumulation of a principal in INTEREST CALCULATIONS 353 such cases is illustrated in the following table which shows the accumulation of $100.00 for five years at 6 per cent, interest con- vertible semiannually. (l) (2) (3) (4) Period Principal at Begin- ning OF Period Interest during Period Sdmat End of Period I $100.00 $3.00 $103.00 2 103.00 3 -09 106.09 3 106.09 3-18 109.27 4 109.27 3-28 1I2-SS 5 II2.5S 3-38 115-93 6 115-93 348 119.41 7 119.41 3.58 122.99 8 122.99 3-69 126.68 9 126.68 3.80 130.48 10 130.48 3-91 134-39 It is evident from this table that if the half-year period is taken as the unit of time, the rate per period as the interest rate, and the number of periods as twice the number of years, in place of the year, rate per year, and number of years respectively, the sum accumulates in conformity with equation (2). If the stated annual rate is represented by j, and the frequency of conversion by m, then the rate per period would hej/m, and the number of periods, mn. The formula for the accumulation in this case would therefore be, (4) S = P{t. + jlmY^ To illustrate the use of this equation, consider the principal as $100.00, the nominal rate of interest as 6 per cent convertible semiannually, and the period of accumulation as five years. The substitution of these quantities in equation (4) gives the following, 5=.o(.+fy = 134-39, the same result as was obtained in the table shown above. Table I in Appendix B can also be used as an aid in solving 354 PRINCIPLES OF ACCOUNTING equation (4). This is evident by an inspection of the term (i + i/w)"", which is the same in form as the term (i + i)" in equation (3). Thus when the nominal rate is 6 per cent convert- ible semiannually for five years, the expression (i + i/w)""" be- comes (i -1- .03)^". Now for convenience in computation, 3 per cent can be considered as the rate and that column referred to in the table. Further, 10 can be considered as the number of periods as shown in the column headed "n." The amount opposite 10 in the 3 per cent column, 1.3439164, is the value of the expression (i -1- y/w)"" in the case assumed. This quantity substituted in the original equation gives, 5 = 100(1.3439164) = 134-39 When interest is converted more frequently than once a year, the stated rate without compounding is called the nominal rate, while the rate actually realized in one year is called the effective rate of interest. In the illustration above, for example, the nominal rate is 6 per cent convertible semiannually. The ef- fective rate may readily be found by dividing the total interest accruing in the year, $6.09, by the principal at the beginning, $100.00, which gives 6.09 per cent. A mathematical expression for the relation between the effective and nominal rates may easily be obtained from the definition given. Thus the amount to which one dollar will accumulate in one year at the nominal rate/ is (i -|- _//«)"■- The total interest earned is (i -|- j/m)"' — i . But the total interest on one dollar in one year is the effective rate, therefore, (S) i = (i -\-j/mY- I In the problem just given, where the nominal rate was 6 per cent convertible semiannually, the effective rate may be found by this formula, , ,^ , •• = (■ + ?)-■ = .0609 or 6.09 % The converse of this problem, that is the determination of the nominal rate which will produce a given effective rate, may be solved from formula (5). In this case i and m axe known, but ; INTEREST CALCULATIONS 355 is the quantity to be found. Solving equation (5) for/, the result is, (6) j = w((i + iy'"^ — 1} Thus if it is desired to extend a loan at an effective rate of 6 per cent, and the interest is to be converted semiannually, the nom- inal rate which should be employed may be found from equation ^^^- i=2{(i.o6)*-i}=5.96% THE PRESENT VALUE OF A FUTURE SUM In the preceding section, formulae were developed which ex- press the accumulation of a principal at simple interest, at com- pound interest convertible annually, and at compound interest convertible m times a year. The converse of each of these prob- lems very frequently arises in commercial practice. Stated in general terms the problem is to find the present value of a definite sum known to be due at a definite date in the future. Such a sum may be discounted with the use of a discount rate or with an interest rate, either of which computations gives a different re- sult. To bring out the points of difference, both methods will be illustrated in this section. When a deduction is made from a sum due at a future date to determine the present value, the amount deducted is called dis- count, and the process is called discounting. The amount de- ducted is in fact interest, however, and this fact should be kept clearly in mind. The difference between the present value and the future sum is interest even though the computation is made on the basis of a future sum. Viewed either from the standpoint of the borrower or the lender, discount may be defined as the consideration for the use of the present value (principal). The total discount on one dollar of the sum due in one year is the rate of discount. The formula for finding the present value of a future sum at simple discount may be developed directly from the definition. Thus, if P represents the present value, S, the sum due, n, the number of years, and d, the rate of discount, then P = S - Snd or (7) P = S(i- nd) 3S6 PRINCIPLES OF ACCOUNTING For example, if a Sum of $100.00 due in five years were discounted at the rate of 6 per cent simple discount, the present value would be $100(1 — .30) or $70.00. The rate of simple discount is com- monly used in banking transactions for short-time loans, such as thirty, sixty and ninety-day paper ; but it is very seldom used for transactions covering a period of more than one year. Compound discount is only of theoretical interest as it would practically never be used in actual practice. The reason for this is evident. In compound discount the discount is deducted from the sum due at stated intervals and the rate is appHed to the remaining sum; and since the rate would be applied to a continually decreasing sum this would result in a smaller total discount than would be found by the application of the simple rate. The total interest involved in the transaction would there- fore be less with compound than with simple discount. This may be made still more evident by reference to the following table which shows the compound discount on a sum of $100.00 due ia five years at 6 per cent discount, convertible annually. (1) (2) (3) (4) Yeae Sum Due at End of Year Discount for Year Present Value at Beginning of Year s $100.00 $6.00 $94.00 4 94.00 5-64 88.36 3 88.36 S-30 83.06 2 83.06 4.98 78.08 I 78.08 4.68 73-4° The present value of the sum in this case is $73.40 as compared with $70.00 when the simple rate is used. The equation for compound discount may be developed directly on the basis of the table shown above. Using the same symbols as before, the present value at the beginning of the nth year would be, by equation (7), P = S{i — d). The present value at the beginning of the year (n — i) would be found in the same manner (substituting 5(i — d) for S in formula (7)) to be, P = S{i-d){i -^)=5(i - df INTEREST CALCULATIONS 3S7 At the beginning of the year (n — 2) the present value would be, 5(i — dy, found in the same manner. The formula for the present value at the beginning of the first year would therefore be, (8) P = S{i- d)" Substituting the quantities from the table above, P = 100(1 - .o6)s = 73-40 Instead of applying the compound rate of discount to a sum due, it is customary to discount the sum at a given rate of interest. The question asked in such cases is, "what present sum will accumulate at a given rate of interest to the sum due in the future?" When this question is asked the sum in the future is known and so is the rate of interest to be realized, but the present value is unknown. That there is a relation between the rates of discount and interest which is capable of mathematical expres- sion is evident. The total discount on the sum due is the total interest on the present value, but the rate of discount in a given case is not equal to the rate of interest. For example, if $100.00 due one year from date were discounted at 6 per cent, the discount would be $6.00, and the present value, $94.00. The difference between the present value and the sum due is interest. Consid- ering the present value, $94.00, as the principal now, and $6.00 as the interest, the rate of interest is obviously 6/94 or 6.38 per cent. In other words, a 6 per cent rate of discount produces a 6.38 per cent rate of interest on the present value. The relation between the rates of discount and interest in a given transaction is of sufi&cient importance to be expressed in equation form. The problem may be stated in this form, what rate of discount apphed to a sum due will produce such a present value that a given rate of interest will be realized on the present value? Equations (2) and (8) may be solved as simultaneous equations for this problem, since by hypothesis the terms P and S must be the same in each case. Therefore, from equation (2), S/P = (i -{- i)" and, from equation (8), S/P = ^--. Then 3S8 PRINCIPLES OF ACCOUNTING (i + i)" = • s-nd solving this gives, (i — d)"' (9) d i + i If it is desired to determine the compound rate of discount which, when appUed to a sum due, will produce a 6 per cent rate of interest convertible annually on the present value, this equa- tion is of service, for example, d=. '— 1+ .06 = .0566 or 5.66 % On the other hand if the rate of discount applied to a sum due is 6 per cent, and it is desired to find the rate of interest realized, equation (9) can be solved for i and the substitutions made. (10) i — I — I I — .06 = .0638 or 6.38% Equation. (9) is by far the more important for practical pur- poses. A sum may be discounted very readily at a given rate of interest by use of this formula. Thus if the value of i in this formula is substituted for d in formula (8), P = 5 -(-ttt) + which, when simplified, becomes, (11) P = S^ (I + iY To illustrate, if a sum of $100.00 due in five years is discounted in order to realize a 6 per cent rate of interest convertible annually on the present value, then from equation (11), P = 100- (i -f .oty = 74-73 INTEREST CALCXJLATIONS 359 That is, if $74.73 were invested to-day and $100.00 were received in return at the end of five years, the investor would realize 6 per cent interest convertible annually on his investment. Referring once more to formula (11), it may be seen that when the sum 5 is i, the equation becomes, (12) P = (i + j)" The right-hand side of this equation is the reciprocal of the right side of formula (3). In other words, the present value of one dollar in n years at rate i is the reciprocal of the accumulation of one dollar at rate i for n years. If a table of values for formula (3) is available, the corresponding value for formula (12) may be found by the process of simple division. Table II in Appendix B gives the values of P in equation (12) for several different rates of interest and for periods ranging from one to fifty. The use of this table may be conveniently illustrated by assuming that it is desired to find the present value of $100.00 due in five years at 6 per cent interest convertible annually. Referring to the column headed 6 per cent, the quantity .7472582 is found op- posite the fifth period. This is the present value of $1.00 due in five years, and the present value of $100.00 is of course one hun- dred times this quantity, or $74.73. Or the result may be found by substituting the quantity found in the table in formula (11). P = ioo(. 7472582) = 74-73 Formula (11) gives the present value when interest is convert- ible annually. In order to find an equation to express the pres- ent value when interest is converted more frequently than once each year, it is only necessary to substitute for i in this equation its equivalent in terms oij and m from formula (5). This gives, (13) P = s (i -\r j/mY Thus if the $100.00 sum mentioned in the preceding illustration were discounted at the nominal rate of 6 per cent convertible semi- annually, the present value could be found from the equation, 360 PRINCIPLES OF ACCOUNTING P — 100 (i + .06/2)1' The last term in this expression can be found in Table II in the 3 per cent column opposite the tenth period (.7440939). There- fore, P = ioo(.7440939) = 7441 If a simi of $74.41 were placed in a fund to accumulate at 6 per cent, convertible semiannually for five years, it would amount to $100.00 at the end of the period. THE ACCUMULATION OF AN ANNUITY In the section before last, formulae were developed which ex- press the accumulation of a principal at compound interest. It is the purpose in this section to present the formulae for expressing the accumulation of an annuity. An annuity may be defined as a series of payments made at equal intervals during a length of time specified by contract. Each payment, for the purposes of the immediate problem, may be considered as a principal which accumulates at the given rate of interest to the end of the life of the annuity. Each payment will, therefore, accumulate in conformity with the equation for the accumulation of a prin- cipal sum. For example, if an annuity of $100.00 per year pay- able at the end of each year accumulates at the rate of 6 per cent convertible annually for five years, to what sum does it accumulate ? The following table shows the situation and gives the answer to the question. Year Paxment at End or Year Accumulation to End of sth Year I 2 3 4 5 $100.00 100.00 100.00 100.00 100.00 $126.25 119. 10 112.36 106.00 100.00 Total Accumulation $563-71 INTEREST CALCULATIONS 361 The first payment of $100.00 made at the end of the first year will accumulate for four years at 6 per cent convertible annually. This, by formula (2), would be, S = 100(1 + iy = $126.25. The second payment likewise would accumulate for three years, 5 = 100(1 + iy = $119.10; the third payment for two years, S= 100(1 + i)^ = $112.36; the fourth for one year, 5 = 100(1 + i)= $106.00; and the fifth does not accumulate as it is paid at the end of the period. The whole annuity will accumulate to the sum of these quantities or $563.71. A general formula for the accumulation of an annuity may readily be developed from the preceding discussion. If Sn rep- resents the sum to which the annuity will accumulate in n years at rate i, convertible annually, and R the annuity payment, then Sn = R{i + iy-"- + i?(i + i)"~' + R{t- + iy-^ - R{i + i) + R = R{(i + iy-^ + (i + iy-^ + (i + iy-' + - + (i + ^) + 1}. The expression inside the brackets on the right side of this equa- tion is a geometrical series which may be summed to the expres- sion, (i + iy — J i Therefore : (14) s. = r (^+^^:-^ The use of this equation will be evident if instead of using the table of accumulations in the illustration immediately preceding, use be made of formula (14). + .06)5 - i)\ ?„ = 100 f — = 563-71 .06 In case the annuity payment is one dollar, R in formula (14) is I, and for convenience the equation may be written in this form, / N . {1 + iy - I (is) Sn = ■ -. This equation expresses the accumulation of one dollar per year for n years at the rate i convertible annually. An interesting observation may be made in regard to the term on the right-hand 362 PRINCIPLES OF ACCOUNTING side. The numerator is the total interest on one dollar for n years and the denominator is the rate of interest. The equation may be solved by finding the amount to which one dollar will accumulate to the end of the period, subtracting i, and divid- ing by the rate of interest. Since there are but two variables in this expression, moreover, the values of Sn for different rates of interest and periods of time may conveniently be arranged in tabular form. This is what is done in Table III of Appendix B. This table is of service in finding the accumulation of annuities similar to the one already used in the illustration above. In Table III in the column headed 6 per cent the amount for five periods is 5.6370930. This amount substituted in equation (14) gives, Sn = 100(5.6370930) = 563-71 Another kind of case arises when the annuity payments are made in installments more frequently than once a year and in- terest is convertible the same number of times per year. For example, if the annuity just mentioned in the preceding illus- tration were payable in semiannual installments and the rate were 6 per cent convertible semiannually, what would be the sum accumulated ? It may readily be seen that the result would be the same as though an annuity of $50.00 per year were ac- cumulated for ten years at 3 per cent convertible annually. This fact may be expressed in the following formula, . o _ i?f (i -fj/m)'""— I (,IO; Jmn < / • I s m [ ij/m) _ioof (i-f .03)^°- I 1 2 1 -03 1 The value of the term in the brackets may be found in the column headed 3 per cent, opposite the tenth period in Table III. This amount, 11.4638793, substituted in the equation gives, S^r. = 50(11.4638793) = 573-19 Formula (16) is merely a restatement of (14), the period being INTEREST CALCULATIONS 363 changed from the year to i/mth part of a year, and the rate of interest to the rate per period. ' A different case arises when the payments are made at the end of each year but the interest is converted m times per year. For example, if $100.00 is placed in a fund at the end of each year for five years, but the interest is converted semiannually, what would be the accumulation? The following table illustrates the situation. End of Year Payment to Fund Expression toe Accujto- LATION TO THE END Or STH Year AcCtTMtrlATrON at 6% Convertible Semi- annually I $100.00 100(1 +i/«)' $126.68 2 100.00 100(1 +j/m)'^ 119.41 3 100.00 100(1 +j/my 112. S4 4 100.00 100(1 +j/my 106.09 S 100.00 100.00 Total . . $564.72 An equation to express the general case of this type may be de- veloped by substituting for i in equation (14) its equivalent in terms oij and m from equation (5). This gives, (i + i/m)"'" - I ' (17) 5n""' = R (i + j/m)" A table could be prepared for the expression in the brackets but as this problem does not frequently arise in accounting practice one has not been included in this text. Table I can be used, however, to aid in its solution. The term (i -\-j/m)'^ in the numerator and the term (i + j/m)'" in the denominator can both be obtained from this table. In the illustration just given, for example, the numerator would be, (i + .03)1" - I = 1. 3439164 - I and the denominator, (i + .03)^ — I = 1.0609 ~ I Dividing the numerator by the denominator, the result is : •3439164 H- .0609 = 5.64722 364 PRINCIPLES OF ACCOUNTING Substituting this quantity in equation (17) the result is, SJ"'^ = 100(5.64722) =^ 564.72 There is still one further possibility which should be discussed in this section. The annuity payments might be made at cer- tain intervals throughout the year and the interest compounded at different periods. Suppose for example that an annuity of $100.00 per year is payable in four equal installments but that interest is converted but twice a year at the nominal rate of 6 per cent. This case may be placed in tabular form as follows : Period Payment Expression for Acotmula- TioN TO End of sth Year accukdlation Amount at End OP 5TH Year I $25 25(1 +.03)'^ $33-'^° 2 25 25(i+-03)\ 32.62 3 25 2s(i + .03)85 32.14 4 25 2S(i + -03)' 31.67 5 25 25(i+-03)'* 31.20 6 25 25(i+-03)' 30-74 7 25 2s(i+.o3)«4 30.29 8 25 25(i+-o3)^ 29.85 9 25 25(i+-P3)=^ 29.41 10 25 25(i+-03)\ 28.98 II 25 2s(i-|-.o3)^* 28.56 12 25 25(i + .03)^ 28.14 13 25 25(i + .03)^^ 27.72 14 25 2S(i+-03)\ 27.32 IS 25 25Ci + -03)^' 26.92 16 25 25(1 +-03)^ 26.52 17 25 25(1 +.03)'^ 26.13 18 25 25(1 +.03)^, 25-75 19 25 2S(i+-03)* 25-37 20 25 25.00 Total . . $577-43 The first payment is made at the end of three months and ac- cumulates for four and three-fourths years. As this principal will accumulate in accordance with formula (4) where n is 4f and TO is 2, the exponent is therefore 9I. As the second payment INTEREST CALCULATIONS 365 at the end of six months accumulates for four and one-half years, the exponent is 9. The accumulation of the whole annuity is the total of the sums of each one of the payments as shown by these expressions.* The only new complication here is the use of fractional exponents, and the computation can be abbreviated through the use of logarithms. A general equation covering this case can be developed through the summation formula for geometrical series. If the symbol p represents the number of payments made per year, and all other symbols are used as before, then Sn^^'> = R\{i +i/OT)'"<"-i'''^' + (i +j7w)'»("-2/*) + (i +y/w)"'"'-3/*) H h (i +j/m)"''P + 1} The right-hand member of this equation is a geometrical series. Substituting the summation of this series in the above equation gives, (18) 5 (*> = R- (i +i/w)""' - I " / (i ■\-jlmYl* - I To illustrate the use of this formula take the illustration in the preceding paragraph. Here R is $100.00 ; /, 4 ; y, 6 per cent ; and m, 2. Therefore, 5 «) ^125 (i + .03)1° - I 4 (i + -03)* - I = 577-43 The only term in this equation which is somewhat difficult to obtain is (i + -03)^. This cannot usually be found in ordinary interest tables such as are given in the back of this book but with the use of logarithmic tables the solution is greatly simplified. PRESENT WORTH OF AN ANNTJITY What is the discounted present value of an annuity? This question is evidently the converse of that discussed in the pre- ceding section. The answer to this question can also be de- veloped in a similar manner for it is evident that the discounted value of all annuity payments must be the sum of the discounted values of each payment. Further, the present value of each 366 PRINCIPLES OF ACCOUNTING payment may be found from the formulce in the second section in the chapter. To make the problem concrete, what should be the purchase price of an annuity of $100.00 per year payable at the end of each year for five years, if the investor desires to realize 6 per cent con- vertible annually on his investment ? He is investing in five sums due at different times, and the following table shows the present value of the series as determined from formula (11). The first $100.00 payment P = 100 I + .06 — $94-34 The second $100.00 payment P = 100 I = 89.00 (I + .06)2 The third $100.00 payment P = 100 I = 83.96 (I + .06)' The fourth $100.00 payment :P = 100 I = (I + .06)* 79.21 The fifth $100.00 1 payment P = 100 I = 74.73 (I + .06)^ The present value of the annuity $421.24 That is, if the investor turned over $421.24 and received in return an annuity of $100.00 per year for five years, he would realize 6 per cent interest on his investment. A general formula for expressing the present value of an annuity can easily be developed, li An represents the present value of an annuity of R per year for n years, at the rate i, then 4„ = i?|-4— + — ^— -+-^— + ••'• + The term in the brackets is a geometrical series which can be summed to the expression : (I + iy INTEREST CALCULATIONS 367 Placing this expression in the above equktion, it becomes, I (19) ^„ = R (i+iT Thus, the present value of the annuity in the illustration given above would be, I An = 100 (i + .o6)« .06 = 421.24 In case the annuity payment is one dollar, equation (19) may be written, I (20) _ ^ (i + i)" This is the expression for the present value of one dollar per year for n years at rate i. The numerator of the fraction is one minus the present value of one dollar due n years from date, while the denominator is the rate of interest. Computations from this formula would be quite simple in most cases, but Table IV in Appendix B gives the values of ^„ for several different rates of interest. For example, the present value of one dollar per year for five years at 6 per cent (4.2123638) may be found in the column headed 6 per cent and opposite the fifth period. This quantity substituted in formula (19) for the preceding illustra- tion gives, An = 100(4.2123638) = 421.24 Now as a second case suppose that the annuity payments of $100.00 are in semiannual installments and that the interest rate is 6 per cent convertible semiannually. The present value of this annuity is the same as an annuity of $50.00 per year for ten years at 3 per cent convertible annually. Expressed in general terms this question would be, what is the present value of an annuity of R per year payable m times per year for n years 368 PRINCIPLES OF ACCOUNTING at the nominal rate of j convertible m times per year ? The equa- tion for this is, (21) A =^\ m (i 4-i/»w)"" j/m In the problem as stated the amounts would be, I '^mn lOO (l + -03) 10 •03 = 50(8.5302028) = 426.51 The value of the term in the brackets is found in Table IV in the 3 per cent column opposite the tenth period. Valuations of annuities of this class can be made in this manner with the aid of Table IV. A somewhat different situation arises when the annuity pay- ments are made annually but the interest is convertible m times per year. The formula for this case can be obtained by sub- stituting for i in equation (19) its equivalent in terms of ^' and m, which gives, (22) An Cm) _ R I — (i -1- ilmY'^ (i -|- jlm)'^ — I If the annuity payments of $100.00 for five years are made at the end of each year, for example, and the interest rate is 6 per cent convertible semiannually, formula (22) can be used as follows. Ar' = 100 (i + .03) 10 (i -f .03)2 - I The second term in the numerator of the fraction in this formula can be found in Table II, in the 3 per cent column. The amount for the tenth period (■^— ; — TTFo) ^^ •744°939- The first term V(i + -03) INTEREST CALCULATIONS 369 in the denominator, (i + .03)^, can be found in Table I, in the 3 per cent column and for the second period, 1.0609. Substitut- ing these quantities in the above equation the result is, ^„<'">=iooJ ^--744°939 l I 1.0609 ~ I i = 420.21 This illustrates the common cases of this type. Tables have not been prepared for the values of the expression -^ — - — — — - — (i + i/w)"' - I therefore the fraction must be solved in the detail form as shown. A third type of cases arises when the annuity payments are made p times per year but interest is converted m times per year. For example, what would be the purchase price of an annuity of $100.00 per year, payable in four installments of $25.00 for five years at 6 per cent convertible semiannually? This case can be presented in tabular form as shown on page 370. Formula (13), P = S ; , is used to obtain thepres- (i +77m)"'" ent value of each payment. Thus for the first payment, m is 2 and n, \, and the exponent of (i +///»)"" is therefore |. For the second payment, w is 2 and n, |, which makes the exponent i, etc. Moreover as the present value of the annuity is the pres- ent value of all of the payments, the general formula would evidently be, A ^ = R\ (i -|- y/w)""'' {1+ j/m)'^'^'^ (i -|- y/w)"'^' + (i -Fy/w)"'"-'^^' (i -h j/mY The term in the brackets is a geometrical series which can be summed to the expression. I — I (i -t-j/w)"" p {1 + j/mT'^ - I 37° PRINCIPLES OF ACCOUNTING Period Payment Expression for Present Value Present Value 3 4 5 6 7 8 9 13 14 IS i6 17 i8 19 20 Total $25 2S 25 25 25 25 25 25 25 25 25 25 25 25 25 25 25 25 25 25 25 25 25 25 25 25 25 25 25 25 25 25 25 25 25 2S 25 25 25 25 (I + .03)i I (1 + .03)1 I (1 + .o3)'i I (I + .03)^ I (I + .o3n I (I + .03)' (X + .03)^1 I (X + .03)* (x + .03)4 (I + .03)^ 1 (I + .03)4 I (x + .03)= (I + .03)H (X + .03)' I (1 + .o3)'i 1 (I + .03)' I (x + .03)4 (I + .03)^ I (1 I (l + .03)^° $24.63 24.27 23.92 23-56 23.22 22.88 22.54 22.21 21.89 21.56 21.25 20.94 20.63 20.33 20.03 19.74 19.44 19.16 18.88 18.60 $429.68 INTEREST CALCULATIONS 371 Placing this expression in the equation the result is, R (23) (p) (i -\- j/mY {i-Vj/mT'"- I The only part of this equation which is difficult to solve is the term (i + j/m)'^'^ when p is greater than m. In such cases it is usually necessary to use logarithms to extract the root indicated by the fractional exponent. The expression in the numerator can be obtained from Table II. To illustrate the use of this formula, take the case just given. Here, (p) 100 4 I — (i + .03)^ . (i + -03)^ - ] = 429.68 There is still one further case in the valuation of annuities of sufficient importance to be mentioned in this section, namely a perpetuity. If an annuity of R per year is payable perpetually, the value can be obtained from formula (19). In this case, 11 is infinity and the equation becomes, I A,, = R- (I + iY The fraction • (i + i) tion can therefore be written, —^ is zero in any case, however, and the equa- (24) A.-^. " t Thus a perpetuity of $100.00 per year is worth at 6 per cent, ICO or $1,666.67. This method of valuing perpetuities is used very frequently, particularly in placing values on capital stock. A share of stock with a par value of $100.00 on which a dividend 10 of 10 per cent is consistently paid, for example, will sell at —r or $166.67, if valued at the rate of 6 per cent. 372 PRINCIPLES OF ACCOUNTING SINKING FUND CONTRIBUTIONS The contract covering a bond issue frequently imposes upon the issuing corporation the responsibility of accumulating a fund for the purpose of retiring the bonds at maturity. Con- tributions are made to the fund in the form of annuity payments and usually these bear interest which is also added to the fund. In such cases it is desirable to make the annuity payment just large enough to permit the fund to accumulate with the' interest additions to the desired sum and no more. That is, if the fund must accumulate to $1,000.00 at the end of five years, the annuity payment will evidently be less than $200.00, the actual amount de- pending on the rate of interest which can be earned by the fund. Stated in general terms, the problem is to determine the annuity payment which will accumulate to a definite sum in the future at a given rate of interest. Equation (14) expresses the sum to which an annuity of R per year will accumulate in n years at rate i. The present problem is merely the converse of this and may be solved by finding the value of R in that equation. Thus since, 5„ = i^{(L±f^} ^''^ ^ = ^"{(7:fV^} If the fund is to accumulate to $1,000.00 in five years at 4 per cent convertible annually then, .04 ^ ^ = ^'°°° (1.04)^ - I = i,ooo(.i84627i) = 184.63 The sinking fund payments of $184.63 will accumulate in five years to $1,000.00, as shown by the following table : INTEREST CALCULATIONS 373 (l) (2) (3) (4) (s) Year Fund at Beginning Interest on Fund Annuity Payment Fund at End op OP Year DURING Year AT End op Year Year I $ o.oo $ 0.00 $184.63 I184.63 2 184.63 7.38 184.63 376.64 3 376.64 15.06 184.63 576.33 4 576.33 23.0s 184.63 784.01 S 784.01 31.36 184.63 1,000.00 When the amount to be accumulated is i, equation (25) may be written, (26) (i + i)" — I This is the reciprocal of equation (15) and might be written, r = The value of r in this equation can be obtained by taking the reciprocal of the quantity found in Table III at the given rate of interest and for the same number of years. A special table has been included in Appendix B for the value of r in equation (26). To find the annuity payments which will accumulate to one dol- lar in five years at 4 per cent, for example, refer in Table V to the 4 per cent column opposite the fifth period. The amount given here is .1846271, and if the amount to be accumulated is $1,000.00 multiply by 1,000, and the result is $184.63. This is the amount shown in the computation above. If the sinking fund payment of R per year is paid into the fund m times per year, and interest is convertible m times per year, the amount of each contribution may be obtained by solving R equation (16) for — , thus. m (27) j/m (i -1-y/m)"" — I For example, to find the semiannual payment to a sinking fund 374 PRINCIPLES OF ACCOUNTING which will accumulate to $1,000.00 in five years at 4 per cent convertible semiannually, this formula may be used. R f .02 = 1,000 m ^' [(1 + .02)"- The term in the brackets may be found in the 2 per cent column, opposite the tenth period, in Table V. — = 1,000 (.0913265) m = 91-33 That is, $91.33 placed in a fund every six months, -and accumulat- ing at 4 per cent convertible semiannually, will amount to $1,000.00 at the end of five years. THE ANNXriTY WHICH A PRINCIPAL WILL PURCHASE This question frequently arises, particularly in the admin- istration of estates. What sum wiU a certain principal purchase at a given rate of interest ? In this case a certain sum is avail- able for investment and it is desired to determine the annuity in which it may be invested. If the annuity to be purchased is a perpetuity, the question is easily answered. The annual pay- ments will be the principal multiplied by the rate of interest in- volved. Thus the perpetuity which $100,000.00 will purchase at 4 per cent is evidently $4,000.00. But if the annuity is to run for a Hmited period, a more complexj situation arises. If the $100,000.00 is to be invested in a twenty-year annuity at 4 per cent, instead of a perpetuity, for example, what will be the annual payment? Stated in another way, $100,000.00 is the present value of a twenty-year annuity of R dollars per year at 4 per cent, and it is desired to determine the amount of R. Now formula (19) expresses the present value of an annuity of R per year as, INTEREST CALCULATIONS 375 In the present problem ^„ is known but R is not, therefore solv- ing for R the equation is, (28) R (i + irl In the problem under consideration, ^„ is $100,000.00 and the value of R may be found from formula (28). R = 100,000 .04 (I + .04)^° = 100,000 (.0735817) = 7,358-17 That is, $100,000.00 will purchase an annuity of $7,358.17 per year for twenty years at 4 per cent. It may be noticed that the expression is the re- (i + i)» ciprocal of the right-hand member of formula (26). The value of this expression may easily be obtained by taking the reciprocals of the amounts shown in Table IV for the same rates of interest and number of periods. The amount .0735817, for example, may be found by dividing i by the quantity found i"n Table IV in the 4 per cent column, opposite the twentieth period. If it is desired to find the annuity payable m times per year for n years, which a given principal will purchase at the rate /, convertible m times per year, this may be done by solving the following expression for (29) R m — -^ji m j/m (i -\- jlmY If the $100,000.00 fund of the preceding illustration were to be invested in a twenty-year annuity, the payments of which were 376 PRINCIPLES OF ACCOUNTING made semiannually, and interest is involved at the rate of 4 per cent convertible semiannually, then, R — = 100,000 2 .02 (1.02)^0 = 100,000 (.0365557) = 3>6SS-S7 This is the semiannual annuity payment. THE APPORTIONMENT OF ANNUITY PAYMENTS When a principal sum has been invested in an annuity, the in- vestor receives in return both his investment and interest in the annuity payments. In order to keep the investment intact, it is necessary to apportion the annuity payments between the return of the investment and the interest earning. To take a concrete case, suppose that corporation A offers a five-year annuity of $20,000.00 per year, payable in semiannual install- ments, and that Mr. B purchases the annuity on a 5 per cent basis interest convertible semiannually. The purchase price (found by formula (21)) is $87,520.64. Mr. B then invests an estate of $87,520.64 in a security which will pay him $100,000.00 during the succeeding five years. Now it is evident that the interest earned on the whole transaction is $100,000.00 minus $87,520.64 or $12,479.36. But at what time is this interest earned ? Surely a certain part of each annuity payment contains some interest. The question is, how much of each payment is interest, and how much a return of the original investment of $87,520.64? This apportionment is shown in the table on page 377. At the end of the first six months $10,000.00 is received. Since an investment of $87,520.64 was made at the beginning of this period, on a 5 per cent basis interest convertible semi- ahnually, Mr. B has earned 2^ per cent on this amount at the time of the first payment. The amount of interest on this basis is $2,188.02, and $7,811.98, the balance of the annuity payment, is evidently a return of part of his original investment. The INTEREST CALCULATIONS 377 amount remaining invested at the beginning of the second period is $79,708.66, on which 2^ per cent, or $1,992.72 is earned during this period. The balance of the payment, $8,007.28, constitutes a further return of investment. The succeeding annuity pay- ments are apportioned in Hke manner, and when the last payment is received, the total investment will have been returned together with interest on it to the amount of $12,479.36. Further, the interest has been accounted for in the years during which it was earned. The maintenance of the integrity of the accounting period has been sufhciently emphasized in preceding chapters to show the necessity for such apportionment in any case. (1) Half-year Period (2) Investment Beginning or Period (3) Annuity Payment (4) Interest (s) Return oe Investment I 2 3 4 5 6 7 8 9 10 Total $87,520.64 79,708.66 71,701.38 63,493-91 55,081.26 46,458.29 37,619-75 28,560.24 19,274.25 9,756.10 $10,000.00 10,000.00 10,000.00 10,000.00 10,000.00 10,000.00 10,000.00 10,000.00 10,000.00 10,000.00 $100,000.00 $2,188.02 1,992.72 1,792-53 1,587-35 1,377-03 1,161.46 940.49 714.01 481.85 243-90 $12,479.36 $7,811.98 8,007.28 8,207.47 8,412.65 8,622.97 8,838.54 9,059-Sl 9,285.99 9,518.15 9,756.10 $87,520.64 In general, then, annuity payments may be apportioned be- tween investment and interest, (i) by multiplying the rate per period by the investment at the beginning of the period to find the amount of interest, and (2) by deducting the amount of interest thus found from the annuity payment to find the return of principal. In the illustration given, the dates for annuity payments and for converting interest correspond. In case the frequency of conversion differs from the number of annuity payments the interest earned each period can be determined from the proper formula in the preceding section, and the second step would be the same as stated above. 378 PRINCIPLES OF ACCOUNTING THE VALUATION OF BONDS The most common type of contractual security in American finance is the bond. A bond is a security which contains (from the point of view of accounting at least) two promises to pay, m.,(i) a definite sum at a future date, called the par, and (2) an annuity from date of issue until the par is paid, called bond interest. The amount of the annuity payment is usually ex- pressed as a percentage of the par. Thus a five-year, $1,000.00, 4 per cent bond, interest payable semiannually, consists of (i) a promise to pay f 1,000.00 at the end of five years, and (2) an annuity of $40.00 per year payable semiannually for five years. The 4 per cent stated in the bond serves no other accounting purpose than to express the amount of the annuity payment. What, then, is the investment value of a bond ? It is evident that this figure will be the sum of the present values of the two promises to pay. This sum can be conveniently expressed in a formula. If B represents the present value of a bond , S, the par value , and R the annual payment of bond interest, payable m times per year ; and if the nominal rate of interest is j, con- vertible m times per year, the formula for determining the pres- ent value is/ I (30) 5 = _g. I _|_^ (i-Hj/w)""' (i -t-i/w)"" m j/m Thus if the 4 per cent, $1,000.00 bond mentioned in the preceding paragraph were valued on a 5 per cent basis, the equation just given would show. S=iooo.j 1^^ + 40 = 956-24 I (i + .025)1' .025 ' See formula (13) for the present value of a sum, and formula (21) for the present value of an annuity. There are bond tables prepared which give the values of B in this equation for different bond and market rates of interest. The formula may readily be solved in most cases by using Table II for the I I expression f, -, ^ and Table IV for i d -f-j/w)" Vd -\-j/mf"'l \ j/m INTEREST CALCULATIONS 379 If the investor wished to realize 5 per cent convertible semi- annually on his investment, the purchase price of the bond would be $956.24. This figure is called the purchase price or present value of the bond. The excess of par value over the present value is called the bond discount. The accumulation of bond discount between the date of issue and the date of maturity will be discussed in the next section. It will be of interest to find the value of this 4 per cent bond on two other interest rate bases, 4 per cent and 3 per cent for example. If the market rate of interest is 4 per cent, then p _ __ , I (I + -02)^' ij = 1 ,000 { > + 20 < ' ^(l+.62)l»J^ 1 .02 = 1,000.00 In this case the present value of the bond is equal to the par and the bond is said to be sold at par. The bond interest just equals the market interest at each payment date. If, now, the market rate were 3 per cent, the present value would be. B = 1,000 { } + 20 = 1046. 1 1 (I + .015)1' .015 The present value here exceeds the par and the amount of the excess is called premium. The bond is said to be sold at a pre- mium. The treatment of the premium between date of issue and maturity will be discussed in the next section. Bond interest on the ordinary bond is payable twice a year; and interest on bond valuations is usually converted semi- annually. The above formula for bond valuation, therefore, covers most cases which arise in practice. Other conditions are possible, however, such as bond interest payable annually, while interest is convertible semiannually, or vice versa. Or the bond interest might be payable quarterly or oftener while the interest is convertible less frequently, etc. All such cases may be solved by using a combination of the proper equations for the present value of a sum and for the present value of an annuity as given 38o PRINCIPLES OF ACCOUNTING in the preceding sections. It is only necessary to consider the bond as made up of the two parts as suggested. In the illustrations given above, it waS* shown that when the bond interest rate and the rate of interest used in the valuation are the same, the present value is equal to par ; when the interest rate is greater than the bond rate, the present value is less than par ; and when the interest rate is less then the bond rate, the present value is greater than par. Now it may easily be demon- strated that the difference between the par and present value is equal to the present value of an annmty, the annual payment of which is measured by the difference between the bond interest payment and the amount the bond interest payment would be at the market rate of interest. Thus if R represents the bond interest payment, payable m times per year, and I the amount the bond interest payment would be at the market rate, and D, the difference between the par value and present value of the bond, then. (31) D = R- I m (i -{- j/mY j/m If R is less than 7, D is the discount ; if i? is greater than J, D is the premium. For example, the discount on a 4 per cent, five- year, $1,000.00 bond, interest payable semiannually, is, at 5 per cent, I D 40- 50 2 = - 43-76 (i + .025) .025 10 The discount, $43.76, deducted from the par leaves $956.24, the present value of the bond. Now if the same bond is valued on a 3 per cent basis the premium is. D = 40- 30 2 46.11 I — (i + -03) 10 •03 The premium, $46.11, added to the par gives $1,046.11, the pres- ent value of the bond. INTEREST CALCULATIONS 381 ACCUMULATION AND AMORTIZATION It is a fact scarcely needing demonstration that the difference between the amount received from the sale of bonds by a cor- poration and the total of the bond interest payments and par is interest. Yet a failure to recognize this fact has often led to erroneous entries on the books. Too often the bond interest payments alone are considered as actual interest, while discount is considered as a loss and premium as a profit. The impropriety of this reasoning seems fairly evident. If ■$956.24, for example, is received for a $1,000.00, five-year, 4 per cent bond, then the total interest is $1,000.00 plus $200.00 minus $956.24, or $243.76. The question immediately arises, however, as to the accounting periods during which the interest accrues, or what, in other words, should be considered as a net revenue charge in each accounting period during the life of the bond. The interest actually accru- ing in each period for the case just stated, assuming that the rate of interest involved in the valuation is 5 per cent, would be greater than the amount of bond interest paid during the same period. This fact is illustrated in the following table for the accumulation of discount. (l) (2) (3) (4) (5) Haif-Yeae Period Investment in Bond Beginning OF Period Interest on Investment Bond Interest Payment Accumulation [ . $956-24 $23-91 $20.00 $3-91 2 960.15 24.00 20.00 4.00 3 964-15 24,10 20.00 4.10 4 968.25 24.21 20.00 4.21 S 972.46 24.31 20.00 4-31 6 976.77 24.42 20.00 4.42 7 981.19 24-53 20.00 4-53 8 985-72 24.64 20.00 4.64 9 990.36 24.76 20.00 4.76 10 995-12 24.88 20.00 4.88 Total . $243.76 $200.00 $43-76 In column (2) the figures given represent the present value or investment in the bond at the beginning of each half-year period. 382 PRINCIPLES OF ACCOUNTING At the beginning of the first period the value as already stated is $956.24. The amount loaned to the corporation issuing the bond is $956.24 and as the rate of interest involved is 5 per cent convertible semiannually, the amount of interest earned by the bondholder or the amount accruing against the net revenue of the corporation during the first period is 2 J per cent of the amount invested; or $23.91. On this date the corporation pays this interest in part ; $20.00 is paid on account, so to speak, which leaves $3.91 accrued but not paid. This latter amount ($3.91) is added to the investment, as the bondholder's equity in the con- cern has — from an accounting standpoint — increased from $956.24 to $960.15. Now since the investment at the beginning of the second period is $960.15, the interest which accrues in that period amounts to $24.00. But again the corporation pays but $20.00, which leaves $4.00 to be added to the investment. At the end of each period a similar computation must be made in order that the correct amount of interest may be entered in the Net Revenue account. The accounting entries to be made at each date will be discussed in the next chapter. The amount of the accumulation (column (5)) by the end of the fifth year is $43.76. This is just the amount of the original discount, and on being added to the original investment brings that figure up to par. The total interest, $243.76, is thus seen to be paid in two parts ; $200.00 in the form of an annuity and $43.76 in the payment of par at the end of the fifth year ; but the interest earnings are properly recorded in the periods during which they are earned. If this bond were valued on a 3 per cent basis, the present value would be $1,046.11 and the total interest, $1,200.00 minus $1,046.11 or $153.89. The amount of interest for each period is shown in the table (page 3^3) for the amortization of premium. The amount received for the bond at the outset is $1,046.11 ; and since the interest rate is 3 per cent, convertible semiannually, the amount of interest accruing during the first half year is ij per cent of this amount, or $15.69. A payment of $20.00 is made at this time, however, which pays the interest accrual and $4.31 of the investment besides, leaving the investment at the begin- ning of the second period at $1,041.80. Then i§ per cent on this amount gives $15.63, the interest accrual for the second half INTEREST CALCULATIONS 383 year. The $20.00 payment at this time pays this interest and $4.37 of the investment. This process, carried on to the end of the fifth year, reduces the investment to par at the time the bond is paid. The table given below shows the interest accruing in each period in column (3), the annuity payments (bond interest) in column (4), and the amount of the returned investment (amortization of premium) in column (5). The accounting entries concerning this case will be discussed in the next chapter. (I) (2) (3) (4) (5) Half- Year Period invesiment in Bond Beginning OF Period Interest on Investment Bond Interest Amortization of Premium I $1,046.11 $15-69 $20.00 $4-31 2 1,041.80 is-63 20.00 4-37 3 1,037-43 15-56 20.00 4-44 4 1,032.99 15-49 20.00 4-51 S 1,028.48 15-43 20.00 4-57 6 1,023.91 15-36 20.00 4-64 7 1,019.27 15.29 20.00 4-71 8 1,014.56 ' 15.22 20.00 4.78 9 1,009.78 15-15 20.00 4-8s 10 1,004.93 15-07 2O.C0 4-93 Total . $153-89 $200.00 $46.11 DETERMINING THE INTEREST RATE In all of the formulae given so far in this chapter it has been assumed that the interest rate is a known factor. The interest rate is used in the right-hand member of the equations as a factor in the determination of the value of the unknown quantity on the left-hand side. It is possible to have situations arise, how- ever, where the rate of interest involved is the only unknown quantity. This case frequently arises in connection with bond issues, and might arise in any of the other types of securities mentioned in this chapter. Given the purchase price and bond rate of interest on a par- ticular bond, what is the market rate of interest ? A corporation, for example, will offer a certain bond for sale and the purchaser 384 PRINCIPLES OF ACCOUNTING makes his bid at a certain price. The corporation must determine the rate of interest involved in the transaction in order to make the proper entries on its books. In this case all of the quantities in formula (30) are known with the exception of y, and the problem is to determine the value of this term. Theoretically this can be done by solving the equation for 7" but when this is attempted the resulting equation has ternis in the right-hand member that run into such high powers that it is practically impossible to solve in any given case. For this reason the ordinary algebraic method of solution is not resorted to. The only practicable method avail- able is to estimate the rate. When one has become fairly famil- iar with bond valuations he can estimate the rates involved with some degree of accuracy. In order to finally determine the actual rate, however, several estimates are usually necessary; and trials are made until the correct rate is finally obtained. The method of interpolation used in logarithmic tables is of considerable aid in this connection. To illustrate, if i represents the rate involved in the valuation, unknown, and A the present value of the bond, known; then (i) an estimate of the rate is made at i', and the present value of the bond A' found at that rate ; (2) a second estimate of the rate is made at rate i" and the value of the bond A" is found at this rate. If the two rates are fairly close to the actual rate, the following ratio is approxi- mately true, i-i" A- A' i" - i' A" - A' Therefore : A — A' (32) i = i' + „ _ , {i" - i') (approximately) The value of i as found by this formula will usually be near erioughto the actual rate for practical purposes, but if still greater accuracy is desired the rate thus found may be used for a new trial rate and the same operation repeated. By continuing to use the values for i in the equation for new trial rates several times, the rate involved will be obtained to a greater and greater degree of accuracy. Suppose, for example, that a twenty-year, 4 per cent bond is sold for $1,109.66. If the par value is $1,000.00, at what rate INTEREST CALCULATIONS 385 was the transaction consummated ? The rate is probably some- where between 3 per cent and 35 per cent, and these rates may be used as first trial rates. The value at 3 per cent would be $1,149.58, and at 3J per cent, $1,071.49. Using formula (32), then, , (1,109.66 — 1,149.158) , - -"^ + (.:o,;.49-.:.!9.Ssi <-°3S - •°3) - 3.S5 % The rate thus found, 3.255 per cent, although not the actual rate, is probably near enough for practical purposes. In case greater accuracy is desired, 3.255 per cent may be used as a new trial rate with one of the other rates and the process repeated. This same method of interpolation can also be employed in cases where the interest rate involved in an annuity is desired. Here the annuity tables are of particular service. The annuity payments and present value are both known but the interest rate is unknown. Divide the present value figure by the annuity payment figure and the dividend is the present value of one doUar per year at the unknown rate of interest. Look in Table IV for the two quantities which most nearly correspond to this figure for the same number of periods. Then interpolate between the interest rates for these two quantities and the result is the ap- proximate interest rate. Suppose, for example, that the X Company is a mining con- cern. It has $100,000.00 of capital stock outstanding on which it is paying a 12 per cent dividend. It has just been determined that this dividend rate can be maintained for a period of ten years in the future, after which the mine is exhausted and the stock will be worthless. Suppose further that it is agreed that no fund shall be maintained to redeem the stock at the end of the ten years. The stock, from the point of view of the investors, is then a ten-year annuity of $12,000.00 per j'ear. Now an in- vestor with all these facts at hand purchases $10,000 par value of this stock for $10,368.09. What rate of interest does he make on the investment? The $10,368.09 is the present value of an annuity of $1,200.00 per year for ten years. Dividing the first figure by the second gives $8.6400761, and this is the present value of one dollar per year for ten years at the unknown rate. Re- ferring now to Table IV, it may be seen that the nearest quan- 386 PRINCIPLES OF ACCOUNTING titles to this figure for ten periods are, 8.7520639 and 8.5302028 at the rates of 2I per cent and 3 per cent respectively. Then, i — .025 _ 8.6400761 — 8.7520639 .03 - .025 8.5302028 - 8.7520639 i — .025 — .1119878 .005 —.2218611 Solving this for i the result is, i = .02752 or 2.75 per cent approximately. The investor then will realize 2f per cent on his investment. A similar situation arises whenever a return on a security depends on revenue from a wasting asset and no depreciation fund is maintained to reimburse the stockholders at the termination of the enterprise. Most other cases in which the interest rate is the unknown factor are relatively simple and may be solved either directly from the formulae given in the early part of the chapter or by interpolation with the aid of tables as just illustrated. The formulae presented in the foregoing discussion cover the more important problems in interest calculations. No Attempt has been made to discuss the more intricate and complex prob- lems that occasionally arise as those questions belong more par- ticularly to the field of actuarial science than to accounting. SufiBicient examples have been given, however, to illustrate the computations involved in the ordinary transactions met with in accounting practice. XVII Interest Transactions — Equity Accounts The mathematical formula discussed in the last chapter are of a sufficiently general nature to be applied to accounting prob- lems of very different types. They can be used in connection with contractual interest transactions affecting both sides of the balance sheet. This chapter will be devoted to a consideration of the transactions involving contractual interest particularly from the point of view of the equities. In such cases interest is an accrued deduction from net revenue in favor of the equities whose claims are listed among the fixed capital items on the equity side of the balance sheet. The ordinary situations which present themselves in the issuing of the typical forms of securities will be considered, and frequent reference will be made to the math- ematical discussions of the preceding chapter. LONG-TERM NON-INTEREST BEARING NOTES Non-interest bearing notes are frequently used for borrowing in ordinary commercial transactions. Notes of this character are usually of the short-term type, that is for thirty, sixty, or ninety days. Their accounting treatment, already considered in an earher chapter, is relatively simple. Long-term non-interest bearing notes, while very seldom used in practice, present certain ques- tions of sufficient importance, however, to warrant special men- tion. A corporation might find it convenient, for example, to raise capital by issuing a five-year, non-interest bearing $10,000.00 note. The only advantage of such a procedure would lie in the fact that no cash payment would be required on the contract from the date of issue until the date of maturity. Interest would accumu- late, however, in each accounting period, the amount depending 387 388 PRINCIPLES OF ACCOUNTING on the rate involved in the original sale. The investor would give $7,440.94 for this note if the rate of interest involved were 6 per cent, convertible semiannually.^ The entries on the cor- poration's books at the date of issue would therefore be, Cash $7,440.94 Discount 2,559.06 Notes Payable $10,000.00 These entries recognize the receipt of cash in exchange for a promise to pay a larger sum at a future date, the difference be- tween the two amounts being placed in a valuation account. The investment at the outset is $7,440.94, and as interest accrues at the rate of 6 per cent it amounts to $223.23 during the first half year, and the entries at that time would be. Interest $223.23 Discount $223.23 The charge to interest shows an accrual of $223.23 in favor of the noteholder, and since no payment is made, the equity itself in- creases. This increase in equities is recognized by the credit to Discount, for a credit to Discount reduces this valuation account and this in effect increases the equity. Taken together the Notes Payable and Discount accounts now show the present investment ($7,664.17). The interest accrual during the second half year on this amount would be recorded as follows, Interest $229.92 Discount $229.92 The entries for each succeeding period would be made in like manner until the end of the fifth year, at which time the entries recognizing the interest accrual would be, - Interest $291.26 Discount $291.26 The original charge to the Discount account would now be re- duced to zero, and this means that the equity, notes payable, 1 See formula (13), Chapter X\JI, for the method of obtaining the present value of a sum due at a future date. Table II is of service in this case. INTEREST TRANSACTIONS — EQUITY ACCOUNTS 389 now stands at par. Since the note must be paid at this time the additional entries, Notes Payable $10,000.00 Cash $10,000.00 would now be made. Thus the only transactions with the investor directly are the one at the beginning of the first year and the one at the end of the last year. The first transaction recognizes an investment and an equity claim of $7,440.94, the last, the payment of an equity claim of $10,000.00. The entries for the intervening period ex- plain how the equity actually increased from the former to the latter figure. The following table shows in detail how the change occurs. Column (2) shows the investment at the beginning of each period ; column (4) the investment at the end of each period ; and column (3) the interest accrual which is also the in- crease in the investment. On the books, the investment is found in each case by deducting the balance in the Discount account from the credit of $10,000.00 in Notes Payable. (l) (2) (3) (4) Half-year Period Peesektt Valcte Be- ginning or Period Interest ACCTMCIATION I $7,440.94 $ 223.23 $7,664.17 2 7,664.17 229.92 7,894.09 3 7,894.09 236.82 8,130.91 4 8,130.91 243-93 8,374-84 S 8,374.84 251-25 8,626.09 6 8,626.09 258.78 8,884.87 7 8,884.87 266.55 9,151-42 8 9,151.42 274-54 9,425.96 9 9,425-96 282.78 9,708.74 10 9,708.74 291.26 10,000.00 Total .. . $2,559-06 The equity of the noteholder is thus shown to increase steadily from $7,440.94 to $10,000.00, and good financing would demand of the corporation that its assets available for Hquidating this note should also increase by the same amount. That is, the 390 PRINCIPLES OF ACCOUNTING credits to Net Revenue from operation should always be suffi- cient to cover the interest debits. If this is not the case, the capital invested by the noteholder is impaired. It is true that he has no claim for these accruals until the note is due, but failure on the part of the corporation to earn the necessary amount does represent an impairment of capital. The total par of the note must be paid at maturity in any event, and if the interest ac- cruals arp not earned they must be met out of surplus — the stockholders' equity. In case the date for closing the accounts and making statements should not coincide with one of the conversion dates for interest, accuracy of statement requires another adjustment in the ac- counts. Suppose, for example, that the five-year note just mentioned had been issued March 31st, making the dates of con- version March 31st and September 30th, and that the date for closing the accounts was December 31st. It would then be necessary to make an entry covering the interest accrual from September 30th to December 31st each year. The amount of this accrual theoretically should be found from formula (4) . For the end of the first year it would be, S = 7,664.17 (i + .03)4 = 7,664.17 (1.0148892) = 7,778.28 The amount of the interest would be $7,778.28 minus $7,664.17 or $114.11 ; and the journal entries would be. Interest $114.11 Discount $114.11 This entry would cause Net Revenue to be charged with the in- terest actually accruing in the period ending December 31st, and would increase the equity item, notes payable, to its current status. Then at the next interest conversion date, March 31st, the entries should recognize the interest accruing for the remain- ing three months. This amount is found in the same manner as that for the preceding three months, and the entries are. Interest . , . .' $iiS-8i Discount |iiS-8i INTEREST TRANSACTIONS — EQUITY ACCOUNTS 391 The two entries, one for $114.11, and one for $115.81, make up the total interest accrual ($229.92) for the conversion period of six months as shown by the table. Each year throughout the life of the note, the March 31st interest accrual would be ap- portioned between the two accounting periods on this basis. In actual practice the bookkeeper would generally prefer to accrue interest on the simple interest basis for the three months rather than to use compound interest for a fraction of the con-, version period as was done here. His reason for this is two-fold. First, it is much easier to compute the interest at the simple rate than at the compound rate. In the illustration given it would mean the simple division of the six months' interest by two. This result would be charged to Interest at each date, the same entries being made December 31st and March 31st, Interest $114.96 Discount $114.96 In the second place the difference between the two figures is so slight as to be of little importance to any of the equities involved. The difference here, for example, is that when the accurate method is used the December 31st entry is 85 cents less and that of March 31st is 85 cents more than when the entries are made equal by the bookkeeper's usual method. Yet although such a small error on a $10,000.00 note is of little significance, in order to be theoretically correct the first method should be used. ANNUITIES Corporations in America have not as a general rule resorted to the practice of issuing formal annuities for the purpose of raising capital. The chief reason for this fact is that it has been con- venient to finance through bond issues and the pubKc is much more familiar with bonds as an investment security than with annuities. Annuities are, however, a convenient form of security for certain kinds of investment such as trust funds or estates, and there seems to be at present a tendency on the part of cor- porations to cater to this market. This tendency is evidenced by the extensive use of serial bonds. Such securities are prac- tically but one step removed from annuities. 392 PRINCIPLES OF ACCOUNTING In addition to such definite annuities, however, there are a great many contracts which involve annuity computations. The purchase of leaseholds which bear- an annual rental for a defi- nite number of years, copyrights with a definite royalty pay- ment, etc., are cases in point. The accounting treatment of such items often involves many questions of theory and a special chapter has been devoted to these topics. But the annuity aspects of these items are ahke in character and can be ex- plained by the use of an illustration of a definite annuity con- tract. The A. B. Co., a corporation, promises to pay $20,000.00 per year for five years, the amounts to be paid in semiannual install- ments, in exchange for some asset received. The asset received may be cash, a patent, a leasehold, or what not, as explained in the preceding paragraph. For purposes of illustration it may be assumed that the asset received is cash. The amount received would obviously be the present value of the annuity at the market rate of interest for the class of security involved. In case some other form of property were received, the value of the property item would also be the present value of the annuity at the market rate of interest. The property account, Cash in this illus- tration, would therefore be charged with the amount received as determined by the process of valuation shown in formula (21) of the preceding chapter. If the rate involved were 5 per cent convertible semiannually, this value would be $87,520.64. The company receives, then, $87,520.64 and promises to repay $100,000.00 during the succeeding five years. The difference between the two quantities given is, of course, interest. The interest accrues during the intervening period and should be apportioned among the various net revenue statements prepared. The original entries at the date of issue would be. Cash $87,520.64 Discount on Annuity 12,479.36 Annuity Payable $100,000.00 Discount on Annuity is a valuation account, offsetting the Ha- bility account Annuity Payable which shows par rather than present value. At this date the annuity holder's equity in the assets is $87,520.64, but the par value of all the annuity coupons INTEREST TRANSACTIONS — EQUITY ACCOUNTS 393 is $100,000.00 — hence the necessity for a valuation account. The account Annuity Payable is used here to indicate the equity item. If the transaction is of a different type the name used for this credit would of course be different. Thus it might be Leasehold Payable, Royalties Payable, etc., depending on the nature of the contract. The annuity might even consist of a series of notes, non-interest bearing, all covered by the same security. In this case the Notes Payable account would be used. At the end of six months, the first payment of $10,000.00 is made and the entries would be. Annuity Payable $10,000.00 Cash $10,000.00 Interest has accrued up to this time amounting to 2I per cent on the original value, or $2,188.02 ; and this amount must be charged to Net Revenue for the period. The entries are,. Interest .... $2,188.02 Discount on Annuity .... $2,188.02 This reduces the balance in the valuation account. Discount on Annuity, from $12,479.36 to $10,291.34, and the net equity is shown by the difference between this figure and the $90,000 re- maining in Annuity Payable, or $79,708.66. The interest ac- crual for the next period is 25 per cent of this amount or $1,992.72, and the entries at the end of the period would be the same as for the preceding accrual except for the amount of interest involved. This procedure is followed at each payment date throughout the life of the annuity and at the end of the fifth year the balance of the Discount on Annuity account is reduced to zero. The amount of interest at each date may be found from the fourth column of the table on page 377 in the preceding chapter., The Annuity Payable account will always have a credit balance equal to the par value of the unpaid annuity installments and the equity of the annuity holder is always the difference between this balance and the Discount on Annuity balance. In some cases it might be advisable to show the net equity in the Annuity Payable account and therefore not use the discount account at all. Fol- lowing this procedure in the example given, the entries at the date of issue would be, 394 PRINCIPLES OF ACCOUNTING Cash $87,520.64 Annuity Payable $87,520.64 The only objection to this procedure Kes in the fact that at no place does the total liabiHty on account of the annuity appear, and it is quite desirable to have this information presented in the balance sheet in some form. The entries at the first payment date in this case would be, Annuity Payable $7,811.98 Interest 2,188.02 Cash $10,000.00 These entries reduce the balance of Annuity Payable to the present value of the remaining payments, and charge net revenue with the interest accrual. The same procedure would be fol- lowed for each subsequent payment date until the last. This would reduce the balance of Annuity Payable to zero. When the dates for closing the accounts differ from the dates of the annuity payments, it becomes necessary to enter the in- terest accruing from the last payment date to the closing date. Suppose, for example, that the annuity mentioned above was issued October ist and that the books are closed December 31st. The first payment will not be made until March ist, but interest accrues at the rate of 5 per cent convertible semiannually for three months. The total accumulation by formula (4) would be, 5 = 87,520.64 (i -I- .025)^ = 87,520.64 (1.012423) = 88,607.90 The interest accrued would be $88,607.90 minus $87,520.64, or $1,087.26, and the entries, if the first method of accounting for the annuity were used, would be. Interest $1,087.26 Discount on Annuity .... $1,087.26 The amount of the interest accruing for the following three months, up to the next paynient date, may be found by the same method to be $1,100.76, and this accrual calls for similar entries. INTEREST TRANSACTIONS — EQUITY ACCOUNTS 395 On this date, however, a payment of $10,000.00 is made and the regular entry recording this payment must be made. Here again it is customary to use the simple rate instead of the compound rate in accruing interest between payment dates. That is, instead of finding the compound interest for the three months ending December 31st, as was done in the illustrations, simple interest for the period at the rate of 5 per cent per year would be used. This computation would give $1,094.01. The justification for this practice is its obvious simplicity as compared with the other method, together with the fact that the amount of the error is relatively small. BONDS ISSUED AT PAR Bonds are the most common form of security for raising capital exclusive of capital stock. The nature of the bond is quite familiar. It consists, as was shown in the preceding chapter (and earlier in the text), of two promises to pay : (i) a principal sum at a future date ; and (2) an annuity in the form of bond interest payable from date of issue until the par is due. Failure to recognize this two-fold nature of the bond contract has often been the cause of rather serious accounting errors, especially in cases where bonds have been issued either at a discount or at a premium. It would be entirely possible to make the entries covering the two parts on separate bases by treating the par of the bond as a long-term non-interest bearing note, as was shown in the first section of the chapter, and the bond interest as an annuity, as was shown in the preceding section. Entirely accurate results would be obtained from this procedure. It is possible and much more convenient, however, to treat the bond as a unit in the accounts. Further, it is desirable to keep the information in regard to this equity in one account since the right to property and net revenue is vested in a single contractual claim. Current accounting practice, therefore, is to be preferred, if it does not lead to a misinterpretation of the facts. The advantage of treating the bond as a whole is particularly evident when the bond is issued at par. In this case the present value of the par plus the present value of the bond interest pay- ments is just equal to par, and each annuity payment just cancels 396 PRINCIPLES OF ACCOUNTING the accrued interest for the period. The bond is issued at par when the bond rate of interest and the market rate are the same. Thus, a 4 per cent, |i,ooo.oo, five-year bond, interest payable semiannually, would bring par if the market rate were 4 per cent convertible semiannually. The journal entries at the date of issue would be, ' Cash $1,000.00 Bonds $1,000.00 The $1,000.00 entry in the Bonds account represents the pres- ent value of the bondholder's equity as represented in his claim for $1,000.00 at the end of five years, and for ten*payments of $20.00 each every six months. The total claim is for $1,200.00, but the present value, $1,000.00, is entered in the account. This is the customary method of recording the original issue of bonds at par, and it will readily be seen that this is simpler than record- ing the sum of all payments in the Bonds account when it comes to recognizing the bond interest payments. At the end of six months the interest accrued on the amount invested at the mar- ket rate (4 per cent) is $20.00. The bondholder is paid $20.00 on his contract at this time, however, so that the bond interest pay- ment just offsets the interest accrual. The only entries neces- sary, therefore, are. Interest $20.00 Cash $20.00 Since the accrual of interest will be equal to the bond interest payment at each payment date, these same entries will be suffi- cient at each date. The credit in the Bonds account then will remain steadily at $1,000.00, this figure representing the present value of all future payments at each payment date as well as par. After the last bond interest payment, the Bonds account will still be stated at par, but the par of the bond is immediately paid and the entries. Bonds $1,000.00 Cash $1,000.00 close the transaction. ' It was said that this method is simpler than it would be to credit the total of all payments to the Bonds account at the date INTEREST TRANSACTIONS — EQUITY ACCOUNTS 397 of issue. This is what would be done if the two parts of the bond were treated separately.. It will be worth while, however, to consider the entries which would be made according to such a method. In the first place, the total of all the payments, $1,200.00, would be credited to the Bonds account. But only |i,ooo.oo is received in cash, the other $200.00 is the interest, and not yet accrued ; or, looked at in another Hght, this amount may be con- sidered as the total discount on all payments. The entries at the date of issue would be, Cash $1,000.00 Discoiint 200.00 Bonds $1,200.00 The Discount account is again a valuation account offsetting the overstatement of the equity item, Bonds. The difference be- tween these two accounts represents the present equity of the bondholder. At the end of six months interest would have ac- crued on this equity at the rate of 4 per cent amounting to $20.00. This requires a charge to Interest and a credit to the valuation account, thus : Interest $20.00 Discount $20.00 But a cash payment is made to the bondholder amounting to $20.00, hence the additional entries, Bonds $20.00 Cash $20.00 would be made. The Bonds account now shows a balance of f 1, 180.00, this being the total of the remaining payments. At the same time the balance in the Discount account is $180.00. Deducting this item from the balance in the Bonds account leaves $1,000.00, the present value of the remaining payments. Inter- est on this figure for the next period of six months would again be $20.00, and a payment of $20.00 would be made at the end of the period necessitating the same entries as before. Again this would leave the net value of the equity at $1,000.00. The same entries would then be made at the end of each period until the tenth. This process would reduce the Discount balance to zero, and at this time also the par of the bonds would be paid. 398 PRINCIPLES OF ACCOUNTING This latter method of handhng the Bonds account, while sel- dom or never used in practice, illustrates quite clearly the nature of the bond contract, and calls particular attention to the fact that the par value figure is not of as great significance as the present value of the future payments. Still the simplicity of the first method of accounting is sufficient to commend it for general use where bonds are issued at par. It was assumed in the above illustrations that the bonds were sold on the date of issue, that is, that the dating on the bonds was determined by the date the bonds were sold to investors. Very frequently in practice this is not the case. The total issue of a series of bonds bears the same date of issue, and the same interest payment dates, although the sales to investors are made at various dates. When the bonds are sold between regular in- terest payment dates, accrued interest to the dafe of sale must be taken into account. Suppose, for example, that the series of bonds in which the one in the preceding illustration was included were issued as of March 31st, 1918. Then the interest payment dates would be September 30th and March 31st, and the par would be payable March 31st, 1923. Now the separate bonds might all be sold on March 31st, i9i8,in which case the entries would be the same as those given above ; or they might be sold in quantities at various dates after March 31st with accrued interest from that date. In the present illustration the bonds were issued at par, and if a $1,000.00 bond of this series were sold on June 30th with accrued interest, the amount of cash received should be found by formula (4) , which is, S = P(i +y/m)""' In this case P would be the present value at the preceding interest payment date ($1,000.00) ; j, the market rate of interest (.04) ; m, the number of conversions (2) ; and n, the number of years (t). Therefore, 5, / 1 \i o = 1,000.00 (i + .02)* = 1,000.00 (1.009951) = 1,009.9s The accrued interest then at this time is $9.95. The entries re- cording the sale of the bond would therefore be. INTEREST TRANSACTIONS — EQUITY ACCOUNTS 399 Cash $1,009.95 Bonds $1,000.00 Interest 9.95 The accrued interest item is credited directly to the net revenue account, Interest, though no interest has been earned by the in- vestor at this time. As a matter of fact the $9.95 is a part of the bondholder's investment which is returned in the first bond interest payment. This fact can be clearly shown by taking the viewpoint of the investor for a moment. He has invested $1,009.95 3-t 4 per cent convertible semiannually, and receives a payment at the end of three months. His investment has accumulated for three months at the stated rate, hence it wiJl amount to, S = 1,009.9s (i + -02)^ = 1,020.00 The original investment was $1,009.95 ^^d this accumulated to $1,020.00; but $20.00 is paid, and this reduces the investment to $1,000.00. The interest earned by the investor for the period is $10.05 ; a^nd this is the interest chargeable to net revenue by the corporation. Now since $9.95 was credited to Interest at the date of sale, the whole $20.00 payment on September 30th can be charged to Interest in order to produce the desired net charge to this account. Then on September 30th the entries would be, Interest $20.00 Cash $20.00 The net result of the entries in the Interest account may be seen in this account form. Interest Sept. 30 $20 June 30 95 The $20.00 charge on September 30th offsets the $9.95 credit of June 30th, and leaves a net balance of $10.05 on the debit side. 400 PRINCIPLES OF ACCOUNTING This is as it should be, a charge against Interest for the accrual from June 30th to September 30th. It is customary in practice to apportion the interest accruing in a fractional part of an interest conversion period on a propor- tional basis rather than on the compound rate basis as shown here. That is, instead of charging $1,009.95 for the bond in this case, the company would have charged $1,010.00. The $10.00 is simple interest for three months as compared with $9.95 if the true compound rate were used. It is evident that this practice works to the disadvantage of the investor as he fails to realize the compound rate on his investment for the re- maining part of the period in which he made the purchase. The difference is small, however, and therefore the investor seldom objects seriously to this practice, though as a matter of accuracy the compound rate should be used as was illustrated. In case the accounts are closed at dates other than payment dates, interest again must be accrued for the fractional periods involved. To illustrate this point, suppose that the books of the corporation issuing the bond in the illustration above were to be closed on December 31st. Then interest must be accrued and entered on the accounts for the three months from September 30th. At the compound rate of 4 per cent" convertible semi- annually this would amount to $9.95 and the entries covering this accrual would be, Interest $9-95 Accrued Interest $9-95 The Accrued Interest account would appear on the balance sheet as a liability. Then on March 3 ist, when the next payment is made, the entries would be,^ Interest $];o.os Accrued Interest 9.95 Cash $20.00 The net result of these two entries is to place $9.95 in the net revenue sheet of the accounting period ending December 31st ' Instead of using the Accrued Interest account the inventory method as shown in Chapter VIII might be used. INTEREST TRANSACTIONS — EQUITY ACCOUNTS 401 and $10.05 ill the succeeding period. This is just what is desired when accounts are kept on the accrual basis. BONDS ISSUED AT A DISCOXJNT In the preceding section the simple case of bonds issued at par was treated ; but bonds are very seldom issued exactly at par. The reason for this is the fact that corporations cannot, or at least do not, usually use the market rate of interest for the bond rate when issuing bonds. It is difi&cult to determine in advance just what will be the market rate for a given issue of bonds, and whenever the market rate is different from the bond rate the bonds will sell either at a discount or at a premium. Both of these cases present certain difhcult accounting questions. In this section the problems of analysis arising in connection with bond discount will be considered. If a five-year, 4 per cent, $1,000.00 bond, interest payable semi- annually, were offered for investment on a market which called for s per cent convertible semiannually, the price would be $956.24. (See formula (30) , preceding chapter.) The amount of cash received at this time by the corporation is $956.24 in ex- change for its promise to pay $1,200.00 (par $1,000.00 and bond interest $200.00). The difference between the amount received and the total promise to pay is interest, $243.76 ; and the same must be distributed to the net revenue sheets of the proper years. Here again it is current practice to credit the Bonds account with the par of the bonds issued. In this case, however, the par does not also represent the present value. This fact has led to a great deal of confusion in accounting practice. The par of the bond is a convenient figure to carry in the Bonds account. When the bonded indebtedness of a corporation is mentioned, for instance, the par value of the bonds is quoted, and the total capitalization is often referred to as the sum of the par ,values of capital stock and bonds. Further, in case of failure to meet interest payments it is generally recognized that the bondholder's claim on the mortgaged property is for the par value of his bond. All these facts tend to establish current practice as the most logical method. But — and here is where confusion usually arises — par and present value in this case are not synonymous. 402 PRINCIPLES OF ACCOUNTING Present value is somewhat less than par, and a valuation account must be kept to record this difference. This account is Dis- count on Bonds. The proper entries at the date of issue then are, Cash $956.24 Discount on Bonds 43-76 Bonds $1,000.00 It is the nature of the account Discount on Bonds that seems to cause most of the difficulty. This, as was just stated, is a valuation account whose function is to offset the amount entered in the Bonds account in order to reduce that item to the present status of the equity involved. Many peculiar notions arise in connection with this item among accountants and business men. Sometimes it is said that it is a property item. The argument for this contention runs something like this. Discount is a cost of getting capital ; capital is just as essential to the establish- ment of an enterprise as the buildings, machinery and other struc- tures ; engineers' and draftsmen's salaries paid for the plans for the building are a part of the cost of the structure, and are charged to property accounts ; therefore as discount is an item akin to the draftsman's salary, discount is a property item. There are two very obvious answers to this contention. In the first place, the amount of discount entered in this account is only a part of the total discount on the issue. The total dis- count is the difference between the total promises and the present value, $243.76, while the amount under consideration is only the difference between the par and present value, $43.76. If this latter amount is property, then why not all of the discount? This would mean that all of the interest arising during the life of the bond would be charged to property, but no one would ever urge such a policy. Again, the amount of discount depends on the bond rate of interest. The higher the bond rate of in- terest, the less the discount. In fact if the bond rate is high enough there will be a premium instead of a discount, and who would think of crediting the property with the amount of the premium ? Yet this is what such a policy would logically lead to and this should make it clear that discount is not a cost of property, but an interest item. Another error consists in considering discount a loss. That INTEREST TRANSACTIONS — EQUITY ACCOUNTS 403 is, it is said that the corporation receives $956.24 in return for a promise to pay $1,000.00 and that therefore $43.76 was lost in the deal. One can answer this again by saying that the amount of $956.24 was received in exchange for a promise to pay $1,200.00, therefore $243.76 was lost in the transaction. When stated in this way, the absurdity of this claim is obvious. The present value of the bond, then, is always shown by the difference between the par as shown in the Bonds account and dis- count as shown in the Discount on Bonds account. At the date of issue the balance sheet items representing the bond mentioned above would show, Cash (or other property Bonds $1,000.00 received for bonds) . . $956.24 Discount on Bonds . . 43-76 $1,000.00 $1,000.00 Now at the end of six months, a payment of $20.00 is made for bond interest. There has accrued during the same period 25 per cent of the original investment $956.24, or $23.91. There has accrued in favor of this equity, then, $23.91, and but $20.00 is paid in cash. The entries would be. Interest ... . $23.91 Cash $20.00 Discount on Bonds 3.91 The credit to Discount on Bonds reduces the balance in that valuation account and hence increases the net valuation of the bondholder's equity. Assuming that there was sufficient net revenue to cover the interest charge of $23.91, the journal entry made at this time actually reserves $3.91 in property for the bondholder. The situation as regards this bond, and exclusive of other facts, would be. Property (from origi- Bonds $1,000.00 nal issue) . . . $956.24 Cash (or other prop- erty retained) . . 3.91 $960.15 Discount on Bonds . 39.85 ' $1,000.00 $1,000.00 404 PRINCIPLES OF ACCOUNTING The present value of the bond as shown by this statement is $960.15. The bondholder's equity has increased by $3.91 as compared with the last statement. In fact it might be said that the bondholder has made a new loan to the corporation not in the form of cash but in the form of foregone interest. He accepts less in cash than the interest accrual on his investment. At the end of the next six months' period, the interest accrued on the investment since the beginning of the period at 2I per cent would amount to $24.00, and the entries would be, Interest $24.00 Cash $20.00 Discount on Bonds 4.00 The results of these entries may easily be traced in the same manner as was explained above. The same procedure would be followed at each succeeding interest payment date. The amounts for each entry may be obtained from the accumulation of discount table shown on page 381. Accumulation tables are always of service in making entries for bonds issued below par. In case the bond is issued between interest dates at a discount the method of entry is essentially the same as when issued at par, as was illustrated in the preceding section. Thus suppose that the 4 per cent bond which was sold on a 5 per cent basis had been dated March 31st as before, and that the sale was made on June 30th. In this case the selHng price should be $956.24, the price at the preceding interest payment date, plus interest at the rate of 5 per cent convertible semiannually for three months, that is, 5 = 956.24 (i + .o2s)i = 956.24 (1.012423) = 968.12 and the accrued interest is $968.12 minus $956.24 or $11.88. The entries would be. Cash $968.12 i)iscount on Bonds 43-76 Bonds $1,000.00 Interest 11.88 INTEREST TRANSACTIONS — EQUITY ACCOUNTS 405 The entries at the first interest payment date would then be the same as shown above, and the Interest charge of $23.91 would offset the credit to interest of $11.88, leaving the net charge to interest for the period at $12.03. Again it should be mentioned that in practice such precision is seldom attained. The investor is generally charged simple interest from the last payment date. In this case simple interest would amount to 5 per cent of $956.24 for three months or $1 1 .95 . The bondholder is overcharged 8 cents on this plan and fails to earn the market rate during the succeed- ing three months, but the amount of the overcharge is small and may be considered as a sort of commission paid for the service of handling the funds. In case the closing date falls between two interest payment dates, accrued interest must be taken into account. This is done in the same maimer as shown in the preceding section. The accumulation should be figured at the market rate on the book value at the preceding interest date. Thus in order to close the books on December 31st for the bond just mentioned, interest must be accrued on the June 30th figures, $960.15, at 5 per cent convertible semiannually for three months. This accrual amounts to $11.93 ^iid the entries are. Interest $11.93 Accrued Interest $11.93 Then on March 31st when the bond interest is paid the entries are. Accrued Interest $11.93 Interest 12.07 Cash $20.00 Discount on Bonds 4.00 These latter entries cancel the Accrued Interest item on Decem- ber 31st, charge Interest with the accrual since that date, and write off the proper amount of discount for the whole period. BONDS ISSUED AT A PIUEMIUM Whenever the market rate at which a bond is issued is less than the bond rate of interest, a bond sells at a premium. The present value of all the promises to pay involved in the bond con- 4o6 PRINCIPLES OF ACCOUNTING tract is greater than the par value. Here again it is customary to credit the Bonds account with just the par value, and this practice is justified by the same reasoning as in the case of bonds sold at a discount. This practice, however, has also led to in- correct analysis in many cases. The difficulty seems to He in a failure to understand the nature of the additional amount re- ceived above par for the bond. For example, if the 4 per cent bond used in the preceding illustration were issued on a 3 per cent market basis, the amount of cash received would be $ i ,046 .11. The premium is $46.11. Just what is the nature of this item? It is doubtless clear that it represents a part of the present value of the bond — a part of the investment of the bondholder — just as discount in the preceding, case constituted a deduction from the par value to get the present value or investment of the bond- holder. The amount of the premium, then, should be credited to an equity account, the proper journal entries being, Cash $1,046.11 Bonds $1,000.00 Premium on Bonds .... 46.11 The total equity of the bondholder at this time is $1,046.11. This is the present value of the total of all promises to pay, $1,200.00. The difference between $1,200.00 and $1,046.11 is the total interest, or in other words it is the amount by which the total payments have been discounted. Particular emphasis is placed on this fact because frequently one hears it said that the premium on bonds is a profit. In fact, cases are known where corporations have credited the premium on bonds to revenue or to surplus accounts. The absurdity of such a practice seems evident as this would mean that premiums received are revenue items, revenue obtained from one's own promise to pay. One might venture the remark that if revenue may be obtained as easily as this, why not go into the business of issuing bonds ? Surely this would be much less troublesome than ordinary industrial operations. All that would be necessary to make large revenues would be high bond interest rates in com- parison with the market rates, for the amount of premium de- pends on the bond rate of interest and this may be stated at any figure suitable to the management. Evidently, therefore, INTEREST TRANSACTIONS — EQUITY ACCOUNTS 407 premium on bonds is not a revenue but is part of the original investment. Six months after the date of issue, interest accrues to the ex- - tent of i| per cent on the original investment. This accrual is $15.69. The annuity payment on this date, however, is $20.00, and the difference between these two amounts is a return of part of the original investment. The journal entries are, Interest $15.69 Premium on Bonds 4.31 Cash $20.00 The debit of $4.31 to Premium on Bonds reduces the balance of that liability account. The present value of the bond at this date is the sum of the Bonds account balance, $1,000.00, and the balance in Premium on Bonds, $41.80, or $1,041.80. The function of the Premium on Bonds account can perhaps be shown more clearly by the use of a balance sheet statement. Taking into account just those facts relating to the issue of this bond, on the date of issue, the balance sheet would show. Cash $1,046.11 Bonds $1,000.00 Premium on Bonds . . 46.11 $1,046.11 $1,046.11 The bondholder's equity is shown in the two accounts on the lia- bility side. Now at the end of six months, and after the first $20.00 payment is made, the balance sheet would show, with respect to this bond, Cash (or other Property) Bonds $1,000.00 from bond issue . . $1,041.80 Premium on Bonds . . 41.80 $1,041.80 $1,041.80 If all of net revenue had been distributed, these statements would show the fact that an investment of $1,046.11 was made, and that six months later $4.31 was returned to the investor, leaving the net investment at $1,041.80. Interest would accrue during the following half year at the rate of 3 per cent on $1,041.80. This accrual is $15.63 and the entries at this time would be, 4o8 PRINCIPLES OF ACCOUNTING Interest I1S.63 Premium on Bonds 4.37 Cash $20.00 This procedure carried out to the end of the fifth year would reduce the balance of the Premium on Bonds account to zero. At this time the only part of the bondholder's equity remain- ing on the books would be shown in the Bonds account (par). The bonds would now be retired at par and this equity would be entirely extinguished. The entries to be made during the life of such a bond can easily be obtained from an amortization table similar to the one explained on page 383. In case a bond is sold at a premium on a date subsequent to the date of issue, accrued interest is charged to the investor from the last payment date, just as was shown in the preceding sec- tion where the bond was sold at a discount. As an illustration suppose that a 5 per cent bond due May ist, 192 1, interest pay- able May ist and November ist, is sold on a 4 per cent basis on August ist, 1916. The value of the bond on May ist at 4 per cent is $1,044.91, and the August ist price will be this amount plus interest at 4 per cent for three months. This amount may be obtained by formula, thus, 5 = 1,044.91 (i -1" .02)^ = 1,044-91 (1-009951) = 1,055.31 This price, $1,055.31, is made up of: (i) par $1,000.00; (2) premium May ist, $44.91 ; and (3) accrued interest from May ist to August ist, $10.40. The entries at date of sale would in- clude these thrfee items. Cash $1,055-31 Bonds $1,000.00 Premium on Bonds .... 44.91 Accrued Interest 10.40 Three months later when the semiannual interest payment is made, the actual payment, though called semiannual interest, will really include: (i) the accrued interest item as shown in this entry; (2) the interest accruing since that date, $10.50; and (3) $4.10 on the premium. The entries will be. INTEREST TRANSACTIONS — EQUITY ACCOUNTS 409 Accrued Interest $10.40 Interest 10.50 Premium 4.10 Cash $25.00 The Accrued Interest account here is treated in the same manner as was shown in the similar case for bonds sold at a dis- count. Another case in which the Accrued Interest account would be necessary is where the closing date is different from the interest payment date. The' treatment of this case is analogous to that required for the cases already shown in the preceding section. THE REFUNDING OF SECURITIES In the illustrations of securities issued under various conditions thus far given, it has been assumed that the original contract is carried out to the date of maturity. That is, if a 4 per cent bond is issued on d 5 per cent basis, the entries were shown as they would normally be if no changes took place, as far as the issuing company is concerned, until the bonds matured. The market rate of interest used for determining the amount charged to net revenue remains at 5 per cent throughout the whole period. Some question might arise as to the propriety of retaining this original computation figure throughout the whole period. Most bonds are issued for relatively long periods of time, twenty, thirty, fifty and even ninety-nine years. Now it is true that the general market rate of interest changes during such periods, so that were the company to issue the same bonds at some later period, the interest rate would be different. Why then main- tain the old 5 per cent market rate in the face of such changing market conditions? At first thought it might appear that this is in contradiction to the general viewpoint emphasized in this text that the accounts should always be sensitive to price change. Market conditions should be reflected in the accounts as soon as possible. Yet this contradiction is only apparent, for this situa- tion is not analogous to the general situations emphasized in other connections. Here there is a definite contract entered into between the corporation and the bondholder. The whole agreement is consummated at the date of issue and the market at that date governs the whole contract regardless of how long 4IO PRINCIPLES OF ACCOUNTING the time covered by the contract may be. There can be no change in the market rate of interest paid by the corporation so long as it is fulfilHng the terms of the original contract. Any change in the general market situation affecting interest rates cannot affect the terms of this contract. Hence so long as the original contract remains in force, that is, so long as the bonds are outstanding, the original market rate of interest controls the journal entries as they have already been shown. A company may have chosen to issue its bonds at an inoppor- tune time, and thereby be compelled to pay a high rate of interest. If this is the case, that rate will apply to all of that corporation's transactions relating to these bonds until they are redeemed either at maturity or at an earlier date. This is undoubtedly the reason why corporations usually issue short-term bonds, five- and ten-year, during a period when the interest rate is high, and long-term bonds, twenty-, thirty- or fifty-year, when the in- terest rate is very low. It is an evidence of good financial man- agement to choose a period of low interest rates in financing through bond issues. In order that a concern might avail itself of an opportunity to get the benefit of an improvement in the interest rate in its favor, bonds are sometimes issued which are callable at certain dates by the corporation at par, or sHghtly above par. When this is the case the corporation has the right to cancel the old contract by paying the bondholder the par value ; and then it may go on the market with an entirely new issue which will be sold at the new market rate. This process of refunding a debt for the purpose of getting a better rate selddm presents any very comph- cated accounting problems. The accounts representing the old contract at the date of refunding must be written off the books, and the new bonds entered in the new accounts. Sometimes the option of cancelhng the contract before matxirity rests with the bondholder. He may, on certain specified dates, present his bond for redemption either at par or at some other stated price. He will exercise this privilege if the interest rate is increasing in order to make a more profitable investment, but if the interest rate is falling, he will prefer to keep the. bond. In case he does exercise his privilege, the old accounts representing the bonds involved must be closed out. INTEREST TRANSACTIONS — EQUITY ACCOUNTS 411 Still another case of refunding consists in the issuing of a new security in exchange for an old one. A second mortgage, 5 per cent bond with five years yet to run, for example, might be can- celled in exchange for a 4I per cent first mortgage thirty-year bond. If the exchange is made at par, then any discount or premium still on the books from the old issue must be spread over the succeeding thirty years instead of five. This case always involves the finding of the interest rate of the new issue of bonds as was shown in Chapter XVI. If the exchange is not made at par, the case is much more complicated but it would be treated the same in principle as though the old issue were can- celled through payment, and the new securities issued in exchange for the proceeds of the old. The balances in the discount or pr^emium accounts would be increased or decreased according to the terms of exchange. There are so many different situations that might arise in con- nection with the refunding of securities that no adequate classi- fication can be made. The general statement can be made, however, that at the time of any refunding, accounts represent- ing the old contract should be closed entirely and new accounts opened for the new contract in accord with the terms of the issue. The accounts for the old issue should have been kept up to the date of refunding according to the principles as shown in the pre- ceding sections, and the new issue should be handled according to the same principles from that date forward. The main prac- tical difl&culty which usually arises is the finding of the new interest rate. It has been the purpose of this chapter to explain the more important transactions involving interest calculations from the viewpoint of the equity accounts. It will be the purpose of the next chapter to consider the same question from the standpoint of the property accounts. XVIII Interest Transactions — Asset Accounts The last chapter was concerned with the interest transactions primarily as they affect the equity accounts. It is obvious that the same transactions which were discussed in this connection also involve the asset accounts on some ledgers. To make this clear one need only be reminded that there are two points of vi^w to every list of asset items ; one has to do with the equities in the property, the other with the property items themselves. Every equity item cm one balance sheet may be represented on t^le asset side of the balance sheet of the party holding title to the equity. Capital stock, bonds, notes, etc., are all equities on the balance sheet of the corporation which has issued them, but the same items are assets on the books of the owners of the shares of stock, the bonds, the notes, etc. Further, certain firms and individuals act as trustees, executors, administrators, and in other fiduciary relationships to persons who own property of this character. In such cases, an analysis of the interest trans- actions involved is of particular importance. It is the purpose of this chapter to raise the problem of interest with particular reference to the asset accounts. investments in securities The first question to be considered in this cormection is con- cerned with the investment by individuals and companies in the securities of other concerns. Whenever a firm or corporation invests in the notes, annuities, or bonds of another corporation, these securities must be entered in asset accounts and the earn- ings must be credited to the appropriate net revenue accounts for the periods during which the revenue is earned. At first thought one might suggest that the entries on the books of the owner of 412 INTEREST TRANSACTIONS — ASSETS ACCOUNTS 413 the securities should be the reverse of those on the books of the issuing company. This, however, need not always be the case. The reason for this difference requires careful consideration. To make the question concrete, suppose that the X Company has purchased the amount of $100,000.00 par value of the 4 per cent, twenty-year bonds of the Y Company, on a 5 per cent basis, interest convertible semiannually, the principal being $87,448.62. Now as was shown in the last chapter the entries to be made on the books of the Y Company would be, Cash $87,448.62 Discount on Bonds 12,551.38 Bonds $100,000.00 At the date of the first interest payment the interest accrued would be 2I per cent of $87,448.62, and the entries, Interest $2,186.22 Cash $2,000.00 Discount on Bonds .... 186.22 would be made. The valuation of the bonds remains on the books on a s per cent basis, and will remain so throughout the whole twenty years, or at least until the bonds are refunded. It was shown in some detail that this must be the basis of entry on the books of the issuing company, and that no change in the basis of valuation should be made as long as the original contract remains in force. The transaction takes place on a 5 per cent basis and no act of the corporation (except payment of the bond, refunding or failure) can alter this condition. The Y Company, therefore, accumulates discount according to the principles out- lined. Now the question at this point is whether the X Company should make entries exactly the reverse of those for the Y Com- pany. That is, should the entries on the date of purchase and at the first interest payment date respectively be, (i) Bonds Owned $100,000.00 Cash $87,448.62 Discount on BondsOwned . 12,551.38 414 PRINCIPLES OF ACCOUNTING and, (2) Cash $2,000.00 Discount on Bonds Owned 186.22 Interest $2,186.22 According to this policy the bonds are carried on the books as an asset at all times at a net valuation determined by the present values of the future sums on a 5 per cent basis.^ It would seem offhand as if this were the proper procedure, since this is just the other side of the same contract which was recorded on the Y Company's books. If this were the method always to be adhered to, there would be no necessity for going further into an analysis of the entries on the books of the investor, since in every case of the purchase of a security the purchaser would make exactly the reverse entries of those made on the books of the issuing company ; and these entries were explained in the last chapter. But there is some reason for inquiring as to a possible difference in the attitude of the investor toward the investment, as compared with that of the issuing company. The essential difference lies in the fact that the original owner of the bond need not remain an owner until the contract is can- celled. The corporation issuing the bond is always one party to the contract but the other party may change, in fact often does change because of the very ease of transferring securities from hand to hand. An investigation of the purposes for which securities are purchased will show that changes in the market rate of interest must in many cases at least be the basis for read- justments on the books of the purchaser when such readjust- ments would be entirely erroneous on the books of the issuing company. What then are the purposes involved in the purchase of such securities? For convenience of discussion the following classi- fication maybe of service:^ (i) investments where the con- ' It is probably unnecessary at this point to explain what is meant by the net valuation. The bonds are carried on the asset side at par in the Bonds account; Discount on Bonds Owned is a valuation account which shows the offset to par ; and the net valuation of the securities involved is the algebraic sum of the balances from these two accounts. 2 This classification is not intended to be exhaustive but rather to serve as a basis of investigation. INTEREST TRANSACTIONS — ASSETS ACCOUNTS 415 tractual character is dominant; (2) long-term investments which may be easily disposed of ; (3) temporary and specula- tive investments. \ In the first group would fall the annuities purchased from life insurance companies, > the endowment funds of institutions and societies, and securities for which there is little or no market. In any of these cases the buyer has no intention of selling the security before maturity. The original owner, and investor, for practical purposes, may be looked upon as the other party to the contract permanently. In the case of an annuity purchased from a Hfe insurance company, for example, there is very little opportunity to dispose of the security. Of course the owner might make an assignment of his right to receive the annuity installments but even this is an exceptional case and as such would not affect the generaHzation with respect to this class of assets. Certainly a change in the market rate of interest would have little or no effect on the value of such a security to the owner. The investor in securities of this class looks upon his investment as the other side of a contractual agreement, and he should make entries on his books which are the reverse of those on the books of the issuing company. The statement that the entries in all cases in this class must always be the reverse of those on the books of the issuing com- pany must not be taken as a rule to be rigidly adhered to. Con- ditions might arise which would cause a change in policy. The risks assumed by the investor might be considerably increased due to the fact of the issuing company becoming financially embarrassed. If such new conditions bring with them a loss to the investor such loss should be recognized in the accounts. But such situations are not tj^ical of securities alone. Any asset item may suddenly become worthless because of some unforeseen contingency, and in such cases accounting practice demands that the book value of the asset be reduced. The exceptional loss of any asset must be recognized by a charge to net revenue or sur- plus at the time it is incurred. The rule given for the treatment of the securities in this class may therefore be accepted with this general reservation. It is somewhat difficult to delimit this class of investments. The test which can be applied with best success is the question : 4i6 PRINCIPLES OF ACCOUNTING does the investor to all practical intents become a permanent owner of the security ? If this question can be answered in the affirmative, the whole transaction may be treated as a contract governed by the general rule for this class, and there are certainly several situations in which the question asked may be answered affirmatively. The purchase of an annuity, already mentioned, is perhaps the clearest case. But, again, if an organization such as an educational institution is endowed, the fund being turned over in the form of bonds of a particular corporation, the case is practically a parallel with that of the annuity. The insti- tution must, from the nature of the contract, keep the secu- rities until maturity. Another case, not quite so clear perhaps, is the investment in bonds or other securities of small corporations or municipalities for which there is practically no market. When an individual or firm invests in such securities his intention generally is to retain possession until maturity. He may sell before that date, but unless he does, he has no basis for making a revaluation as there is no general market for such securities which can be ob- served by the investor. He must therefore accept the interest rate involved in his own original purchase price as the basis for future valuations until such date as he actually disposes of his holdings. Such investments form no inconsiderable part of the total. To make this evident one need only recall from his own observation the fact that the securities actively dealt in and quoted on various stock exchanges constitute a very small per- centage of the total securities in the hands of the public. There- fore it may be assumed that the number of cases is very large in which asset items represented by securities must be recorded by entries essentially the reverse of those on the books of the issuing company. The second class consists of long time investments for specific purposes. The investments of insurance companies to meet their reserve requirements, of trust companies for savings funds and estates, the sinking funds of corporations, municipalities, and the like, come in this class. Should there be any difference in the treatment of these items as distinct from the first class? There is more reason for making adjustments in accordance with changes in the market situation here, for the investment is not INTEREST TRANSACTIONS— ASSETS ACCOUNTS 417 made with the intention of retaining the securities until maturity. The individual or corporation in this case makes the investment for the purpose of earning some interest on funds which are not needed for current operations but which must be available to meet its own future demands. An insurance company, for example, invests in bonds of another corporation in order to earn some interest on funds that are awaiting the demands of its policy holders. The important consideration for the insurance company is to have funds always available, either in cash or securities which can readily be turned into cash, to meet the maturity claims of its policy holders. Changes in the market prices of the securities held for investment purposes therefore are of particular importance and should be made a matter of record. The same thing may be said in general of the other in- vestments in this group. Investments made in securities that are likely to be resold should therefore be kept on the books at approximately the current price. This does not mean, however, that every fluctuation in price as reported on the stock exchange should be recorded on the books. The claims to be met by these secu- rities are not demand claims in the sense that the funds must be available immediately on presentation of a claim. There is always the right reserved to defer the payment of a claim for some considerable time, sufficient at least to enable the company to dispose of its securities at an advantageous price. Small fluctuations in the quoted ^rice, therefore, are of little signifi- cance. It is the relatively permanent or long time changes that must be booked. As an example of the change in price referred to, suppose that the bonds purchased by the X Company in the illustration on page 413 were of this class. That is, the X Company made the investment with the intention of keeping a fund available to meet certain future claims upon itself. At the date of purchase it ip supposed of course that the bonds would retain a 5 per cent val- uation basis as this is the basis on which the bid is made. The original entries then are the same as shown above, namely, Bonds $100,000.00 Cash $87,448.62 Discount on Bonds Owned . 12,551.38 2E 41 8 PRINCIPLES OF ACCOUNTING An accumulation table would be prepared on a 5 per cent basis for the purpose of making the entries which would be the reverse of those on the Y Company's books, and, assuming no essen- tial changes in the market price of this bond the entries would be made on this basis. At the first interest payment date this entry would be made. Cash $2,000.00 Discount on Bonds Owned 186.22 Interest $2,186.22 And at each subsequent payment date the entries would be made on the same basis unless some change in the market price of im- portance took place. Now suppose, however, that the market price of these bonds had changed to a 5I per cent basis by the first interest payment date. The value of the bonds to the X Company would no longer be the same as the book value after the above entries were made. The value would be $82,194.81. But the book value, after the interest payment is received and the journal entry recording the receipt has been made on the 5 per cent basis, as shown in the journal entry of the preceding paragraph, is $87,634.84. The new book value should then be $5,440.03 smaller than that shown in the accumulation table at 5 per cent. To make this correction the entries should be, Net Revenue $5,440.03 Discount on Bonds Owned . . $5,440.03 The two journal entries taken together show a net loss for the period of $3,253.81. The first entry credits Interest (net revenue) with $2,186.22 and the second charges Net Revenue with $5,440.03, which gives the net result as stated. The credit to Discount on Bonds Owned reduces the book valuation and leaves the net valuation at $82,194.81. This is the present value of the bond (now having 19I years to run) on a s| per cent basis. A new accumulation schedule should be made out and the entries made according to this schedule until a rather significant change occurs in the market rate. In the case just given, the market rate increased, causing a loss to the investor. Many investment concerns which approve INTEREST TRANSACTIONS — ASSETS ACCOUNTS 419 of this policy in this case nevertheless object to writing up the asset if the market rate of interest decreases. Suppose, for ex- ample, that the market rate had fallen to 4^ per cent instead of rising. The present value would have been $93,554.28 and a consistent policy would require the writing up of the book value as follows, Cash $2,000.00 Discount on Bonds Owned . . . . 6,105.66 Interest (on 5% basis) .... $2,186.22 Net Revenue (for appreciation) . S>9i944 Subsequent entries should be based on an accumulation table at 4J per cent until some further change in the interest rate. The objector would say that the appreciation of the assets, $5,919.44, is not realizable and therefore should not be considered as a revenue of the period. This is just the old question as to whether appreciation of assets in general should be recognized in the accounts; and as has been shown at numerous places, since it is the function of accounts to represent as far as possible present values, appreciation is logically as significant a fact as depreciation. The question as to whether cash has been re- ceived equal to the credit to Net Revenue is unimportant. An asset item of value equal to cash is present and available. The general conclusion with respect to the second class of securities, therefore, is that changes in the rate of interest of a relatively permanent character should be recognized in the ac- counts. The third class of investments in securities mentioned above consists in funds which are invested very temporarily and which must be available for other purposes practically on demand. The purchase of stocks and bonds by brokers, or more particularly the acceptance of such securities by banks as security for loans, are the typical examples of such investments. There is perhaps some question as to the advisability of considering these as in- vestments, since they belong more in the category of speculative holdings. In all cases of this class, the assets must be highly liquid in character. It must be possible to dispose of them readily to avoid financial embarrassment. In fact the securities are often 420 PRINCIPLES OF ACCOUNTING a form of merchandise for the firm holding them and ability to meet current Habilities depends in large measure on the oppor^ tunity to dispose readily of the stocks and bonds held. The market situation therefore is of the utmost importance and ac- cumulation and amortization schedules are of Httle or no use. In most of these cases there is an active market, and valuations on the books should be adjusted to correspond with the quoted market prices very frequently. A broker, for example, should recognize market changes at least daily and in many cases it is better to follow the changes throughout the open market hours of the day. Banks holding large amounts of securities as col- lateral keep constantly in touch with the stock market, being prepared to sell the collateral to cover loans in case prices should materially lower. It is evident that in this group, the mathematics of investment plays no part in the revaluation of securities owned. The con- tinued contract relationship with the issuing company is not intended nor is the purchase made for relatively long-term in- vestment purposes. The market is the continual basis of valua- tion. The conclusions reached in this section may be briefly summa- rized as follows. There are roughly three classes of invest- ments in securities. The first consists of long-term invest- ments of which the investor intends to retain his possession until maturity. Here the contractual character of the trans- action is recognized and subsequent valuations should be made on the basis of the original market rate of interest. The second consists of long-term investments made primarily for investment purposes where there is no intention of recognizing the continued contractual relationship. Here small changes in market condi- tions should not be recognized but relatively permanent changes should be the basis for revised book figures. The third class consists of speculative investments. Here the market situation is the sole guide to the revision of book valuations. It is impos- sible to give a hard and fast rule as to just when a security is in one or the other of these classes but the facts of each situation should be taken into consideration in making the assignment. INTEREST TRANSACTIONS — ASSETS ACCOUNTS 421 INTESEST IN FIDUCIARY ACCOUNTING Many .of the questions already raised in connection with prin- cipal and interest present themselves in a peculiar manner to the person or corporation acting in a fiduciary capacity. The most common example is the trusteeship for an estate. The trustee is intrusted with the administration of the estate of the deceased in accordance with the terms of the will. In general this task does not present any particular problems as distinct from any other form of accounting. The estate must be admin- istered in a businesslike manner in the interests of the beneficiaries. The property belonging to the beneficiaries is managed by the trustee. All net revenue as well as the corpus of the estate is distributed according to the terms of the probated will. It would seem proper then to compare the position of the trustee with that of the manager of a private business. He manages the property or business of others and renders periodic accounting statements to those who have equities. The essential difference Hes in the apportionment of the net revenue and assets to the proper parties. Instead of a board of directors meeting to decide on these questions, the will of the deceased, as approved by the proper court, is the guide. The actual records kept and the method of recording transactions are highly specialized, but the accounting principles are essentially the same as for any business. The importance of maintaining the integrity of the account- ing period in this case should be especially emphasized. The will, for example, often specifies that the income of the estate shall be paid to one person (the hfe tenant) throughout his or her Kfe and that the corpus of the estate shall pass to another person (the remainder man). Now it is evident that any mis- statement of net revenue is bound to jeopardize the interests of either one or the other of these parties. To make the case concrete suppose that A dies and leaves an estate which, after all the expenses incident to probating the will, taxes, etc., have been met, amounts to $106,838.87.^ The will provides that all ' The amount was assumed at this figure to make the illustration particularly effective. In no case would the whole estate happen to equal the present value of some particular bond at the market rate. This illustration may be considered to refer to the part of such an estate invested in a particular security. 422 PRINCIPLES OF ACCOUNTING the income of the estate should go to the widow B, and that at the death of B the corpus of the estate should pass to the son C. The trustee must manage the investment of the estate, pay ex- penses of management, obtain his own fee from the gross revenue, and pay all net revenue to B throughout her Ufe. Suppose fur- ther that the trustee decided to purchase $100,000.00 par value X Company, twenty-year, 4I per cent bonds which are quoted at $106,838.87, this being on a 4 per cent basis. The balance sheet of the estate at this time would be, Bonds — X Company C's Equity . . $106,838.87 Par . . . $100,000.00 Premium . 6,838.87 $106,838.87 $106,838.87 Now at the end of six months, the trustee receives $2,250.00 from the X Company for bond interest. How should this amount be treated as between B and C ? It is clear that, unless the market rate of interest has fallen, the value of the bonds has decreased. The actual interest earned is $2,136.78, and there- fore the remaining $113.22 is a return of principal, a part of C's equity. Only $2,136.78 (ignoring the trustee's commissions and expenses) should be turned over to B, and the balance sheet would then show, , Bonds — X Company C's Equity .... $106,838.87 Par . . $100,000.00 Premium . 6,725.65 $106,725.65 Cash 113.22 $106,838.87 $106,838.87 The cash item, $113.22, should now be invested as a part of the principal and the interest, turned over to B. At the next interest payment date only 2 per cent of $106,725.65 should be considered as income (as far as that portion of the estate invested in the X Company's bonds is concerned). In other words the amortization schedule must be used to apportion the bond interest payments between the two beneficiaries. It should be the purpose of the INTEREST TRANSACTIONS— ASSETS ACCOUNTS 423 trustee to keep C's equity at $106,838.87 continuously, and this could be accomplished only by writing off the bond premium, as shown above. Failure to recognize the necessity of this procedure would lead to the dissipation of a part of the estate. That this would be the case may be shown very clearly by assuming that B lives for twenty years after the death of A and that the bonds of the X Company are held until maturity. At the end of the twentieth year, the bonds are paid off at par and the balance sheet would then show only, Cash $100,000.00 C's Equity . . . f 100,000.00 The amount of $6,838.87 would have been paid to B in the bond interest payments at the expense of C's equity. If the total of the bond interest payments were treated as income, then, the terms of the will would be violated. On the other hand, the trustee might have purchased bonds at a discount. Here the accumulation of discount table should be used. In order to simpHfy the illustration in this case, it will be assumed that the estate amounted to but $93,724.30, the conditions of the will being as before, and that the trustee pur- chased $100,000.00 of the 4I per cent, twenty-year bonds of the Y Company at $93,724.30 — this being on a 5 per cent basis. The balance sheet now appears as follows, Bonds — Y Company C's Equity . . . $93,724.30 Par . . . $100,000.00 Less Discount 6,275.70 $93.724-30 $93,724-3° Now at the end of six months $2,250.00 is received from the Y Company as bond interest but the actual interest accrual is $2,342.11; and this amount should be accounted for as B's equity. If only the $2,250.00 were turned over to B the balance sheet should show, Bonds — Y Company Par .... $100,000.00 C's Equity . . . $93,724.30 Less Discount . 6,182.59 B's Equity . . . 93.11 $93,817.41 $93,817.41 424 PRINCIPLES OF ACCOUNTING The value of the investment in the Y Company's bonds has in- creased by $93.11, and since income goes to B by the terms of the will, this must be considered as B's equity. A question might arise as to how this income can be paid to B inasmuch as there is no cash in the trustee's hands to cover this item. This is a very practical question. B might, of course, leave the income with the trustee on deposit so to speak until the bonds mature. The obvious objection to this is that B might die long before this time and would have been deprived of this income in the meantime. C might purchase the right to this item from B and thus have it credited to his account ; or in some cases the trustee might be called upon to make the ad- vance to B, accepting a hen on the bonds at maturity as con- sideration. The actual decision with respect to the treatment of B in this situation is not an accounting matter. Whatever arrangement is adopted may easily be recorded in the books, but the important accounting consideration is the recognition of the accumulation of discount as an income which accrues in favor of the life tenant. Another situation might arise with respect to the bonds either in the case of purchase at a premium or at a discount. The market value of the security might change. It might show a tendency to increase permanently or decrease permanently in value. Should this fact be considered by the trustee? This situation would come under the second class of cases in the preceding section. Permanent changes should be recognized. Failure to take the new market conditions into account would work to the disadvantage of the remainder man in case of falling prices and to the disadvantage of the hfe tenant in case of rising prices. In the discussion thus far in this section it has been assumed that the trustee simply acts as agent for the estate, that title to the property remains in the estate, and that the trustee receives a stipulated fee for his service. In many cases, however, the trustee takes over title to the property of the estate and agrees to pay a definite return to the life tenant and to turn over funds equal to the value of the corpus of the estate to the remainder man at the death of the life tenant. In such cases the trustee's balance sheet shows on the asset side the property to which he INTEREST TRANSACTIONS — ASSETS ACCOUNTS 425 has title and on the liabiHty side the equity of the remainder man in the trustee's assets. Any excess of assets over the remainder man's equity (and other habiUties) is the trustee's own equity. The net revenue sheet shows a distribution of income to the life tenant on a contractual basis and any residue after this distribu- tion is a credit to the trustee's accounts. No particular account- ing problems as distinct from those in the precedihg section arise here. The business of a trustee may in this case be likened to a pure investment business, and the estate treated as a long time deposit the interest on which is paid to a different party than the investor. Other cases of fiduciary accounting, while often involving many complicated questions, do not as a rule present different situations with respect to interest computations and analysis than those given. A special discussion of accounts for receivers, in cases of bankruptcy, reaHzation and liquidation, etc., is given in a later chapter of the text. SINKING FUNDS It is customary for corporations to protect the interests of their bondholders by making some provision in the bond contract with regard to assets to be used for meeting the bonds at maturity* Often this provision takes the form of a sinking fund requirement. This calls for the setting aside of a special fund to accumulate by the annual contributions of the corporation, and interest earned on the fund, to the par of the bonds at maturity. The funds thus set aside may be placed in the hands of a trustee out- side of the organization, or may be retained as a separate fund in the possession of the corporation but not used for current opera- tions. The accounting entries for sinking funds are of particular interest as considerable confusion exists on this point. The amount of the sinking fund contribution may be deter- mined by formula (25). The rate of interest involved may be obtained in different ways. If the corporation intends to handle the fund itself, the rate of interest will depend on what can be obtained from time deposits at a bank or trust company, or on the rate it can expect to obtain from investment in other secur- ities. If the fund is to be handled entirely by a trust company, the rate may be- determined by agreement. The trust company 426 PRINCIPLES OF ACCOUNTING agrees to pay a certain rate, say 4 per cent, on all contributions. Once the rate has been decided upon the annual contribution necessary may easily be determined. For an illustration of the entries suppose that the X Company has issued $1,000,000.00 of 4 per cent, twenty-year bonds, with a sinking fund proviso in the bond contract. The trust company which agrees to handle the fund will pay 4 per cent per annum on the contributions. The annual payment necessary then is $33,581.75. At the end of the first year this amount is paid over to the trustee, the entries being. Sinking Fund Assets I33, 581.75 Cash 133,581.75 Of course the debit might be made to the sinking fund trustee account, but for balance sheet purposes the title Sinking Fund Assets is more desirable. At the end of each successive year, the same amount would be paid to the trust company and the same entry made until the end of the twentieth year, when the fund would have accumulated in the trustee's hands to $1,000,000.00. The interest as it accrues in the hands of the trustee must also be recognized on the corporation's books. At the end of the second year the interest amounts to $1,343.27. This is retained by the trustee but it is property of the corporation and should be treated as such. The entries would be. Sinking Fund Assets $1,343.27 Interest $1,343.27 The third year's interest earning on the fund would be 4 per cent of the total fund at the beginning of the third year. This would be $2,740.27, and the entry would be the same in form as the previous one. It is important to notice the effect of this sinking fund policy on the balance sheet of the corporation. Suppose, for example, that the X Company originally issued $1,000,000.00 of stock at par together with the same amount of bonds at par and used the proceeds for purchasing the necessary fixed and current assets for carrying on its operations. The balance sheet in summarized form would show, INTEREST TRANSACTIONS — ASSETS ACCOUNTS 427 Property (used in Capital Stock . . $1,000,000.00 operation) . . . $2,000,000.00 Bonds 1,000,000.00 $2,000,000.00 $2,000,000.00 Now at the end of the first year let it be assumed that all pro- prietary net revenue is distributed to the stockholders in divi- dends so that there will be no accumulated surplus. Then as a result of the sinking fund transactions described above, I33,- 581.75 of the original property used for business operations must have been converted into cash and the cash turned over to the sinking fund trustee. The balance sheet would then show, Property (used in Capjtal Stock . . $1,000,000.00 operation) . . $1,966,418.25 Bonds 1,000,000.00 Sinking Fund Assets 33,581.75 $2,000,000.00 $2,000,000.00 Passing now to the end of the second year and making the same assurription the balance sheet would show that additional assets were turned over to the sinking fund trustee equal to the second payment and interest on the first. Interest on the first payment, it must be remembered, was credited to net revenue and ac- cording to the assumptions made proprietary net revenue is paid in dividends. Property (used in Capital Stock . . . $r ,000,000.00 operation) . . $r,93i,493.23 Bonds 1,000,000.00 Sinking Fund Assets 68,506.77 '_ $2,000,000.00 $2,000,000.00 If this policy were continued until the end of the twentieth year the assets would consist of $1,000,000.00 used in business operations and $1,000,000.00 in the sinking fund trustee's hands. The latter sum of course would then be used for paying off the bonds and there would be left but $1,000,000.00 of property represented by the stockholders' equity. It must be admitted that this is an extreme case but it was stated in this form to illustrate the effect of the sinking fund policy on the business when no restrictions are placed on the payment of dividends. The effect is evident ; the bondholders' 428 PRINCIPLES OF ACCOUNTING investment is gradually transformed from property used in the particular business for the purpose of producing revenue, to a fund in the hands of a trustee. The margin of safety for the bondholder is not altered from the original condition. This is an unusual case as the average corporation would not pay all of its net revenue in dividends but would accumulate a surplus of some size. The growth of that surplus is of particular importance to the bondholders as the margin of safety for the bond increases in direct proportion to the increase in that figure. The bondholders may and often do wish to have that surplus increase by exactly the same amount as the sinking fund in- creases each year. When this requirement is placed in the bond contract it is said that the corporation must accumulate its sinking fund "out of profits." It is the use of this phrase that causes so much confusion in accounting for sinking funds. This phrase simply calls upon the directors to set aside sufficient net revenue to equal the sinking fund requirements before paying dividends, and further to label that part of the surplus so re- served as Sinking Fund Reserve. This part of the requirenient is entirely distinct from the other and necessitates another pair of journal entries each year. The entries the first year would be, Net Revenue $33,S8i.7S Sinking Fund Reserve . . . $33,581.75 This would set up a specialized surplus account on the liability side of the balance sheet.' The next year the same entries would be made except that this time the amount should be increased by the amount of the interest accrual. When this requirement is in- cluded in the contract, the property used in business operation can be maintained at $2,000,000.00 as the amount turned over to the trustee comes from net revenue obtained from the .sale of the product. At the end of the twentieth year the sinking fund assets would be used to pay off the bonds and the balance sheet would then appear, Property (used in Capital Stock . . $1,000,000.00 operation) . . . $2,000,000.00 Sinking Fund Reserve i,opo,ooo.oQ $2,000,000.00 $2,000,000.00 INTEREST TRANSACTIONS — ASSETS ACCOUNTS 429 The Sinking Fund Reserve then becomes a free surplus as was explained in a previous chapter. (See Chapter XIII.) It has been the purpose of the past four chapters to explain the nature of the interest problem as it affects accounting in general, to explain certain mathematical formulas for the com- putation of interest, to illustrate some of the situations that arise which require interest calculations and entries in connection with equity accounts, and to analyze similar transactions with respect to asset accounts. The preceding chapter was con- cerned with problems connected with the equity accounts and therefore with the subject matter of Part Two. This chapter is concerned primarily with the valuation of certain kinds of assets involving interest calculations and is therefore closely connected with the subject matter of Part Four. PART FOUR THE VALUATION OF ASSETS XIX Organization and Construction Under the general head of the valuation of assets it will be convenient to consider first the problem of determining the original property values arising during the organization and construction period. The setting up of the asset accounts and the preparation of the first balance sheet are matters which often involve troublesome questions. This is particularly true of the initiation of the large enterprise. In fact the extent of the financial program required to successfully launch the typical modern enterprise, and the complex nature of the property equip- ment necessary to the operation of such an undertaking, give rise to some of the most difficult problems of accounting analysis. The organization of a single-proprietor enterprise or partnership, with a capital outlay of a few thousand dollars, can be speedily accomplished, and the purchase or actual construction of the necessary property will usually require but a few weeks — or possibly months. The modern corporation, however, often re- quires many milHons in capital, and the construction of the property — in the case of a railroad enterprise, for example — sometimes covers a period of several years. In the following discussion it will not be attempted to cover completely all the accounting problems that arise in this connection. But suffi- cient illustrations will be presented to suggest the nature and scope of the questions involved, and as far as possible the prin- ciples according to which these questions must be answered will be stated. organization costs It is sometimes urged that certain organization costs which do not directly result in physical property should be considered as expense rather than as investment. Examples of such items are 2F 433 434 PRINCIPLES OF ACCOUNTING lawyers' fees and other clerical incorporation costs, commissions paid to underwriters, fees paid to promoters, etc. There is no force in this contention. All legitimate costs which must be incurred to bring about the successful organization of the enter- prise can properly be considered as cost of property or investment. In the first place it should be observed again that whether an item results in an addition to physical property or not is a point of little significance for accounting. Even the outlays for actual construction represent payments for elements other than physical commodities. Both labor and material costs are involved in nearly all items of physical property ; and material cost itself, moreover, can be resolved again into labor and material cost. Both- commodities and services are purchased concurrently during the entire construction period ; and one cost is just as thoroughly a part of the investment as the other. The property category, as has been emphasized repeatedly in the preceding pages, is fundamentally an economic rather than a physical con- cept. Further, the engineering costs — both commodities and serv- ices — are no more properly capital outlays than are the costs of financiering. The building of a railroad, for example, could never be accomplished by the construction engineer alone. The capital of the investor must be drawn to the task, and it may be necessary to interest hundreds or even thousands of individual capitalists. Hence the cost of the promoters' services (the promoter may be said to be the financial engineer), the cost of ' the prospectus, the expenses of underwriting, issuing security certificates, etc., fees paid to the government for the privilege of incorporation — all these outlays are property charges. It might be urged that some services, Uke those furnished by the underwriter, do not have definite market prices, and hence that expenditures for such services are susceptible of financial juggling and manipulation. It is true that the commissions paid to organizers are frequently illegitimate in the sense that nothing of value is received, and occasionally the promoter is overpaid although his service may be a real one ; but there is nearly as much danger of the exploitation of the investor through unreason- able engineering expenditures as through the costs of financier- ing. The contractor's "rake-off" is a too-familiar fact. ORGANIZATION AND CONSTRUCTION 435 In determining the proper property charges during the con- struction period each item should be scrutinized on this basis : does the charge in question represent a condition, service, or commodity necessary to the initiation of the enterprise, and was the price paid a legitimate one under all the circumstances ? In the case of complex properties it is probably seldom possible to secure a record in the property accounts which represents the status of the assets with perfect accuracy at the moment opera- tion begins. The complexities and accidents of the individual case as well as the errors in judgment which are likely to occur on the part of those immediately concerned preclude the pos- sibility of such a result. Some of these difficulties will be con- sidered in the following sections. But certainly the test as to whether or not a particular cost is directly connected with a tangible result is no satisfactory criterion as to the legitimacy of considering the cost in question a capital charge. Some question arises as to what particular property accounts should be charged with organization costs which do not result directly in tangible property. How should costs which are as- signable to the property as a whole, but not to definite units, be treated in the accounts? It would be possible to charge these items on some uniform basis to the specific accounts which repre- sent tangible property ; and the rate of depreciation on the tan- gible assets could be altered to make allowance for these amounts. On the other hand such costs can be charged to special accounts set up for this purpose and this is usually much the best pro- cedure. Wherever costs can not be allocated definitely to specific units of tangible property, and hence to the accounts represent- ing these units, not only should such items be segregated in special accounts but the amount of such costs should appear in the balance sheet specifically labeled. If this practice is followed a question is at once raised as to the legitimacy of any item which seems disproportionately large. ' Unfortunately it is common practice to charge the various plant and equipment accounts with these general costs. The temptation to do this is strong because of the general prejudice in favor of definite tangible assets ; but such a practice makes it possible to cover up unrea- sonable allowances to promoters, construction company profits, and actual losses under the head of tangible property. The 436 PRINCIPLES OF ACCOUNTING amount of organization and construction costs which is not definitely assignable to specific property accounts on a rational basis should therefore always be set up in a separate account. Even if the property is a simple one consisting essentially in a single important asset such as a store building it might be de- sirable to distinguish in the asset accounts between general ex- penditures and ordinary construction costs. The classifications of the Interstate Commerce Commission prescribed for the steam railways recognize the need for such special organization and construction accounts. In the classi- fication "investment in road and equipment" under the head "general expenditures" are found such accounts as "Organiza- tion Expenses," "General Officers and Clerks," "Law" and "Stationery and Printing." These accounts are charged with outlays which are not specifically applicable to the ordinary asset accounts. DEPRECIATION DURING CONSTRUCTION The treatment of depreciation during construction constitutes another important problem of accounting analysis. Whenever the construction- period is of considerable length, physical de- terioration of property inevitably takes place. The question arises as to whether this deterioration is to be considered as giving rise to the expiration of property value — depreciation, and whether this fact should be shown by charges to expense and de- ductions from the cost of property. If one is to be consistent with the view above stated that all outlays for commodities and serv- ices necessary to bring about the initiation of the enterprise are costs of property and hence investment, then a negative answer to the above questions must be given. One or two analogies may serve to justify this conclusion. In constructing buildings and other structures much material is consumed which is not embodied in the final physical result. Consider, for ex- ample, the "forms" necessary in concrete work. This material may be later taken down and discarded, but its cost is always considered as part of the cost of the finished structure. Again, in working up the building material, the workmen are obliged to waste a considerable amount. Raw materials are not of proper size and shape and some waste is unavoidable. Further, the ORGANIZATION AND CONSTRUCTION 437 costs of the tools and machines that are depreciated or worn out in construction work are considered as a part of the cost of the property. No one questions any of these cases. Then why should the wear and tear of the permanent parts of the structure during the construction period be deducted from the cost of the property and considered as an expense? The partial decay of physical property which is embodied in the finished structure is one of the costs of construction akin to the decay of property necessary to the result but not represented in the physical con- stitution of that result. Accordingly, during the construction period proper it is pos- sible for a property as a whole to deteriorate but not to depreciate. At the end of the construction period a property should always stand at one hundred per cent of its legitimate cost (ignoring price changes), although its physical efficiency may be fifteen or twenty per cent less. For if a property is of such a character that its condition when complete is inevitably but eighty per cent of new from the engineering standpoint, then a condition of eighty per cent physical efficiency must represent a value of one hundred per cent. A complication arises in the case of a property which, when complete, is composed of a number of distinct units. Take the case of a railroad enterprise, for example, which requires several years for organization and property construction. The com- pleted property will be composed of tracks, bridges, buildings, locomotives, etc. Each class of property — or even each im- portant asset item — may require a distinct account. Now sup- pose, for example, that twenty locomotives were purchased to haul construction trains, and that at the end of the construction period these locomotives have remaining but sixty per cent of their service Hfe. At the time of purchase the cost of these loco- motives was recorded in a distinct account. Then, although the property as a whole is at a one hundred per cent value, these particular locomotives have actually depreciated forty per cent (ignoring scrap value), and if the account recording the value of these locomotives is to show the correct status of these specific property items it will be necessary to credit the Locomotives account with this item of depreciation. In what account should the concurrent charge be entered? As was explained above 438 PRINCIPLES OF ACCOUNTING this item of depreciation does not constitute a property expiration from the standpoint of the property as a whole. The locomotives in question have virtually given up their value in constructing the finished property in the same manner as have the spades and other small tools used for grading. Hence, when a specific property account (or a valuation account) is credited to indicate • depreciation during construction the concurrent debit should be to some other property account and not to expense. But in what property account is this debit item incident, supposing there be no general property account ? This situation calls for a special asset account, which iriight properly be called Depreciation during Construction. This account should be charged with all the credits to specific property accounts which represent depreciation during the construction period. In this way the status of individual property items can be accurately reflected in the accounts. If the locomotives mentioned above depreciated during a year of the construction period to the amount of $30,000, the following entries would be necessary at the end of the year : Depreciation during Construction .... $30,000 Locomotives $30,000 This depreciation account represents a real property item and should be maintained as a permanent asset account as long as the property as a whole (investment) remains intact. If the other capital assets become depleted the amount appearing in this account should, of course, be written down. Such an ac- count represents a part of the amount by which the value of the entire property as a completed unit exceeds the sum of the values of its specific parts when taken individually. Any construction cost which cannot be directly allocated to specific asset accounts gives rise to the need for a special asset account. INTEREST, DIVIDEND AND TAX ACCRUALS DURING CONSTRUCTION It was emphasized in a preceding chapter that interest in some form is involved in all transactions covering a significant period of time. Evidently, then, interest on the capital invested ac- ORGANIZATION AND CONSTRUCTION 439 crues as an economic fact during the organization and construc- tion period. This can perhaps be made clear by an illustration. Suppose that A and B, equal partners, invest $100,000 in a busi- ness enterprise. It requires a year to construct the plant, in- stall the equipment, and make the other necessary preparations for operation. During this time no sales are made and no in- come is realized, yet undoubtedly the finished plant, ready to operate, is worth more than $100,000. It has a value of $100,000 plus interest on $100,000 for one year (assuming that it was necessary to place the entire amount in a non-interest bearing account at the beginning of the year). If the partners were now to sell the completed property they would certainly expect to receive something more than $100,000 ; and normally the buyer would expect to give more than this figure. The partners have borne the burdens of risk and waiting for which they expected to be recompensed in later prosperous years. If they bear these burdens and forego the future prospects of the business they can reasonably expect some remuneration. The rate of interest that would be involved in such a sale, however, would be somewhat difficult to determine in advance. If A and B had not made this investment they might have al- lowed their funds to remain as bank deposits drawing perhaps four per cent. As another possibility they might have invested in securities yielding seven per cent. Or it might have been pos- sible for the partners to have left their capital in some com- mercial undertaking where it would have yielded fifteen per cent. On the other hand the buyer has had an opportunity during the past year to employ his capital in many alternative lines. Prob- ably no one of these special rates would be effective in setting the value of the finished plant. The market rate of interest implicit in the competitive price for completed establishments of the special type involved would be the effective rate. If it cannot be said that there is any regular market for such properties, then the rate of interest would be determined by the higgling between buyer and seller and the special circumstances involved in the transaction. If A and B do not sell the finished plant, however, should the year's interest accrual be recognized on their books? The first practical difficulty arising would be the determination of the 440 PRINCIPLES OF ACCOUNTING proper rate to be applied to the investment as explained above. Even if this difficulty be ignored other more serious questions rise. In discussing this query it will be convenient first to con- sider the entries that would be made if the interest accrual were recorded, and the general significance of such a policy. Suppose that a rate of six per cent is used. The interest ac- crual during the year of construction, then, is $6,000. This increase in the value of the plant means a corresponding increase in the equities of A and B. The entries would be somewhat as follows : Plant (Interest during Construction) .... $6,000 A, Capital $3,000 B, Capital $3,000 These entries have the same effect upon the balance sheet as would an ordinary annual income item which was not distributed. Assets have increased by $6,000, and proprietorship has increased by a hke amount. In other words the first year was not a lean year at all. Income has actually accrued. Now while un- doubtedly interest has accrued in a sense, would not such an accounting policy defeat the purposes for which the accounts are intended? Is it reasonable to capitalize the services of the owners themselves in determining the value of the property? The accounts are kept, it must be remembered, primarily from the standpoint of 'the private owners. Then should not the asset accounts show only the value of all services and commodities purchased by the owners, and not the value of services furnished by themselves? Further, to be consistent with the view that interest accruing during the operating period is not an expense but a distribution of income, it is necessary to insist that interest accruing on the investment of the owners is never a capital charge. From the standpoint of the partners the construction period in this case is actually a lean period. No income accrues in the first year. It is expected, however, that income in later years will yield a high enough rate on the original investment to make up for the period of waiting. To accrue interest in the first year tends to obscure the actual business situation. Any such policy is a step in the direction of the elimination of the fluctuations in ORGANIZATION AND CONSTRUCTION 441 the rate of net income. If the property account is charged with interest on investment the actual income realized in later years gives a smaller rate per cent on the value of the property than would otherwise be the case. Is it not more rational for ac- counting purposes to assume that no interest accrues during the construction period, and that the income earned in later years gives a correspondingly higher rate on the actual investment ? If the value of all of the services of the equities — risk-bearing, waiting and management — were considered as asset charges year by year there would be no net revenue at all in the ordinary sense. Income paid to the owner would be the price of the owner's service, the retirement of a current asset, in much the same way that the wages paid to the laborer are the price of the laborer's service. The expense for the year — the expiration of capital assets plus the value of commodities and services pur- chased and consumed during the period — would exactly bal- ance revenues. (It should be admitted, of course, that there are accidental and "supra-marginal" incomes going to particular enterprises which do not in any sense represent returns for serv- ices or abihty, but are rather economic "rents.") If the in- dustrial community were organized as a gigantic socialistic en- terprise the services of ownership might be purchased and entered in the accounts in the same manner as all other items. In the present situation, however, any such viewpoint in accounting seems fantastic. To consider interest accruals or other phases of income as a part of the cost of a property, in other words, introduces into ac- counting the capitalization theory in an unreasonable manner. The owners of a property expect to realize a satisfactory return on the investment, it is true, but in the typical case the exact rate of return is not known and no return whatever is assured. The owners not only may not realize any income but the original investment may be lost if the enterprise is unsuccessful. It cannot be insisted,- therefore, that the value of the property is increasing as time elapses because of interest accruals. There are some further considerations on the other side of the question to be noted", however, for if the partners in the above case actually sell the completed property for $106,000, it must be admitted that on the books of the buyer the increased valua- 442 PRINCIPLES OF ACCOUNTING tion should appear as an asset. But the property is unchanged by the sale, it might be urged, and is accordingly worth $106,000 before the transaction occurs. Therefore is it not being insisted that a company that buys a completed property shall prepare its first balance sheet on a different basis from that used by a com- pany that constructs its own property? This seems a rather serious objection to the viewpoint stressed above, and it can only be answered by saying again that the accounts in a particular case are kept primarily to furnish information to the particular owners involved. If a construction company builds the plant, the operating company buys the service of the construction com- pany. Interest and profit are involved in this price as in every other market price. This situation is exactly analogous to the purchase of a finished machine or any other asset. The price of the unit covers all of the essential economic elements. There is still a serious question, however, as to the propriety of accruing interest in the accounts on a firm's own capital because of the lapse of time. This means putting into the balance sheet the value of a service which the owners furnish to themselves, so to speak. The case in which interest payments are actually made to the owners during the construction period should be considered. Suppose that the partners A and B mentioned above decide at the end of the year to withdraw $3,000 each from the joint funds. In this event, evidently, but $94,000 would be invested in the ■property. The entries recording the withdrawals should be: A, Capital $3,000 B, Capital $3,000 Cash $6,000 The amount withdrawn cannot still be considered a part of the cost of the property. Obviously if the partners had not made this agreement an additional $6,000 would have been invested in the plant. Similarly in the case of a corporation, dividends paid to the stockholders during the period of construction cannot be con- sidered a capital charge. Suppose, for example, two manufac- turing companies organize with exactly the same capitalizations, each company issuing capital stock to the amount of $1,000,000 ORGANIZATION AND CONSTRUCTION 443 at par. In each case it requires a year to construct the plant. Company A pays its stockholders $60,000 as dividends for the year, company B pays no dividends. The value of the com- pleted property in the first case is evidently $60,000 less than in the second case. There is no way of avoiding this conclu- sion. Company A has no advantages marketwise over company B because of the particular arrangement made with the stock- holders. A compKcation arises in the case of an enterprise financed with both stocks and bonds. Bond interest accrues and is paid regu- larly from the date of issue if the company is not operating. Such interest accruals again are really distributions of capital. It can hardly be said for accounting purposes that the payments made to the bondholder are additions to the value of the property. A comparison between two companies is again useful in this connection. Company A is organized to build an electric rail- way line. Its capitalization is represented by a stock issue of $1,000,000 and a bond issue of $1,000,000, and while the hne and terminals are being constructed interest accrues on the out- standing bonds and is disbursed to the amount of $75,000. Com- pany B is likewise organized to build an electric road. Its capi- tahzation is $2,000,000 in stock issues, and no disbursements are made to the stockholders during construction. Obviously com- pany B will build more miles of track and have a more valuable property than company A. The question now arises as to what particular equity is affected by such a capital withdrawal. Referring to the distinc- tion that has already been made between stockholder and bond- holder it is evident that this burden falls upon the stockholder. The stockholder assumes the larger element of risk, and conse- quently his equity is residual in character. The attitude of the stockholder toward his investment naturally differs from that of the bondholder. The bondholder expects to receive a definite return at certain specified times ; this return is constant, neither increasing nor decreasing. The stockholder, on the other hand, does not look for a return on his investment during the con- struction period. For the interest lost and the risk assumed he expects to be compensated in later prosperous years. He further assumes the burden placed upon the joint capital because of the 444 PRINCIPLES OF ACCOUNTING bondholder's contractual annuity. The stockholder is willing to make this bargain with the bondholder because his later in- come is correspondingly increased due to the small rate allowed the bondholder. It should be reiterated emphatically that this view does not conflict with the well-known economic fact that interest on an investment normally accrues in time, and that consequently an investment in a sense accumulates during the construction period. It is urged, however, that to recognize such an accrual in the accounts simply results in restricting the stated rate of income realized during operation. Such a practice is inconsistent with the theory of accounts followed in this text ; and it would also seem to obscure the practical realities of the case. To the owner the investment does not accumulate during the construction period as does a deposit in the savings bank. Instead the rate which is realized during the operating period is normally enough higher to make up for the period of waiting. This rate is realized, however, during the operating years. In the classifications of the Interstate Commerce Commission already referred to several times is found a capital account en- titled "Interest During Construction." This account is charged with all interest accruing during construction on bonds and sim- ilar securities and on the investment of the stockholders as well. While this practice is contrary to the general view suggested in the foregoing discussion it should be noted that the public utili- ties are not on an entirely competitive basis. The rates of the railroads, for example, are regulated. In view of the fact that the investor in railroad stocks is restricted pretty largely to a non-speculative rate of return there is some propriety in capital- izing the burdens assumed by the stockholder during the initial period of waiting. It should further be noted that the rules of the Commission in prescribing that interest on all investment shall be charged to property are entirely logical. Interest on bonds and stocks are properly placed in exactly the same account- ing category.^ In a later chapter some of the special problems ' "This account shall also include reasonable charges for interest, during the construction period before the property becomes available for service, on the carrier's own funds expended for construction purposes." Classification of Investment in Road and Equipment, 1914, p. 39. ORGANIZATION AND CONSTRUCTION 445 of this type arising in connection with public utility accounting will be discussed. General property taxes must be paid at stated intervals whether net revenue exists or not. The state's claim stands prior to all private equities. Consequently taxes often accrue and are paid during the period of organization and construction. How shall such items be treated in the accounts ? Tax payments, as was previously explained, constitute a somewhat anomalous element in the accounting system. Such items accruing during operation are not expense in the ordinary sense. Nor can tax ■ accruals be considered as a distribution to a typical equity. Nevertheless, as has been pointed out the state virtually has an equity in all taxable property. This equity has a recurring char- acter. It accrues during the government's fiscal period, and is extinguished when the enterprise pays its taxes only to accrue again during the next period. If this accrual were concurrently recorded in the accounts the instants of payment would be the only times at which the government's claim was not shown in the financial records. As was stated in Chapter VIII tax ac- cruals are often recorded at all periods of closing ; but this can be done accurately only when the amount of the tax can be ascertained in advance of payment. Tax payments arising during construction are usually treated as capital charges, and Httle fault can be found with such a pro- cedure. Property taxes are generally levied alike (or roughly so) on all enterprises — operating or in process of construction — ■ of similar character and under the same governmental jurisdic- tion. Accordingly, unless prices are sufficiently high to cover all costs of construction — including taxes — capital will be withdrawn from the given industry until the price of the product rises to a point at which a normal return on these outlays is reaUzed. The actual investment may then be said to include tax payments. It should be freely admitted that practically the same thing may be said about interest accruing during construction. The price of the product in later years will normally recompense the investor for the necessary period of waiting. Again it should be remembered, however, that the accounts are kept from the standpoint of the private equities. Tax payments are a neces- 446 PRINCIPLES OF ACCOUNTING sary outlay, a part of the private owner's actual investment. The interest accrual, on the other hand, is simply a phase of the owner's return, arising from the fact that he makes these neces- sary outlays and waits for his remuneration. THE CONSTRUCTION PERIOD — ILLEGITIMATE COSTS Thus far it has been assumed that no question arises as to the definition of the construction period, but as a matter of fact ■ this is often a serious problem. If the enterprise is forced to languish for long intervals because of the lack of capital, or if the actual construction work is carried on inefficiently, it would be decidedly improper to capitalize the costs of this delay and inefficiency. Or if unusual accidents occur and retard the con- struction work, it would seem unreasonable to load the value of the property with such costs. The determination of a proper length for the construction period presents probably the greatest difiiculty in the case of railroad building. The construction of a railroad several hun- dred miles long may require a number of years. In determining what is a proper construction period in any case, the whole situa- tion must be canvassed. The topographical nature of the country through which the railroad passes is an important factor. All legitimate obstacles to speedy construction must be taken into consideration. It may be that part of the road will be turned over for operation before the entire line is completed. In such a case the depreciation of specific property items and similar charges made from this time on and appKcable to the finished portion of the property cannot be considered as property charges, but are rather deductions from revenue. The construction period is sometimes confused with the "de- velopmental" period. The following case illustrates this con- fusion. A railroad company is compelled because of traffic conditions to change its route and abandon one hundred miles of track. The company petitions the public utihties commission that it be allowed to carry the cost of this abandoned property in the balance sheet as an asset, arguing that the cost of this abandoned fine is really part of the cost of the new road. The old fine is analogous to the "false- work" in a bridge — a neces- ORGANIZATION AND CONSTRUCTION 447 sary step in construction ; the new road is analogous to the com- pleted bridge. This contention represents a questionable ex- tension of the term "construction period." The interval be- tween the time that the road was originally turned over to the operating department, and the date of the completion of the new line, might be called the developmental or experimental period. It would seem unreasonable, however, to consider the finished plant as in the process of construction throughout this entire period.^ It should be admitted, however, that it is not always easy to draw the line between construction and operation. The build- ing of a modern enterprise is a more complex process than the mere physical construction of the property. It is necessary to do preliminary advertising, establish sales agencies, organize the operating force, etc. . It would seem to be a conservative poHcy, however, to treat practically all such costs as operating charges as soon as revenue begins to accrue. There may then be only a small rate of net revenue earned in the first two or three years, or even no net revenue. To extend the construction period unreasonably, however, tends again to inflate property values and to obscure the actual situation. In this connection it should be emphasized that capital may be dissipated as easily during construction as at any other time. The management of a newly organized company is naturally loath to begin business with a deficit appearing in the balance sheet; but if the balance sheet at the end of the construction period were to present the actual status of the enterprise in many cases such a deficit would be shown. The capital of the investor is not in an inviolable position during the construction period. If the construction force is not properly handled the length of the construction period is extended beyond a reasonable time, and the labor cost of the finished plant is consequently inflated. If materials are carelessly used there may be unusual waste and delay, and the material cost will be, accordingly, an unreasonable figure. Dishonesty and inefficiency are often responsible for ' Peculiar problems arise in railroad accounting, however, as -vf as stated above, because of the fact of public regulation. Chapter XXXI is devoted to a discussion of some of these problems. In Chapter XXIV the significance of " going " or developmental value wiU be considered. 448 PRINCIPLES OF ACCOUNTING construction figures which are ridiculously high, and though all such items are usually charged to the property accounts yet this fact does not justify the practice. It is just as important that the original values set upon the assets taken over by the operating officials should be correctly stated as that later valuations should be correct. The fact that an actual transaction has taken place and that a cost has been incurred does not of necessity mean that the out- lay is a proper capital charge even if the transaction occurs during construction. If all expenditures during organization and construction are allowed as costs of property the original valuation set upon the assets may include a considerable item of capital dissipation. On the other hand any normal, necessary expenditure for commodities or services is allowable. The rep- resentative case should be taken as a basis for determining the legitimate values of newly constructed property units. DISCOUNTS ON SECURITIES The treatment of the accounts which represent the securities issued at the time of organization requires further consideration in this connection. As was stated in Chapter XIII it seldom happens that the value of the property acquired or constructed (even when all legitimate capital costs are included) exactly equals the par value of the securities issued. Usually the nominal capitalization exceeds the actual investment. This should not necessarily be considered an improper situation. It simply means that in American business finance it is somewhat difficult to issue securities except at a discount. It is customary, however, to enter securities in the accounts at par and to inflate property values correspondingly. Very frequently the par of the securities issued is taken as the basis for the valuation of the assets in the first balance sheet. The securities are placed on one side of the balance sheet at par ; the asset items appear on the other side showing the same total. In other words discounts are covered up by charges to property, in an attempt to validate the par value of the outstanding securities. Such a practice is, of course, entirely improper. In such a case the sums appearing in the asset accounts may bear little ORGANIZATION AND CONSTRUCTION 449 relation to the actual value of the property. The par of the stock issued is a formal fact which reflects investment only in the most general way. In a specific case it may be a fact of little importance. The reluctance on the part of the management to show a valuation item on the left-hand side of the balance sheet seems to be responsible for this practice. If the situation were understood by investors and others interested there is no reason why an item of discount on stock appearing on the balance sheet should be considered as a reflection on the financial condition of the company. For accounting purposes a par value for stock might well be dispensed with. The importance of par value in the accounts is usually greatly over-emphasized. It would be entirely pos- sible to issue securities which have no repayment date (such as capital stock) without a stated par value. It might be objected that capital stock without a nominal value could not be conven- iently handled in the accounting records, but this is not a very serious objection. As was stated before no difficulty arises in the treatment of partnership or single-proprietor proprietary accounts because of the absence of a par value for proprietorship. Without a par value a share of stock would simply represent a certain definite fraction of the total of the stockholders' equity. It is not necessary to state a dividend payment as a certain per cent of the nominal value of the stock outstanding. The sig- nificant fact is the per cent of actual proprietorship represented by the dividend. Here again par value is more confusing than illuminatihg. A dividend declaration may also be conveniently expressed at so many dollars per share. It is noticeable that in some states corporations are allowed to organize without stating a par value for the capital stock. If the par of the capital stock appears in the balance sheet the actual amount of the discount should be shown in a separate account as a valuation item. Such an item is a nominal deficit only, and does not represent a dissipation of capital ; but if actual losses occur during the construction period such items con- stitute a real organization deficit as was previously explained. In every case the values of the assets should be determined by the legitimate costs of construction and organization without reference to the par of the securities issued. 45° PRINCIPLES OF ACCOUNTING Large enterprises frequently make use of bond as well as stock issues to secure the necessary capital as has already been explained. The par value of a bond has a greater significance than the par of a stock certificate because it represents the amount which must finally be paid to the investor. The amount of the discount is at the outset a valuation item, but the amount of the deduc- tion declines as the Hability accrues. The proper accounting treatment for items of bond discount has been fully discussed in preceding chapters, but in this connection the point should be emphasized that bond discounts constitute an adjustment in the interest rate, and must not be considered as property costs. Many other questions arise in connection with the valuation of property during the organization and construction period. In the building of a large plant the construction accounts required may be a complex system in themselves. The valuations set upon the assets appearing in the balance sheet at the moment the completed property is turned over to the operating officials should be based on summaries of the construction records. The nature of the systems of construction records required for par- ticular types of work is a matter of technique which cannot be discussed in this connection. An attempt has been made, how- ever, to present some of the typical and difficult problems of analysis which arise during the initiation of an enterprise. XX The Basis for Revaluation In the preceding chapter were discussed some of the typical problems arising in connection with the valuation of assets during or at the close of the organization and construction period. These problems are of importance particularly in the case of enterprises such as the public utilities which require a long con- struction period. Of much wider appHcation and of much greater importance for the accountant, however, is the general problem of the revaluation of assets during the period of operation. The process of taking inventories and making appraisals at the end of each regular accounting period in many cases furnishes the manager and the valuation engineer with almost insolvable problems; and the interpretation of valuations in view of the effect of such estimates upon the accounts and the important financial statements is the crux of the work of the accountant. The fundamental question of principle that arises in valuations concerns the basis of valuation. In deciding upon asset values which basis shall be used — original cost, cost less depreciation, cost of replacement, or some other kind of present value ? From the standpoint of accounting this whole matter simmers down to a consideration of the relative merits of cost and present value as proper bases for accounting entries involving valuations. In referring to valuations in the preceding chapters the importance of present value as the proper basis for inventories has been stressed. It will be necessary at this point, however, to discuss this question more fully. Some considerations already brought out will be briefly reviewed and other aspects of the problem heretofore neglected will be discussed in some detail. THE GENERAL SIGNIFICANCE OF VALUE CHANGES The fluctuation of values is a familiar economic fact. De- pending as they do upon the manifold and variable influences 4SI 452 PRINCIPLES OF ACCOUNTING which make up the industrial situation values are unstable as- pects of commodities, services, and conditions. A value fact is never a permanent fact. Prices on the market rise and fall, and the values of objects and services outside the regular market are subject to similar disturbances. As applied to a specific business enterprise this means that the economic commodities and rights which come into the possession of the enterprise are subject to variations in value in either direc- tion during the periods of varying length within which such items remain in the business. This statement refers, not to changes in value which naturally accrue as services are per- formed upon an object, but to changes due to general operating and economic conditions — • variations resulting from ordinary wear and tear, unusual deterioration, obsolescence, inadequacy, and changes in prices or costs of replacement. As a preliminary to the consideration of the significance of these value changes in the accounts it might be well to emphasize again the fact that accounting deals primarily with economic data — the value representations of economic objects and rights. This may seem obvious but it is a fact that is frequently over- looked in discussions of the functions of accounting in connection with valuations. The accounts proper show the values of things in terms of the money unit. The physical nature of an object is significant for the accountant only in that it affects the value of the object. In keeping account of properties and equities it is of course necessary to record and make use of auxiliary facts such as names of persons, dates, original-document pages, and other details ; and particularly in cost accounting such subsidiary data as the number of units produced, the quantity of materials consumed, and other physical facts, are of great importance. But the most important accounting statement, the balance sheet (which — to refer again to Sprague's statement — is "the groundwork of accountancy, the origin and terminus of every account "), is a statement of values — assets and representations of ownership or equities all expressed in terms of dollars and cents. Accounting, then, deals immediately with value facts. In determining a sound accounting policy in connection with value changes it should be recognized that an adequate appre- ciation of the functions and purposes of accounting is a matter BASIS FOR REVALUATION 453 of the first importance. In a field such as accounting, where one deals with very concrete material, general theories and principles must be finally tested on the basis of their practical utility. It will therefore be desirable at this point to sum up briefly the general functions of accounting as they have been brought out in the preceding chapters. It would be readily admitted by all accountants that it is at least the function of accounting to make and preserve a record of the so-called actual "business" transactions. An accurate, systematic, intelhgible record of contracts, engagements and authorizations must be made. It is necessary to record invest- ments, withdrawals, purchases, sales, etc. In short, any happen- ing based upon some underlying statement such as a voucher, receipt, note, check or other original paper must be recorded and interpreted. To maintain the integrity of contracts and equities in the complex enterprise, and to fix the responsibilities of em- ployees, such data must be carefully compiled. This is account- ing at a minimum. Anyone who is at all familiar with the status of modern ac- counting, however, must realize that this is only a beginning. A bare record of the so-called actual transactions occurring usually reflects the economic history of an enterprise only in a very im- perfect fashion. A record of operation — the internal trans- actions — is essential. The status of commodities and services as purchased, as was stated above, is only momentarily main- tained. These economic objects and rights expire and pass on into other forms. A record of these changes would seem to be an essential part of the accounting in any case. In other words the accounting transactions of a given period may be divided into two broad classes : (i) purchases and sales and other business transfers and exchanges ; and (2) accruals of cost and income.^ A bare record of the first class of transactions alone would never yield a single accounting statement of real importance. The trial balance is the only conclusion arising from such information. It is necessary as was explained in a previous chapter to adjust nearly every figure appearing in the 1 Accruals of cost and income in a broad sense include all variations in the status of the equities resulting from increases and decreases in asset values from whatever cause. 454 PRINCIPLES OF ACCOUNTING typical trial balance in order to prepare an accurate statement of expense and revenue, and an exhibit which presents the financial status of the enterprise at a given date. That is, it is the func- tion of accounting to classify and interpret the data of the busi- ness process in terms of distinct periods oh a rational accrual basis. All accountants are agreed that accounting must go further than a record of actual transactions ; and they are further agreed that all accruals of cost — including the accrued expirations of all assets — should be charged against revenues in ascertaining net revenue for a given period. Depreciation — the value ex- piration of assets — is not only admitted to be a proper niatter for accounting record, but it is insisted that it should be booked. It is recognized that the maintenance of capital does not depend simply upon the number of property units possessed. The investment in any case is an economic fact ; and unless the assets in which the investment is represented are valued on an accrual basis the equities in the investment will also be incorrectly stated. On the other hand the consensus of opinion is distinctly against the recognition of appreciation — increases in asset values — as an accounting fact except in so far as such changes appear in actual purchase and sale occurrences. The fact that there is this array of opinion opposed to the prac- tice of accounting for appreciation might be considered as prima facie evidence that there is very good reason for this doctrine, and hence that any argument against it might as well be aban- doned at the outset.^ This, however, would be an unwarranted conclusion. It may be that the minority opinion is right. One needs to go back but fifteen or twenty years in accounting and judicial opinion to find serious question raised as to the legiti- macy of recognizing the accrued depreciation of fixed assets as an expense. Indeed it has taken some time for accounting opinion to develop to the point of recognizing that the operating expense of a given period is not synonymous in meaning or numeri- cally identical (usually) with the cash outlay for the period. As stated above, however, accountants, courts and commissions are now almost unanimous in their opinion that accrued depreciation ' The weight of legal opinion also supports the view that accrued appreciation should not be booked. BASIS FOR REVALUATION 455 should be booked as an operating expense. It seems reasonable, then, to at least raise a query as to the validity of present opinion in regard to accrued appreciation. There is Httle question as to the logic of the case. There is no peculiar virtue in either the increase or decrease of values. Ac-* countants quite generally admit the inconsistency of their posi- tion ; but they urge that certain practical considerations justify this inconsistency. In the following sections the more impor- tant of these considerations will be discussed. The effect of the recognition of depreciation and appreciation upon the net revenue figure was sufficiently emphasized in Chap- ter X. It was shown that until all value accruals in both direc- tions are taken into account it is not possible to prepare either an accurate income sheet or an accurate balance sheet. The point was emphasized, nioreover, that the maintenance of the integrity of the accounting period depends upon the recognition of all changes as they accrue.^ In the present chapter these matters will be neglected, and other important phases of the problem will receive particular attention. VALUATION AND MANAGEMENT In general it may be said that all of the interests ^ involved in the business enterprise are furthered by efficiency in production. Efficient management is of advantage to all concerned. Ac- cordingly one of the most important phases of modern accounting involves the uses to which accounts and other statistical records may be put to serve managerial purposes. In this section will be considered the question as to which basis for valuation, cost or cost of replacement, has the greater significance for the manager. What is the task of management? In the broadest sense it is the function of the financial and operating managers to make the most efficient possible use of the economic resources at their 1 At this point the student would do well to review the last section of Chapter X. 2 As has been emphasized several times in this text it is the immediate function of accounting, in the ordinary competitive enterprise, to advance the interests of the private owners. The interests of the prospective investor or creditor, of the laborer, and of the public are, of course, involved. 456 PRINCIPLES OF ACCOUNTING disposal ; and it is generally admitted that it is from the accounts and underlying records that the general manager, in large meas- ure, must draw the information which shall enable him to ac- compUsh this task. To be of the utmost assistance to the man- ager in this connection what should the accounts show — the present significances of all assets as nearly as these facts may be ascertained or some other figures? There are at least some reasons for thinking that present values are the all-important consideration. It is not the cost of the building or power-unit or machine which is most significant to the manager interested in a wise utilization of available resources. It is rather the cost of replacement which must form the basis of his reckoning. Sup- pose, for example, that a machine which cost $8,000 is purchased and installed. A httle later another machine is purchased which is similar in every respect to the first machine and will be used for the same purpose. Market conditions have changed, how- ever, and this time the cost is $9,000. Can the manager who looks merely at original figures in such a case make rational decisions? By assumption there is no physical difference be- tween the two units — is there any economic difference ? Can the manager say that the capital cost of producing the product involved is less per unit in the case of the first machine than in the case of the second ? ^ It would seem that the manager must recognize the fact that he now has at his disposal economic re- sources (capital) amounting not to $17,000 but to $18,000. An advance in the price of raw materials furnishes a better illustration of the importance of present values for managerial purposes. Suppose that a company manufacturing special types of copper wire and cables has stocked up on raw copper in 1914 at low prices. Within six months, it will be assumed, the price of 1 The retailer sometimes appears to reason in this way. He has on the shelves, for example, two shipments of canned goods which are identical in every respect but which cost seventeen cents and nineteen cents per can respectively. He now argues that he can sell from the seventeen-cent lot at a little lower figure than from the nineteen-cent shipment because he made the first purchase before the advance in wholesale prices occurred. Since the units are interchangeable such a method of pricing seems entirely irrational. It is noticeable that the merchant in such a case usually is careful to tell the customer aU about the sacrifice he is making, which is in itself evidence of its unreasonableness. In fact this is generally simply a particular method of advertising. Probably in the great majority of cases cost of replacement is effective in setting prices even in the retail market. BASIS FOR REVALUATION 457 copper has advanced fifty per cent. But the manager, reasoning from the data appearing in the merchandise accounts, argues that the company can still profitably manufacture its old product although the price of that product has remained stationary. Would this be making a wise use of the company's economic resources ? Meanwhile certain other products more immediately connected with the carrying on of war have likewise advanced sharply in price. The company might well turn its attention to the new lines. Both the interests of the owners and of the community, would be thereby advanced (assuming, of course, that the market at least approximately expresses the needs of the community). It may be urged, however, that although market conditions are of importance these matters need not affect the accounts, that the manager in any case will naturally be cognizant of the situation and wUl act accordingly. Yet this is hardly a reasonable position since it is generally admitted that it is an important function of the financial accounts to furnish information which will assist the management in making rational decisions regard- ing the employment of the investor's capital. Further, it is always insisted that depreciation due to changes in market conditions should be booked. In the case of laostfixed assets, value declines due to the various important factors contributing to depreciation — wear and tear in use, extraordinary deterioration and damage, obsolescence, etc. — usually more than offset any possible appreciation due to changes in construction costs. And in such cases it is admitted that present value (cost less net depreciation) is the significant accounting figure for managerial and other purposes. It may well be asked : if present value is significant in these cases, why is this not the case where increasing costs of replacement have more than offset the depreciation tendency ? Even if deprecia- tion is the stronger influence, in any case it is important to notice that the appreciation tendency may necessitate an occasional revision of the rate of depreciation. The economic life of a freight car, for example, does not depend merely upon the ordinary depreciation factors but upon cost-of-replacement conditions as well. A particular car might last fifteen years and be scrapped at the end of that period provided there were no changes in prod- uct prices or in replacement costs. If labor and material costs 4S8 PRINCIPLES OF ACCOUNTING advance, however, the management may very wisely decide to use the car twenty years. In the revaluation of assets the ac- countant usually admits the propriety of allowing for price increases provided this influence does not entirely offset deprecia- tion. This is nothing more nor less than the recognition of ap- preciation in a limited sense. If price changes may be allowed to revise the rate of depreciation, why should the validity of price changes which entirely offset depreciation be questioned? This is only one illustration of the way in which appreciation under present practice gets into the accounts in an imperfect fashion. Land furnishes an important exception to the general rule that the fixed assets are subject to net depreciation. In general all land properties rise in value with the industrial growth of the community. Is present value the significant thing here for managerial purposes? While land may not contribute a price- determining cost from the standpoint of the general market, from the standpoint of the specific enterprise land is virtually in the same category as capital. Those economists who have attempted to extend the concept of capital to include land have always argued from this viewpoint. The manager, then, considers land as of essentially the same character as any other asset — a part of the capital cost. In determining what economic resources are being devoted to a particular end land must then be taken into consideration ; and if present values are not recog- nized the accounts will not be of much service in this connection. Economic resources are always measured in terms of present values. It is sometimes objected that if a factory site, for example, appreciates because of an advance in the prices of contiguous property, it does not add anything to the physical efficiency of the site for manufacturing purposes, and hence the increment should not be registered in the accounts.^ This objection appears to involve the old confusion between utility and value, or, at least, is based on the failure to appreciate the ' Montgomery in his "Auditing" talces the position that in the case of land cost should always be shown in the accounts whether present value is lower or higher on the ground that an appreciated or depreciated site is no more nor less valuable for the specialized purpose to which it is being put than it was when purchased. This BASIS FOR REVALUATION 459 fact that accounting deals with economic data. If all similar sites have risen in value, an advance in the price of the product will accompany this change. If only the value of a particular site has increased, due to conditions entirely outside of the in- dustry involved, this fact should be recognized in the accounts so that the management may realize the situation, and either make more efficient use of the property or move the enterprise as soon as feasible to a cheaper site. It is largely dUe to the recognition of such value changes that the continuous shifting of economic resources so essential to general industrial welfare is accomplished. In the case of the appreciated factory site it is evident that a piece of land is being devoted to a purpose for which it is too valuable — ■ either from the standpoint of public or private interest. This point can be made emphatic by the consideration of a rather extreme case. In a certain large city a small weather- beaten structure used as a repair shop is located in the "down- town" district, surrounded by modern buildings. The site was purchased many years ago for about $1,000. On the basis of the value of contiguous property the site is now worth about $25,000. Should the owner of the shop consider the land as still worth but $1,000 on the ground that this is the cost figure and that the site is no more valuable for his purpose than it was for- merly (assuming this to be true) ? Would not such an opinion is at least a logical standpoint but such a view denies that it is the function of the accounts to show economic facts. Montgomery's argument against the validity of recognizing an increased valuation in land is interesting. He urges that not only is an increase in site values not a benefit to a manufacturing company but it is an actual detriment because of the increased taxes which are likely to follow. In much the same sense it might be said that any increase in capital costs is a detriment. If it costs $2 ,000 more to replace a machine than the original cost of the unit removed, it is clear that the capital cost of producing the commodity or service involved has increased. It is just such facts, however, which the management wishes to know and which should be shown by the accounts. Similarly if an asset declines in value this fact should be recognized, although the physical efficiency of the asset may be as great as before. Obviously a once valuable tract of land might become worthless because of industrial and market changes, although its usefulness for the particular purpose for which it was secured were unimpaired. If an item has actually lost its economic character it no longer represents a part of the capital of the business and may be entirely omitted from the balance sheet. It should be noted, however, that in a few cases an item may have an actual economic significance to a particular enterprise, although it has no general market value. 460 PRINCIPLES OF ACCOUNTING be entirely irrational and impractical, and be judged as due to obstinacy or other eccentricity ? Another phase of the relation between management and the accounts hes in the uses to which the records may be put by those ultimately in authority in determining the efficiency of the oper- ating officials. The accounts can be made an effective tool in fixing the responsibilities of the manager and other employees, and may be used to some extent as an index of efficiency to guide the directors and owners in their judgments. It was suggested in Chapter X (page 242) that in some cases this can be more effectively accomplished by the recognition of appreciation. Another illustration will be given at this point. During 1914, A, it will be assumed, is manager for the X Co. The war interferes with sales and hence there is a poor showing of revenue. A, however, stocks up with raw materials during August and Sep- tember at very favorable prices. By December business has revived somewhat and the prices of materials have advanced. It would now cost the X Co. $200,000 additional to buy its stock of materials. The directors, however, dissatisfied with A's showing dismiss him and engage B. During 1915 the business revival continues, and B makes an exceedingly favorable showing of net revenue for the year. Of this amount $200,000 is clearly due to A's foresight. If these accounts are to be used to reflect managerial efficiency it would seem that appreciation of mate- rials to the amount of $200,000 should be credited to the revenue of 1914. (This situation, of course, is a special case. The manager may or may not be responsible for unusual gains or losses.) Much more might be said concerning the significance of present values for general managerial purposes. The suggestions made would seem at least to raise a substantial query as to the reason- ableness of keeping accrued appreciation out of the records. Can the manager intelligently choose between methods, processes, machines, products, on the basis of historical figures? Should he not base his decisions upon a recognition of the present sig- nificance of all commodities and services available? And if the accounts are to be used by the manager — ■ should not this information be presented in the accounts? BASIS FOR REVALUATION 46]-. THE MEASUREMENT OF INVESTMENT OR SACRIFICE An objection to the recognition of appreciation in the accounts to which particular attention has been directed in discussions of public utility accounting and also of general accounting is based upon the contention that the accounts should show cost figures because cbst represents the investment or sacrifice of the investor. The validity of this viewpoint may be questioned on two bases. In the first place cost figures as ordinarily under- stood do not show the actual sacrifice of the investor ; and in the second place, it is doubtful if it is the function of the accounts to present at all times original sacrifice. Each of these propo- sitions will be briefly considered. Original cost figures would permanently show the sacrifice of the investor only in a regime of static prices ; and the shifting of prices is an important and famihar characteristic of the modern economic order. These general changes reflect a change — rela- tive or absolute — in the measuring unit itself. The dollar, as is the case with all value units, is not a unit of constant sig- nificance. As prices in general advance the significance of the dollar declines and vice versa. Consequently, in a system of shifting prices, original cost (in dollars) does not show original sacrifice. Suppose, for example, that $100,000 in capital is invested in a manufacturing enterprise in 1910. This means fioOjOoo in terms of igio dollars. If in 1917 prices in general have advanced forty per cent this means — ignoring deprecia- tion — that in terms of igiy dollars the actual investment or sacrifice of the stockholders is $140,000 rather than $100,000. Thus the importance of original cost figures — as representing sacrifice — disappears in large measure in a period of changing prices. Moreover, prices are always changing. In accounting there is little propriety in the assumption of static prices. In order to follow original sacrifices, then, it would be neces- sary to recognize changes in the significance of the money unit in the accounts.^ But it is very doubtful if the accounts should show original sacrifice. It has been argued thus far that costs 1 In Should Accounts Reflect the Changing Value of the Dollar?, Journal of Account- ancy, issue of February, 1918, Livingston Middleditch suggests a way in which this may be done. 462 PRINCIPLES OF ACCOUNTING of replacement should form the basis for the revaluation of assets for accounting purposes ; and actual sacrifice and cost of replace- ment are not likely to coincide. The change in the value of the dollar reflects general price changes. But it is not values in general but specific values which the accounts should show. The accounts of an enterprise should present as nearly as possible the actual values of the specific assets which malie up its invest- ment. Cost figures, properly adjusted to allow for changes in the money unit, give a correct expression of the original invest- ment. Cost of replacement figures, with proper allowances for depreciation, give present values. An illustration will perhaps serve to make the distinction between present value and sacrifice figures entirely clear. The A Company buys a shipment of raw materials at the beginning of thej^ear. The cost is $25,000. At this time this figure rep- resents the investment of the owners and actual value as well. Within three months a general price movement has occurred which means a depreciation in the significance of the dollar of twenty-five per cent. This corresponds to an advance in general prices of thirty-three and one-third per cent. Expressed in terms of the new dollar, then, the above shipment of materials would have a value of $33,333.33. This figure represents the sacrifice of the investor in terms of the current dollar. It is very unUkely, however, that the cost of replacement of this particular com- modity has advanced in exact proportion to general price change. The price of the materials involved may have advanced fifty per cent, for example. The values of all commodities and services do not rise and fall evenly. A particular commodity may even fall in price although the general movement is in the opposite direction. Accordingly, if the property accounts are used to represent the values of the specific assets involved, in any case it is specific and not general price changes which are significant, and the figures which represent original sacrifice will not be maintained. It is the function of the asset accounts to follow the capital investment of the owner as it takes shape in different units and types of property. Subject as it is to the varying conditions in the economic situation this investment may increase or decrease, reflecting, of course, a corresponding increase or decrease in BASIS FOR REVALUATION 463 ownership. If it were true that the actual capital of the investor was not subject to change because of technical and economic conditions, then it would be the function of the accounts to show at all times original sacrifice. But this does not at all conform to the realities of the case. A given capital fund may be entirely dissipated because of business losses. Of what importance would it be in such a case to present original sacrifice figures in the property accounts ? Another fund of capital may be doubled in a few years because of successful management or accidental circumstances. Similarly in this case original investment is not the proper basis for asset valuations. No fund of capital is actually static in a dynamic economic situation. The discussion in the preceding paragraphs refers to the com- petitive enterprise. In the case of publicly regulated enterprises, where rates are not market prices, there are other elements to be considered in determining the proper basis for valuations for accounting purposes. The courts have held that the investor in public utilities is entitled to a "fair" return on a fair value of the property in any case. The question as to what constitutes such a fair value is still unsettled. Undoubtedly the original sacrifice of the investor is a matter of greater significance in such cases than in the case of the typical competitive enterprise. In Chapter XXXI this problem will be discussed. SPECIAL OBJECTIONS TO THE RECOGNITION OF APPRECIATION It may be said that to recognize the appreciation of either fixed or current assets is unwise because it may be necessary to revise the estimates if prices fall. This objection does not seem to be very serious because the same thing may be said of any asset value ; and it may be said of original cost as well as of ap- preciated value. All asset values are more or less uncertain, or, in other words, are subject to revision. A factory which costs $1,000,000 to build may become nearly worthless within a short time due to the exigencies of the economic situation ; but it would not be wise, therefore, to anticipate bankruptcy and enter the cost of the structure as a deficit in the first place. It is the function of the accounts to follow just such changes. If an equity is impaired through asset losses in one year the accounts 464 PRINCIPLES OF ACCOUNTING should show that fact. If the loss is recouped in a later period the accounts should show the change and in the proper period. Business fortunes vary from year to year. The accounts should present these variations. In this connection the importance of recognizing appreciation in order to maintain the integrity of the accounting period should be reemphasized. The emphasis upon the period is one of the striking characteristics of modern accounting. In order that periods may be separated sharply trial balance figures are ad- justed on an accrual basis. Inventories of goods in process and finished goods are taken. Costs apphcable to such goods are included in these inventory figures so that deductions from sales for the period will not be overstated. Similarly revenues are accrued. It is considered to be good practice in contractors' accounts, for example, to apportion sales figures over the entire period of construction. All of these accruals are recognized to maintain the integrity of the period. To carry this procedure to its logical conclusion it would seem reasonable, then, to accrue appreciation of raw materials, for example, instead of waiting until a sale is made. Another argument always raised against the practice of ap- preciating unsold assets is that such a procedure anticipates profits. (See Chapter X.) This argument is entirely fallacious. To use selling prices in taking inventories — in other words to capitalize the services of the firm before those services are per- formed — is to anticipate profits. To recognize changing capi- tal costs and equity changes due to the appreciation of working or fixed assets is an entirely different thing. Suppose, for ex- ample, that materials on the shelves cost fifty cents per unit and that cost of replacement becomes sixty cents. This is appre- ciation. To inventory these materials at eighty cents — selling price — would be to forecast profits. This argument comes up in various forms. Sometimes it is said that appreciation is "unreahzed profit." This is again unsound. Suppose that an individual owns a bond and that it advances in value. The profit has been reahzed in the ordinary accounting sense although a sale has not been made. All accruals are, of course, based on "unreahzed" transactions. Accruals of cost in connection with goods in process and finished goods, and ac- BASIS FOR REVALUATION 465 cruals of revenue in connection with an industry like shipbuilding are all in this class. None of these accruals are yet realized in cash. On the other hand a revenue realized in cash may not be a revenue within the period covered by the cash transactions. A railroad company, for example, sells excursion tickets in one month and takes them up in the next. The revenue accrues as the service is rendered. This objection seems to be based on the old fallacy that a profit must be available in cash before it can be recognized. Again it is contended that appreciation is only an estimate and hence that it is not practicable to recognize it in the accounts. In answering this objection it should first be roundly emphasized ' that accounting deals primarily not with absolute certainties but with estimates. Every valuation is an estimate.^ All inventories are estimates. Depreciation is purely a question of estimates, and yet no one argues that accrued depreciation should be omitted from the accounting records. As a matter of fact, moreover, the value of an appreciated asset can be estimated more accurately than a valuation taken on any other basis. In the case of land appreciation, for example, the market for contiguous property gives a fairly reliable indica- tion of the present value of any particular site. But to estimate the depreciation of a factory or a machine is the most difficult problem in accounting. Such a valuation is largely guess. There is no reliable market for second-hand factories. Similarly in connection with working assets and other current items, present values in the case of advances are easily ascertained. The current wholesale prices for materials, for example, can be determined on as rehable a basis as can actual invoice prices. The value expiration of merchandise due to deterioration and shopwear, on the other hand, is very hard to measure. In this connection it may be further objected that present value has so many different connotations that it does not form a reasonable basis for valuations. Present value, for example; may mean a possible cash liquidating value or it may mean the ' In this connection it may be noted that the practice of some auditors who spend a great deal of time endeavoring to locate a small error in the trial balance, and then readily certify to valuations in the balance sheet involving hundreds of thousands of doUars is somewhat unreasonable. 2H 466 PRINCIPLES OF ACCOUNTING cost of replacement. The idea of the "going concern" has con- siderable significance in this connection. Usually it may be taken for granted that the enterprise involved will continue to operate, buying materials and selling finished goods, and that therefore the cost of replacement value is the significant thing. As a rule cost of replacement is higher than the amount which would be received at a forced sale. In the case of such assets as securities, however, liquidating value and replacement cost are essentially the same. The "kind" of present value to be used in making valuations depends upon the condition of the enterprise and the purpose of the valuation in any case. It is usually not very difficult to come to a rational decision. Valuations on a cost basis furnish much more difiicult problems of analysis as will be explained in the next chapter. In the same vein it may be urged that to introduce hypothetical values into the accounts is not a reasonable procedure in itself. This point can be made in a particularly effective way in con- nection with the revaluation of a fixed asset such as land. Can the values of contiguous property be used as a proper basis in revaluing a factory site ? The factory site will probably not come into the market at all for years. The sales of contiguous property may be for residence or other purposes. Do these sales neces- sitate a revision of the value of a site used for an altogether dif- ferent purpose? The valuation of a railway right-of-way fur- nishes a still better case. Should a railroad company's real estate accounts be revised to allow for the appreciation of con- tiguous property which is used for altogether different purposes ? Does the probable cost of replacement — a purely h}^othetical situation ^ have anything to do with the actual value of the railway's land properties ? ^ Can one reason from the market, by analogy, to the values of units in use ? As a general answer to these questions it may be said that the market apparently represents the actual economic situation, and as such it furnishes a standard of value measurement which must never be lost sight of. The market is always admitted to be the proper test when prices decline (price declines constitute a phase of depreciation) and there is no reason for supposing that it is ' In rate-making cases the courts have sometimes held one way, sometimes another, on this proposition. BASIS FOR REVALUATION 467 not of importance as a means of determining value increases. In the case of the factory site mentioned above and in similar problems, however, it should be admitted that even the bona fide values of adjoining tracts cannot always be considered a satis- factory test. If a highly specialized plant is built upon the site, the whole property constitutes an inseparable unit. The values of plant and site are joint. This situation may virtually remove the site from the land market for years. If there is no reasonable possibility that the investor can take advantage of this market it virtually does not exist for him. It may be further contended, as was noted in Chapter X, that although appreciation means an increase in property and conse- quently an increase in property rights, the amount of this in- crease is in no case available for dividend appropriations and consequently should not be recognized. This argument is another phase of the old idea that profits must be available in liquid assets in order to be considered as profits. As a matter of fact the cash with which to pay a dividend can be secured on short-term notes or otherwise. Often corporations find it neces- sary to borrow for brief intervals to make dividend payments, because dividend dates do- not coincide with the times at which the cash balance is large. Net revenue due to appreciation is just as available as is net revenue tied up in any asset other than cash. Net revenue once reaHzed in cash may not be so available at the end of the period, but may be represented then by new equipment and merchandise. Even if cash is available it does not always indicate a rational possibihty of dividends. The cash may be original capital, temporarily in liquid form. Divi- dends depend primarily upon the showing of net revenue and general credit and financial conditions, and not upon the condi- tion of the cash account. A final objection — • probably the most significant — to the thesis that value changes in each direction should be recognized in the accounts is that such a practice savors of non-conservatism ; it opens the doors, it may be said, to all sorts of inflation ; it enables the manager to make any showing he pleases, etc. This objection undoubtedly has some force, but it is hardly conclusive. A clear distinction should be made between conservatism, and downright concealment. The tendency toward overstatements 468 PRINCIPLES OF ACCOUNTING is not necessarily fostered by the adoption of a consistent policy in valuations. Why should a rational mode of thinking be ex- pected to lead to vicious practices? Further it must be re- membered that there are all sorts of ways of juggling accounts, in the absence of governmental restriction, without resorting to an illegitimate use of appreciation. Making inadequate depreciation charges, charging repairs to capital and similar practices, lead to overstatement. Government regulation of some kind is essential if accounts are to be standardized and illegitimate practices prevented. The present illogical attitude of accountants (and of the courts) in regard to asset valuations cannot be expected to do much in the way of promoting sound and conservative accounting practices. Consider this question of conservatism from the standpoint of the auditor who is preparing a balance sheet — the statement of a company's financial condition. The nature of this state- ment is a matter of great importance. In many cases directors, stockholders, bondholders, prospective investors, bankers, credit agencies and other interests see nothing but the summary state- ments and base their conclusions upon these statements. To serve these various interests best how should the balance sheet — the most important financial statement — be prepared ? There would seem to be some reason at least for making the balance sheet what is implied — a correct statement of all the assets and equities in the enterprise as on a given date. What does the investor wish to know ? Certainly he is interested in the actual status of his investment. What does the prospective creditor wish to know? Certainly he is interested in the actual status of the assets and the distribution and extent of the ownership. Now it is evident that every misstatement of an asset means a corresponding misstatement of the proprietor's equity at least. Overstatements of assets by means of fictitious intangibles, in- adequate depreciation charges, maintenance charged to capital, the capitalization of discounts and losses, etc., have long been considered improper because of the fact that everyone concerned is misled by such practices. Any number of actual cases might be given to show that such accounting procedures jeopardize general success and impair specific equities. Understatement of assets is a hardly less reprehensible practice. Such a practice BASIS FOR REVALUATION 469 leads to what are called secret reserves. The impropriety of such accounting has also been stressed by accountants. The de- frauding of minority stockholders and income bondholders, and the other questions of equity that arise have been emphasized in many recent works on accounting. The commendable out- cry against secret reserves, however, should be carried one step further. Ignoring the appreciation of unsold assets which results in an understatement of assets and a corresponding misstatement of equities — is simply another method of building up secret reserves ; and it is essentially as misleading a practice as the charging of capital outlays to expense. To insist that inventories in certain cases must be taken at a figure far below the actual values in order to prevent a general overstatement of assets is from the accountant an admission of incompetence. Is there any reason to think that an understate- ment of the materials inventory by $100,000 will just offset over- statements in other connections ? Why should not each item in the trial balance be handled on its merits? In making adjust- ments why should one not be consistently conservative at all points ? If certain of the accounts receivable are doubtful pare the item to the bone. If the discarded machinery in the store- room has a very dubious value put it on at the nominal sum of one dollar. But when the actual present value of an asset is definitely known, is there any reason for conceahng a part of the item be- cause its present value is above cost? Should the inventories of actual assets whose values are capable of almost exact deter- mination be understated? The point was emphasized in Chapter X that the recognition of appreciation need not obscure cost figures. Special accounts may well be used to represent any such items. If it is desired such value increases might be kept out of the operating accounts. Similarly in the balance sheet special asset and surplus accounts may well be used to represent appreciation. Certainly if the income and balance sheets are prepared on the basis of cost figures (or market if market is the lower) a supplementary state- ment setting forth the actual status of the enterprise should be attached. Accounts and statements which take into account all value changes would surely seem to be of more practical use to all parties concerned than, records prepared on any other basis. XXI The Valuation of Special Assets Whichever basis for valuation, cost or cost of replacement, is decided upon in a particular case, the physical inventories and appraisals must first be taken. The units of certain kinds of property must be counted or measured. Estimates and appraisals are necessary in the case of complex assets such as buildings. Computations and adjustments are required in the valuation of rights such as promissory notes. The taking of inventories is evidently not entirely an accounting problem, but the accountant should be famihar with the general rules to be observed and must be able to decide in a particular case as to whether or not sound principles are being followed. In this chapter a brief discussion of the valuation of particular assets will be given. cash and receivables The values of all assets are measured in terms of money, aild hence, as was explained in a previous chapter, the problem of valuation really does not arise in the case of cash. In other words the trial balance cash figures are usually also the balance sheet figures. If cash is lost or stolen deductions must of course be made; but the physical inventory at any rate is identical with the value inventory since cash is measured in terms of itself as so many dollars and cents. This statement assumes, however, that all kinds of money in the community are cir- culating freely at par or face value. Where paper currency becomes depreciated it is necessary to value such money in terms of the standard currency. In the early days of banking in this country the valuation of the bank notes in the till was about as troublesome a problem as the valuation of a miscellany of shopworn goods. 470 VALUATION OF SPECIAL ASSETS 471 Instruments such as personal checks, cashiers' checks and drafts, postoflftce and express money orders, etc., are commonly treated as cash when received or paid. Since such cash equiva- lents form a large part of the regular medium of exchange it is legitimate to treat such items as cash, although they are not legal tender. Deductions from the face amounts due to ex- change and taxes, however, must sometimes be made. Further, a particular check may of course be worthless because the drawer has insufficient fimds on deposit. Such a situation is usually discovered after the drawee has deposited the check at his bank and has charged the item to his cash account. In this connection it should be remembered that a large part of a firm's cash so- called is simply a highly Uquid account receivable against some bank. Such a fund is consequently not cash in the strictest sense and is subject to a small element of risk. In taking the cash inventory at the end of the accounting period, cash on hand must be carefully counted and added to the sum on deposit. Any cash equivalents should be carefully scrutinized and memoranda which do not represent cash at all should not be included. The cash item as it appears on the balance sheet is often seriously inflated by the inclusion of ficti- tious items. Generally cash is so safeguarded in the case of businesses of much size that practically a perpetual inventory of cash is available. Accounts receivable are one of the most important kinds of current assets in many lines of business. Such accounts usually arise, as was previously explained, from the sale of goods on credit. In a sense an account receivable is not property at all but a claim to property. Such rights, however, are considered as assets in the accounts, and because of their liquid nature such receivables are one of the best assets from the standpoint of creditors. From the accounting standpoint rights to property constitute assets and this class of assets includes a wide variety of items. Securities of all kinds are rights. In much the same sense money is not property but only a highly negotiable claim to commodities and services. With hardly any exceptions the face of the accounts receivable outstanding at the end of any accounting period should be depreciated, as experience has demonstrated that not all cus- 472 PRINCIPLES OF ACCOUNTING tomers can be expected to pay their accounts. This is partic- ularly true of the retail trade, but it is also true in other lines. Bankruptcy is a common occurrence and the creditors of in- solvent firms lose large sums on the open book accounts involved. There are two possible methods of procedure which may be followed in valuing accounts receivable. Each accoimt may be valued on its merits or a certain per cent may be deducted from the outstanding total. In th'e first case the size of the account, the length of time it has run, the financial prospects of the customer, and similar factors would be taken into consideration in deciding upon a proper value for the account. This detailed method of inventory would be advisable in some cases, par- ticularly where a few large accounts only were outstanding. Usually, however, experience furnishes a test which can be relied upon. The merchant finds, for example, that on the average five per cent of the face of the accounts incurred is never paid. At the end of each accounting period, then, an amoimt equivalent to five per cent of the face of the outstanding accounts arising within the past period should be charged against revenue and credited to an appropriate valuation account. The proper entries for such cases were shown in Chapter VIII. In most cases more accurate estimates of the revenue deduction can be made in this way than would be possible if each individual account were appraised. If the business is large enough the amount of worthless accounts can be as accurately estimated as can the total fire loss in the case of a large number of buildings. To select the specific accounts which will not be paid, however, would be almost as difiicult as to pick out the specific buildings which will be burned. Items are sometimes included under the head of accounts receivable which have a doubtful character. Pending railroad claims, accounts in dispute, withdrawals by partners or directors and other questionable items are sometimes thrown in with regular customers' accounts. This is not a desirable practice. In taking the inventory only bona fide accounts should be treated as receivables. Assets which are at best contingent in character should not be included, and loans to owners themselves are a t3^e of asset which should always be isolated. As was stated in another connection, interest usually does not VALUATION OF SPECIAL ASSETS 473 explicitly arise in connection with book accounts. Although impUcit interest may be involved it would not be desirable to attempt to write down such receivables as customers' accounts because they are due in the future. The intervals involved are usually short ; and the theoretical advantages arising from such adjustments would be more than offset by the clerical dis- advantages. There is some question, however, as to the pro- priety of valuing accounts at their face when cash discounts and other deductions may be allowed at the time of settlement. If such potential discounts are large in amount it might be desirable to charge revenue with an amount sufficient to cover the probable deductions and to credit an appropriate valuation account. This is not done as a rule, however, and month by month the error does prove to be a very serious one. The importance of making a reasonable allowance for doubt- ful accounts at the end of each period and the effect of such a deduction upon the accounts and statements has been sufficiently emphasized in preceding chapters. Promissory notes and similar receivables are also subject to depreciation. The accrued deduction may be estimated in much the same way as was just explained for accounts receivable. The payment of a note, however, is somewhat more easily en- forced than that of an account and hence the rate of depreciation is not as high as in the case of open accounts. A note is a written promise to pay, and hence is a prima facie evidence of indebted- ness. An account is only a tacit promise, and it is often diffi- cult to produce satisfactory evidence of indebtedness. The value of a note depends, naturally, upon the integrity of the maker and general financial conditions. In the case of notes the due date is definitely known and the rate of interest involved is either expressly stated or it can be exactly determined. In the case of interest bearing notes the accrued interest is set up as an independent asset. In the case of non-interest bearing notes the interest accrual increases the discounted value. The process of taking inventories of such securities on a mathematical basis was fully discussed in Part Three. It may be assumed that the market for accounts and notes is so imperfect and restricted that the question as to the proper 474 PRINCIPLES OF ACCOUNTING basis for valuation does not arise. As a matter of fact notes are often highly negotiable, and changes in the rate of interest actually affect the values of such assets. MERCHANDISE AND GOODS IN PROCESS Merchandise and finished goods, materials, supplies, and goods in process furnish much more difficult problems of valuation than arise in the case of the receivables. The first question to be considered in connection with the valuation of such current and working assets is the treatment of the various items which make up the total cost. The retailer, for example, buys a shipment of merchandise. The invoice price is |i,ooo. This price, however, does not include the freight which the buyer, it will be assumed, must pay. It does not include the cost of drayage, the cost of uncrating and unpacking, or the expense of shelving and otherwise preparing goods for sale. The value of the merchandise on the shelves, evidently, is the sum of all of these items, $1,200, it may be assumed. The merchant sometimes neglects this analysis and charges the additional costs to expense as they are incurred. Unless the inventory at the end of the period, however, includes a proper percentage of such costs, the value of merchandise on hand will be understated and net revenue will be correspondingly mis- stated. One method of making the necessary adjustment in such cases was explained in Chapter VIII. The theoretically exact procedure would be to charge the merchandise or materials accounts with such additional expenditures as they are incurred. If this is not feasible because of the fact that the amount of operating outlays such as labor and other costs apphcable to the asset accounts cannot be conveniently determined day by day, the division of charges might be made at the end of the period. At that time the proper proportion of the debit balance of the Wages account, for example, could be credited to that account and charged to Merchandise Inventory. The balance of the Wages account would then be closed into Expense and Revenue. Whatever accounting procedure is adopted the inventory of VALUATION OF SPECIAL ASSETS 475 merchandise should certainly not be understated by the omission of legitimate costs. This problem of cost allocation arises still more emphatically in factory accounting in the case of goods in process and finished goods, as was stated in Chapter VIII. Goods in Process must not be inventoried simply on the basis of the value of the materials used. A proper percentage of all the costs of operating the plant should be included in the inventory. Finished goods should be valued on the basis of an apportionment of all the costs with the exception of those expenses peculiarly incident to the selling end of the business. If the entire business process from the purchase of raw material to the delivery of the finished product were considered as a single process, the total cost in- curred, including selling and administrative expenses, might be divided in some arbitrary way between the manufacturing and selling phases of the business. A certain per cent of the total might then be included in the finished goods inventory. The taking of inventories of goods in process and finished goods is essentially a part of the general problem of cost accounting. This is not the place to go into a detailed discussion of cost methods, but the above statement should enable the student to recognize the significance of cost accruals in valuations. Since the prices of such assets as materials and merchandise are subject to market fluctuations the question arises as to whether cost or cost of replacement is the proper basis for valuations. In any case an inventory must be taken to deter- mine the number of units on hand, but in finding the value inventory a decision must be made as to the proper price per unit to apply to the physical inventory. In general accountants adhere to the rule that cost prices should be used unless market prices are lower, in which case market prices should be used. This rule is evidently not in agreement with the general view developed in the preceding chapter ; and it would require some very important practical considerations to justify such an illogical procedure. Why should the cost of replacement or market price be the proper basis for valuation in one case and not in the other? What considerations justify a shifting from one basis to another? The rule adopted is evidently conservative in that the lower 476 PRINCIPLES OF ACCOUNTING of the two important figures is always taken and it is usually justified on this ground. As a matter of fact such a principle of valuation does not insure conservatism. Conservatism is enforced only by sound reasoning, integrity, and governmental regulation. As has been pointed out by several writers a manager interested in making a favorable showing might easily use an illegitimate cost figure in taking the inventory. A small ship- ment might be purchased at an unreasonable price and this figure might be applied to the entire inventory. Unless cost prices are on a strictly competitive basis inventories at cost may be inflated. Similarly in using cost of replacement as a basis for valuation an illegitimate figure may be used. In other words, whichever basis for valuation is nominally adopted, it is possible for a careless or dishonest manager to inflate inventories. The above statement that a manager may take an unduly high cost figure and apply it to all goods on hand suggests one of the most serious difficulties facing the accountant who insists upon cost or market, whichever is the lower, as the proper basis for inventories. In a changing market the goods on hand will usually have been purchased in several lots at several different cost prices. Suppose that all of these cost figures are below the present market price. How is the inventory to be computed? It is usually said that a weighted average cost should be used. This rule, however, only apparently avoids the logical difl&culty of setting several prices upon similar units in the same situation. This may be shown by an illustration. Suppose that a coal dealer is taking an inventory of coal on hand. During the past period he has purchased three shipments of a particular kind of coal at $4, $5, and |6 per ton respectively. There is now on hand 1000 tons of each shipment. The average unit cost is evidently $5 per ton. On the basis of this figure the inventory amounts to $15,000. This, however, is exactly the same figure that is obtained by valuing the three lots of 1000 tons each at $4, $5, and $6 respectively and adding the totals. In other words, the use of the average unit cost in taking inven- tories gives exactly the same results as the valuation of each lot on hand at its actual cost. If cost rather than cost of replace- ment is used as a basis for such valuations there is no way of VALUATION OF SPECIAL ASSETS 477 avoiding a rather ridiculous violation of the law of single price. If this illogical procedure is adopted, there is evidently no advan- tage to be gained from the determination of an average unit cost as far as the taking of the inventory is concerned. Each lot may be valued on the basis of its actual cost without further computation.! The discussion of the valuation of merchandise and materials has thus far ignored the question of possible depreciation due to shopwear or other deterioration, and to obsolescence. Such depreciation, however, is a serious possibility. The management is often reluctant to admit that such value decKnes have occurred, but an important cost in many lines of business is due to deprecia- tion from these causes. Adequate deductions from revenue should be made to cover such expirations. It is exceedingly difi&cult to accurately estimate these changes, and in view of this fact the allowance should be liberal. The concurrent credit entries may be listed in the merchandise accounts or in an appropriate valuation account. As was explained in a preceding chapter it is customary to enter merchandise and similar assets in the accounts at the gross invoice price. When discounts are taken the amount of such allowances virtually constitutes a deduction from the cost of goods purchased. A question arises as to whether in taking the inven- tory any deductions should be made from the value of goods on hand to cover possible discounts. If the amount of the possible discounts is large some deduction on this account should doubt- less be made. Usually this adjustment is ignored and although this procedure is incorrect the amount of the error month by month is small. MACHINERY, BUILDINGS, AND LAND Fixed tangible assets such as buildings and machinery furnish difficult problems in valuations. Such assets are purchased by a business to be used in operation and not to be resold as is mer- chandise ; nor do they become physically embodied in the final product as do raw materials. As was admitted in the preceding ' This discussion is not intended to imply that an average of prices is not a useful figure in connection with inventories and purchases. 478 PRINCIPLES OF ACCOUNTING chapter, cost less depreciation due to causes the effect of which can be calculated with a reasonable degree of accuracy is a fairly satisfactory basis for the valuation of such assets. Espe- cially is this true as long as advancing costs of construction do not offset depreciation entirely. An enterprise in buying a fixed asset such as a building has thereby committed itself to a definite poHcy. Within certain limits changes in the prices of labor and materials do not affect the value of the individual speciaHzed structure. As far as the particular business is concerned, such changes may have no immediate effect upon the price of its product ; and the owners are not in a position to act upon the apparent changing capital cost and convert their capital to an- other use. Only as the building becomes unfit for use through operation — ■ unless conditions change very decidedly — can the capital fund involved be withdrawn. In other words, it is some- what doubtful if market prices can be said to affect the values of fixed assets in use in any definite fashion. The recognition of appreciation due to changing construction costs in connection with fixed assets is then not as important as in the case of current assets already discussed. The changing market prices of materials and merchandise usually are reflected almost immediately in the price of the product. The appre- ciation of such current assets is therefore a fact of immediate significance. In the case of assets such as securities the market price may be identical with the value of securities held without any question, as was explained in Chapter XVIII.-' On the other hand it should be recognized that serious changes in construction costs do affect the values of such assets as machinery and buildings in the long run; and such changes must be rec- ognized by the management if the capital of the investor is to be used to the best advantage. It may .be highly profitable, for example, to remodel an almost new building so that it may be possible to shift from the production of one commodity to another even if the price of the old product is high enough to yield a fair return on the original cost of the plant. While in principle, then, it may be said that market changes affect the values of fixed and current assets alike, it may be ^The regulations governing banking companies, for example, usually re- quire such institutions to value their securities at the market. VALUATION OF SPECIAL ASSETS 479 expedient to ignore minor fluctuations in the construction costs of fixed assets for a period of years. A serious price movement in either direction, however, should be recognized. At least the management must be cognizant of such a change if wise decisions in regard to replacements and reconstruction are to be made. Further, in order to present the correct status of the investment in the balance sheet a significant depreciation or appreciation due to price changes should be recognized in the accounts. The problem of cost allocation also arises in connection with the valuation of fixed assets. The value of a machine purchased and installed, for example, includes the invoice price, trans- portation charges, and installation costs. If a company con- structs its own plant and equipment it may be necessary to set up some special asset accounts which represent the amount of expenditures applicable to the property as a whole but not to individual asset accounts as was explained in Chapter XIX. Wherever costs can be accurately aUbcated, however, they should be apportioned among the plant and equipment accounts. A question sometimes arises as to the valuation of a single property unit constructed by an operating company for its own use. Suppose, for example, that a manufacturing company constructs a power unit at an actual cost of $15,000, and that this same unit, purchased on the market and installed would cost $15,500. Which amount should appear in the company's property accounts? This is essentially the problem of interest during construction already rather fully discussed. The con- clusions reached in Chapter XIX can be applied to this case. The proper asset charge is $15,000. There is no good reason why the company should capitalize its own service and accord- ingly accrue interest and other phases of income on this asset. The company is a constructing as well as an operating company. The rate of return it secures is larger during the period of opera- tion than would be the case if the asset had been constructed by an outside company. It is the function of the property accounts to show the actual investment of the owners, not the amount which the investment would have been if the property had been purchased elsewhere. To increase the value of the property by accruing interest on the actual investment not only means the recognition of revenue before there is good evidence 48o PRINCIPLES OF ACCOUNTING that revenue has accrued, but it also alters the rate of return finally realized in such a way as to obscure the realities of the case. On the other hand, it is important that all costs actually incurred in the construction of the property unit, mentioned above should be charged to the property account. The value of all the materials furnished and labor utihzed is a capital charge. Further, a portion of the ordinary expenses involved in ruiming the regular power plant which furnishes the necessary power for construction operations, as well as a portion of the depreciation of the power plant, should be credited to the regular expense accounts and charged to the new property account. That part of the total expense of operating the plant which is allocatable to the construction of the new unit should be charged to property. If all of these costs are determined and charged to property the difference between the construction cost of the finished unit and its market price should approximately equal the profit of the ordinary construction company. An operating company, evi- dently, will not construct its own equipment unless there is some such difference. The depreciation of such assets as buildings and machinery may be determined by actual appraisals at the end of each accounting period, or these charges may be determined in ad- vance by setting up a schedule which apportions total cost over the estimated service life. In the next two chapters the problems of depreciation accounting will be fully discussed. The distinction between maintenance and improvement of plant and equipment is not always easily made, as was explained in Chapter X, for the actual circumstances of each case must be investigated in coming to a proper decision. Unless a particular charge is quite evidently a value improvement it is a conservative policy to consider the item a repair. The accounting for repairs and renewals will be discussed in the next chapter. Land values are often left on the books for long periods with- out change. This practice is in general justifiable unless very serious changes in the value of contiguous property occur. It is particularly true of land properties that the capital in- volved cannot be withdrawn readily in response to market changes. Hence there is some question as to the importance VALUATION OF SPECIAL ASSETS 481 of the market. As was explained in the preceding chapter a tract of land which is the site of an expensive plant is almost inevitably connected with a particular hne of production for years. It can hardly be said, therefore, that market changes actually affect its value except in the long run. Fluctuations in land values may then be safely ignored unless the change becomes so serious as to make it possible or expedient to change a business pohcy. This statement is only true in the case of factory sites, railway rights-of-way, and similar tracts. The values of lands which are held by realty and development companies, and of timber tracts, mining properties, residence lots, etc., are affected directly by market conditions, and to ignore price changes in such cases is a somewhat questionable procedure. Lands may be acquired by cash payment (or an equivalent) or by the issue of securities. It was stated in a preceding chapter that in such cases the property account is often charged with the par of the securities issued, though such transactions lead to large inflations in the asset accounts since securities are often issued at a discount and the par value in such a case may bear little relation to the actual cost of the property. The property accounts of corporations, accordingly, often show over- stated land values. The valuation of fixed assets such as securities was sufficiently discussed in Chapter XVIII. The fixed intangibles and their valuation will be considered in Chapter XXIV. Deferred assets, such as prepaid insurance and similar rights to services, present no very difficult problems of valuation. The treatment of such assets was briefly considered in Chapter X. XXII The Depreciation Accounts The revaluation of assets for balance sheet purposes, as has already been suggested, presents many complex problems. Particularly is this true of the fixed tangible assets which are used for a rather long period of years and which must have frequent repairs to maintain them in a condition suitable for efficient operation. Between the date such an asset as a piece of machinery is purchased and the date that it is sold for scrap or junk, for instance, there are no market tests obtainable for inventory purposes, and yet valuations must be made if the balance sheet is to be of service as a statement of condition or the expense and revenue sheet as a correct statement of operating results for each accounting period. It is the purpose of this chapter to raise some of the questions in this connection and to explain the nature of the accounts commonly used for recording the data concerning maintenance and depreciation. the depreciation problem It might be well at the outset of this discussion to explain in brief why the problems of maintenance and depreciation are commonly restricted to the fixed asset group of accounts. An important characteristic of the current assets, particularly the current tangibles, is that units of such property are completely consumed in giving off a single service. Consequently the amount of such property consumed may be easily measured. Thus the number of pounds or tons of coal consumed may be determined by physical measurement, and the value expiration may be obtained by multipl}dng this figure by the cost per unit.^ ^ To bring out the essentials of depreciation accounting it has seemed best to ignore, for the most part, the problem of price changes. 482 THE DEPRECIATION ACCOUNTS 483 Similarly the amount of raw materials or merchandise consumed may be determined by inspection (counting, weighing, measuring, etc.) and this amount multiplied by the cost per unit will give the value expiration. In case records of quantity consumed are not kept, the same information can be (and often is) obtained by the inventory process. The quantity on hand is measured physically, multiplied by the price per unit to find the value on hand, and then the value expiration is found by deducting the value on hand from the net charge for item purchased. The important point to be made is that a market price can be applied to single units and that a unit of this type is either completely consumed or not used at all. The value expiration of current intangibles such as the services of advertising, insurance, etc., and outside claims such as notes and accounts receivable, may likewise be measured with ease although the physical units are not available. Such assets remain in the possession of the business for such short periods that inventory figures (and consequently the expense figures) can be readily stated. The market again is available for test- ing the accuracy of the data used in the computation. Moreover current assets are for the most part consumed in the accounting period during which the purchases are made. The retail merchant attempts to "turn" his stock several times during the year and hence keeps as small a stock on hand at any one time as possible. The manufacturer often maintains a stock of raw materials on hand just sufficient to keep the plant ruiming from week to week, and at the close of any accounting period there remains on hand so small a propor- tion of the total purchases of such items that the amount involved in the inventory is relatively small. Contrast this situation with the fixed assets. In the first place ^ fixed asset remains intact, as a unit, over many accounting periods. Such a tangible asset as a building, for example, which costs $10,000 may last for twenty years, the complete building, as a unit, remaining in existence and performing its service throughout the whole period. The amount of $10,000 is an expense of a twenty-year period but the proportion of this expense for each year, or other accounting period, is desired. Physical measurement, obviously, caimot be reUed upon to furnish a 484 PRINCIPLES OF ACCOUNTING basis for value expiration. The building is essentially the same in size, shape, number of rooms, etc., on the day of abandonment as on the day of acquisition. Its condition, however, has deteriorated; the foundation has decayed, the roof needs replacing, the walls are weakened, but it is complete until the day it is retired from service. The value gradually expires throughout the twenty years, however, and it is the purpose of the depreciation accounts to record the value change currently. Depreciation may be defined as the value expiration of fixed property items. As physical measurement cannot be used for determining the depreciation charge in the case of long-hved property items, other types of computation must be relied upon. In the case of long-term securities the accountant has recourse to amortization and annuity schedules, interest tables and formulae, and market quotations. This form of investment, however, presents such specialized problems that a separate chapter has been devoted to the valuation of these assets. Further the downward trend of value changes in securities is not usually spoken of as depreciation although it is of this general character. Fixed tangible and certain intangible assets, however, present a different case. The depreciation problem as discussed in this text is for con- venience divided into two main parts. The present chapter is devoted to a presentation of the different methods for recording depreciation; and a discussion of the methods of measuring depreciation is deferred to the next chapter. One further problem of depreciation which is of considerable practical importance is concerned with the amount which should be deducted from the inventory of the fixed assets of a public utility in order to cover depreciation. The courts have held that the proper base for determining a reasonable rate is the original cost, or the cost of reproduction minus accrued deprecia- tion, but the advisability of this poHcy is often questioned by accountants and engineers. It is said that the method of accounting for depreciation should be considered before deter- mining whether or not any deduction should be made for depre- ciation and if so the amount to be so deducted. This is much more than an accounting question, however, and it will not be taken up in detail. It is simply mentioned here to emphasize THE DEPRECIATION ACCOUNTS 485 the importance of the accounting phases of the problem. Some hght will be shed on the question as the discussion proceeds through both of the chapters. REPAIRS AND RENEWALS Numerous expenditures for repairs must be made on the ordinary fixed physical property item in order to keep the prop- erty in condition for service. The total cost of the property may therefore be considered to be the original purchase price, or construction cost, plus aU expenditures for repairs. The total depreciation of the item is the difference between the total cost and the salvage value at the end of its service life. It is custom- ary, however, to treat this maintenance cost in two parts ; namely, repairs and renewals. A repair is a replacement of a part of a unit, a renewal is a replacement of the whole unit. This is a rather arbitrary distraction but is convenient for use in the accounting records. The unit is the completed property item as represented in the purchase price or construction records at the date of acquisition. Thus the unit of equipment of a railroad is the locomotive, the car, the vessel, etc., though a unit as used in the accounts may differ from the unit of the operating official, who looks upon the locomotive, for example, as made up of a number of structural parts such as boiler, drivers, wheels, etc., any one of which could be considered as a unit for certain purposes. Whenever a replacement of a worn-out part is made it is considered as a repair, and in the technical sense only the replacement of the whole accounting unit constitutes a renewal. A repair is made for the purpose of making good a decrease in the efficiency of a unit through use. If the unit taken for accountrag purposes in each case were sufficiently large, all expenditures to replace property items would be repairs. Usually the imit as accepted is restricted to an asset of such size that this condition could not obtain. It is usually assumed that a repair makes good depreciation which occurs in the accounting period during which the repair is made, but in the ordinary case the repair charge cannot take care of all of the depreciation for it is evident that at some date the entire unit must be renewed. As one author very aptly puts the case, "All machinery is on an 486 PRINCIPLES OF ACCOUNTING irresistible march to the junk heap, and its progress, while it may be delayed, cannot be prevented by repairs." ^ A property unit may become worn out or decayed to such an extent that the cost of repairing the unit would be so great that it would be more practical to abandon the item and purchase an entirely new unit. Indeed one of the functions of the manager is to estimate carefully or compute the comparative expenses incident to the two choices of action. Shall the machine be repaired and operated for another year or shall it be abandoned and a new one purchased? The time must arrive when the latter procedure is the more economical. Further, an item of property which is still in good physical condition for performing the service for which it was purchased, may become worthless through inadequacy or obsolescence. Thus a railroad bridge may be rendered inadequate for use with an increased trafl&c or because a change in the type of commodities carried necessitates heavier locomotives; or a newly invented piece of machinery may replace an older type which is still in good condition but is not capable of producing the service as efi&ciently as the improved t3^e. The depreciation made good by repairs — as stated above — is usually treated as distinct from that made good by renewals. In fact the former is usually spoken of as maintenance to dis- tinguish the character of the charge from depreciation. This terminology may seem somewhat illogical, based as it ultimately is on the arbitrary definition of the unit, but it has certain practical advantages. Obviously, it would be inadvisable, if not absolutely impossible, to treat each small expenditure as a renewal. To make an extreme illustration, there is considerable difference between the replacement of a bolt costing perhaps five cents on an auto truck and the replacement of the truck itself. There are surely certain practical reasons for accounting for the two expenditures on different bases. It must be admitted that the choice of the unit often results in calling certain replacements repairs which might better be called renewals, but the line of differentiation is a good one. The entries for recording repair charges are very simple. The Repair Expense account is charged and Cash, or the prop- '■ Hatfield, Modern Accounting. THE DEPRECIATION ACCOUNTS 487 erty account representing other assets used in making the repair, is credited. Thus if a piece of machinery is overhauled at a cost of $500, the following entries are made, Repair Expense $500 Cash $500 A classification of repair expense accounts is desirable to show the cost of repairing different kinds of property items. A different repair account for each class of property used is desirable. In a large enterprise a complete organization is maintained for doing repair work. The repair expenses in such cases can be used for measuring in some degree the efficiency of the mainte- nance department. The repair accounts again may be further subdivided to show the cost of the different elements entering into the repair work such as labor, materials, power, etc. A classifi- cation of maintenance accounts for administrative purposes is often desired and may be incorporated in a detailed income sheet. The point to be emphasized is that the cost of the repair is charged to the expense accounts of the period in which the repair is made. The renewal of a property item occurs when the old item is taken from service. The item may be replaced with Hke prop- erty or -with an entirely different type. A renewal does not necessarily involve a replacement of a new unit for an old ; the fact that an old item is retired and proper accounting made is sufficient to constitute a renewal. Every unit of property must be replaced by some property equal in value to the one retired if the capital investment is kept intact. That is, if a machine which cost $5,000 is taken from service, property of the same value must be available to take its place. This may be a new machine similar to the old or an entirely new kind of property, but $5,000 must be available in some form to renew or replace the machine taken from service. The cost of the renewal is an expense, a charge against the revenue earned during the period the item is used. All of this expense may be charged against the revenue of the period in which the renewal is made, in which case the replacement poUcy is adopted; or it may be charged partly in each accounting 488 PRINCIPLES OF ACCOUNTING period throughout the service life of the property item, in which case the formal depreciation account pohcy is used. THE REPLACEMENT POLICY When the replacement policy is adopted, the cost of a property item less the salvage value is charged to expense at the end of its service life. This is the most convenient method to use in the accounts as it obviates the necessity for apportioning the depre- ciation over a series of accounting periods. The pohcy is prop- erly applicable, however, only to those properties which consist of a large number of relatively short-hved property units which are consumed in approximately the same quantities during succeeding accounting periods. Railroad ties, telephone poles and the like are illustrations. The number of units runs into the thousands and because of the relatively short period of service, five to eight years for ties, for example, the renewals take place with a fair degree of regularity. It may be assumed without any great degree of error that the value expiration, as measured by the cost of units retired from service, corresponds to the value dechne of all units in service during the same period. The fact that a class of asset items is made up of a large number of units, however, is not conclusive evidence that the replacement policy is the most desirable. The average number of retirements, the tendency .of price changes, the growth of the property, and other conditions must be considered before placing an item in this class. It may readily be seen that this treatment of the depreciation of fixed assets corresponds closely to the method of measuring value expirations of current assets. Each property unit is inventoried at cost continuously from date of acquisition to date of renewal, and expense is charged only when the item is com- pletely consumed. The application of this policy has often led to incorrect analysis resulting in erroneous entries. A few illustrations will serve to make the point clear. A machine which cost $ioo and has been carried in the Machinery account at that figure since the date of purchase is retired from service. The entries for recording the renewal, assuming no salvage value, are, THE DEPRECIATION ACCOUNTS 489 Renewal Expense $100 Machinery $100 These entries should be made no matter what is done about replacing the worn-out item. The expense account must be charged in order to record the fact of property consumption of $100. Machinery, of course, is credited because it is that form of property which has been consumed. A separate Renewal Expense account should be kept for each class of property for which the replacement poHcy is used. Such an account represents the cost of abandoning property and this account, together with the repair accounts for the same class of property, represents the total cost of maintenance. The expense incident to the renewal is measured by the cost of the item retired minus any salvage value; yet this point is not always recognized in the accounts. The classifications of certain pubhc utility commissions define renewal expense as the "cost of replacing in kind" the property item retired minus any salvage value. This rule which is also often followed by industrial concerns leads to certain illogical results in a period of changing prices which can best be explained by illustration. Suppose, for example, that the machine which was retired (refer- ring to the preceding illustration) was replaced by a new machine. The new machine might cost the same amount as the old, or more, or less. The entries in each case are of importance. First then, if the new one cost the same as the old, the entries would be. Machinery $100 Cash $100 This replaces the $100 in the Machinery account and leaves the valuation of machinery the same as before the renewal was made. For convenience in recording the entries and to save duplicate postings, the two entries are often combined, the debit to Machinery in the second offsetting the credit to Machinery in the first, thus. Renewal Expense $100 Cash fioo 490 PRINCIPLES OF ACCOUNTING No criticism can be made of this latter entry provided that it is reaUzed that the expense item refers to the dissipation of the old machine and not the new one. In the case at hand the rule mentioned above that the renewal expense should be the cost of replacing in kind would lead to the same result, but if the new machine costs $iio instead of $ioo there is an important difference. If the first entries had been made charging Renewal Expense with $ioo and credit- ing Machinery with $ioo the entries for the purchase would be, Machinery $iio Cash $110 As a result of the two entries the valuation of machinery is increased by $io, and this is as it should be as the value of the riew machine is, $iio and it should be stated at this figure in the accounts. Now if the two entries were combined as before the result would be. Renewal Expense $ioo Machinery lo Cash $110 These entries recognize what has been said before, that the expense is equal to the cost of the old machine, and the increase in price is added to the machinery valuation. Considerable stress is laid on this point because if the rule mentioned above were applied in this case the following entries would be made, Renewal Expense $iio Cash $iio It may be said that the cost of replacing the old machine in kind is the cost of the new machine, and that therefore the whole cost should be charged to Renewal Expense ; but this obviously leads to an overstated expense account and an understated property account. Two things are doubtless being confused when this rule is applied to such a case, the physical property, and the valtie of the property. It is true that the manager has the same amount of physical property to work with after the renewal as before, but it does not follow from this that the value of the property THE DEPRECIATION ACCOUNTS 491 which he is using is the same as before. The investment in property of the character involved has increased. It has been emphasized at various points in this text that changes in the level of prices should be reflected in the accounts. This is a case in point. The renewal or depreciation cost of the product produced with the aid of the old machine is $100, but this, cost for the product from the new one will be $110. If the entry Just shown were made, this would have the effect of charging $110 to the product of the old machine and further of understating a property account. This also creates a secret reserve. If the accounts were to be used by the manager in directing his course of production these entries would lead to erroneous con- clusions. Likewise security holders would be misled as to the value of their holdings by the extensive use of this method in a period of rising prices. To alter the case once more, -suppose that the new machine costs $90. In this case again the charge to Renewal Expense is $100 but the valuation of machinery has decreased by $10. The entries should be. Renewal Expense $100 Cash $90 Machinery 10 This shows the proper form of entry in the case of falling prices. If the rule of charging Renewal Expense for the cost of replacing in kind were followed here the entries would be. Renewal Expense $90 Cash $90 This would result in an understatement of expenses for the preceding period and an over-valuation of assets on the balance sheet. This procedure is no more to be conamended than in the former case. The renewal expense if the replacement pol- icy is used is the cost of the retired item less any salvage value. FORMAL DEPRECIATION ACCOUNTS When formal depreciation accounts are used, an attempt is made to determine the value expiration of a property unit in 492 PRINCIPLES OF ACCOUNTING each accounting period and to charge that amount to expense. The remaining book value of each unit, therefore, represents the depreciated value. The various accounting, entries possible under this policy will be discussed in the remainder of this chapter ; and the next chapter will be devoted to considering the methods of estimating the amount of depreciation. In order to make the discussion concrete it will be convenient to start with a hjnpothetical situation and alter the conditions for successive steps in the exposition. It will be assumed that the following illustration represents the original balance sheet of an enterprise just organized and ready for business. In order to make the illustration as simple as possible, the balance sheet captions of fixed and current assets are used to designate all of the various types of property items in each group. The ledger of the concern would contain accounts with building, machinery, equipment, etc., under the fixed assets ; and cash, materials, supplies, etc., under current assets. For purposes of illustration these may be grouped under the two headings shown. Fixed Assets .... $100,000 Capital Stock .... $150,000 Current Assets .... 50,000 $150,000 $150,000 After operating for one year, during which time all expenses except depreciation have been recorded, the statement appears as follows. Fixed Assets . . . . $100,000 Capital Stock .... $150,000 Current Assets ■ ■ 7S,ooo Current Liabilities . . 5,000 Revenue (net except for depreciation) . . . 20,000 $175,000 $175,000 The revenue item shown on the equity side is the net result of deducting all expenses from gross revenue except the depre- ciation of the fixed assets. But the decrease of the fixed assets is also an expense, hence the figure stated is not net revenue. If the property has depreciated $10,000, the following entries would record that fact. THE DEPRECIATION ACCOUNTS 493 Depreciation Expense $10,000 Fixed Assets (building, machine, etc.) i $10,000 The Depreciation Expense account is now closed against the revenue figure and the balance sheet would show, Fixed Assets . . . . $90,000 Capital Stock . . . . $150,000 Current Assets . . 7S>ooo Current Liabilities 5,000 Net Revenue . . . 10,000 $165,000 $165,000 The $10,000 item shown in Net Revenue account may be dis- tributed in dividends or otherwise disposed of in the interests of the stockholders. If other classes of securities were outstanding, it is from this figure that the contractual distribution of interest must be met. No distributions could properly have been made until the last journal entry was recorded because, as was stated before, nei revenue was not stated until depreciation was charged. The current asset item will bear considerable analysis. The corporation started operations with an investment of $50,000 in current assets as shown by the first balance sheet, and now there is $75,000 in the same type of property. How did the increase come about? The various current asset items were constantly shifted from one form to another, from raw materials and supplies to finished product and back to cash or accounts receivable from the sale of the product. These were used again for new supplies, labor service, etc., and after producing a finished product, resulted in the acquisition of new assets — cash and accounts receivable. The $75,000 item may not contain any of the original $50,000 of assets. The value of the assets as here represented, however, may well be considered to be a part of the original investment; that is, the original $50,000 invested in current assets is still in the current assets for it has been maintained through the sale of product at least equal in price to the cost of current assets used in production. Then current assets to the amount of $5,000 have been added through the purchase of materials or supplies on open account which are not yet paid for. This is shown in the fact that the current liabilities were increased by $5,000. Further, another $10,000 494 PRINCIPLES OF ACCOUNTING is accounted for in the fact that a net revenue of that amount has been earned. This of course would be in the form of current assets brought in through sales. Finally the remaining $10,000 increase may be accounted for in the fact that the amount of fixed assets which were consumed, and included in the selling price of product, brought in $10,000 in current assets. This accounts for the whole increase. It is the last amount that is of particular significance in this connection. It might be said that a part of the value of the fixed assets ($10,000) has been transferred to current assets; that is, that by charging expense with the depreciation of fixed assets accruing within the period, an equal amount of current assets received through sales is retained in the business as current assets to offset the amount of fixed assets consumed. To make this point still more emphatic, it may be shown that the increases accounted for by the other causes may be disposed of to the present equities without impairing the capital, while the latter cannot. Suppose, for example, that among the current assets there is cash $25,000. The current liabihties could be paid off with $5,000 of this sum and a dividend of $10,000 (equal to the net revenue figure) could be paid out of the balance. After these transactions are consummated, the balance sheet would show, Fixed Assets .... $90,000 Capital Stock .... $150,000 Current Assets . . . 60,000 $150,000 $150,000 There is an additional $10,000 in the current assets over the amount originally invested and this cannot be distributed in dividends without impairing the capital. Any disbursement which does not bring in assets of an equal value at this point would cause a deficit to appear. In this illustration, the credit for depreciation was made directly to the asset accounts. It is assumed that the remaining balance in such an account represents the actual present value of the property. It is often considered desirable to leave the cost figures of all permanent property items in the accounts until a unit is actually retired from service and to make the credits THE DEPRECIATION ACCOUNTS 495 to a valuation account, Allowance for Depreciation, instead. The entries recognizing depreciation in this case would be, Depreciation Expense $10,000 Allowance for Depreciation . . $10,000 As a result of this entry the fixed assets would remain the same and the balance sheet after all other transactions as before would be as follows, Fixed Assets .... $100,000 Capital Stock .... $150,000 Current Assets . . . 60,000 Allowance for Depreciation 10,000 $160,000 $160,000 This represents exactly the same condition as the preceding balance sheet. The use of the account Allowance for Depre- ciation need cause no difficulty as it is the same as placing tem- porarily in another account the credit side of the fixed assets accounts. Each time that a unit of the fixed assets is retired from service, the cost of the item minus any salvage is charged to the Allowance for Depreciation account and credited to the proper fixed asset account. At the end of each accounting period, the accrued depreciation is charged to expense and credited to Allowance for Depreciation. This account should therefore always represent the difference between the cost of the property items actually in service and the present value of those items. The fixed asset accounts always show the original cost of the assets actually in use. In the ordinary situation, the Allowance for Depreciation account will always show a credit balance ; that is, the present value of all fixed assets taken together is always less than the cost of all those assets. This fact scarcely needs demonstration, for in a composite property in no case would all of the assets be renewed at one time. Some items last five years, others fifty or more ; in some years a large and costly item will be renewed, causing a large debit to the valuation account ; in other years, renewals are light causing small debits to this account. The balance therefore fluctuates from year to year ; sometimes it will be a large item, sometimes small, but never reaching zero. The amount of the depreciation charge being in the last 496 PRINCIPLES OF ACCOUNTING analysis an estimate, errors are likely to be made. The charges might be too large or too small. This fact may be discovered at any time but usually not until the date of retiring an item. The amount of depreciation which has been charged for the value decrease in the unit may exceed the actual amount necessary or it may not be large enough. Such a situa- tion is bound to arise and as soon as such conditions are discovered corrective entries should be made. If the previous charges have been too small, Depreciation Expense (or Surplus if the item is large) should be charged and Allowance for Depre- ciation credited for the amoimt of the error. If the converse situation obtains, the correction can be made by debiting Allow- ance for Depreciation and crediting either Net Revenue or Surplus. In case a machine or other property item is suddenly rendered useless because of some unforeseen contingency, the correction might well be temporarily made by debiting a deferred debit account as explained in Chapter X instead of expense. As a general rule corrections are not often necessary and when required are not of much significance. The regular periodical charges take care of depreciation in a fairly adequate manner. In the balance sheet just under discussion there is an additional $10,000 in the current assets due to the fact that the value de- cline in fixed assets has been charged against current revenue. What should be done with these additional assets? Three different policies are open, each being advisable under certain conditions : (i) the assets might be placed in a special fund awaiting the replacement of the fixed assets for which the depreciation charge was made ; (2) they might be given back to the stockholders as a return of capital ; and (3) the funds might be kept active in the enterprise and invested in either additional fixed assets or current assets or partly in each. As each of these cases requires considerable analysis a special section will be devoted to each. THE DEPRECIATION FUND The additional current assets representing the conversion of fixed assets may be placed in a special fund which will always be available for making renewals. Business men and even some THE DEPRECIATION ACCOUNTS . 497 accountants often confuse the depreciation charge as described in the last section with this setting up of a special fund. The statement is frequently made that the depreciation charge results in reserving a fund to replace the property when it is worn out. This does not necessarily follow as has already been shown for the estabhshment of such a fund is purely optional with the company. Other policies are open and are frequently advisable. If a special fund is set up, however, the following entries equal in amount to the Depreciation Expense charge are made, Depreciation Fund $10,000 Cash fio,ooo At the time this entry is made, $10,000 is actually placed in a special cash fund. It may be turned over to a trustee, placed in a special bank account drawing interest, or may be invested in securities which may be easily disposed of when funds are needed for renewals. In any case these funds are not available for general business purposes. After this entry is made, the balance sheet (see the illustra- tion on page 495) would appear as follows. Fixed Assets . . . . $100,000 Capital Stock .... $150,000 Depreciation Fund . 10,000 Allowance for Depreciation 10,000 Current Assets . . . 50,000 $160,000 $160,000 This shows the same condition of the enterprise as the preceding statement except that a part of the current assets has been labeled "Depreciation Fund." The amount in the Depreciation Fund account is just equal to the amount in the Allowance for Depreciation account on the other side of the balance sheet ; but neither one is essential to the other. Allowance for Depreciation would not appear on the balance sheet at all if originally the credit had been made to the asset account instead of to the valuation account. In such a case the fixed assets would stand at $90,000, but the Depreciation Fund would still show $10,000. Likewise it is possible to have the Allowance for Depreciation account shown on the equity side and no fund account on the asset side. This case will be shown more fully in the next section. The point to 2K 498 - PRINCIPLES OF ACCOUNTING be emphasized here is that there is no fundamental relation between the two accounts. The Allowance for Depreciation results from crediting this valuation account instead of a prop- erty account when a charge to expense is made for depreciation. The Depreciation Fund results from taking a certain amount of cash out of the general cash account and placing it in a special fund. The two accounts are equal in amount because the sum set aside is supposed to accumulate to the investment cost of the property, item at the time it is renewed, and the same amount measures the value decline. In some cases it might be convenient to accumulate the fund on another basis than the depreciation charge. In this case the two accounts would not be equal. Normally, however, if a fund is maintained it will be equal in amount to the valuation account balance. The entries at the date of a renewal when the fund is main- tained are of interest. Suppose, for example, that a machine listed in the Machinery account among the fixed assets at $5,000 wears out and requires replacement. The old machine is sold for scrap bringing in $50.' The new machine required to replace the old one costs $6,000. In the first place, the entries recording the salvage from the old unit are, Cash $50 Machinery I50 This leaves $4,950 in the Machinery account which must be written off against Allowance for Depreciation. If the estimate of depreciation has been correct, there will have been just $4,950 charged to Depreciation Expense and credited to Allowance for Depreciation during the service life of the machine. Assuming this to be the case the entries are. Allowance for Depreciation $4,9 So Machinery $4i9So The old machine has now been entirely eliminated from the book accounts. Further, it may be assumed that $4,950 has been placed in the depreciation fund on accoun);' of this machine. This amount should now be available for use in buying the new machine. First that sum will be transferred to the general cash account and for this transaction the entries are, THE DEPRECIATION ACCOUNTS 499 Cash $4,950 Depreciation Fund $4,9So Now the new machine is purchased which, as has been said, costs $6,000. For this purchase the entries are, Machinery $6,000 Cash $6,000 It may be seen that $4,950 of this cash came from the accumulated depreciation fund and $50 from the sale of the scrap. The additional $1,000 called for in the price must be obtained from other sources. Unless the firm has on hand more cash than is needed for current operations, this sum must be obtained through new investment. Additional stock may be issued, or funds may be secured through some form of borrowing such as bonds or notes. In any case, an additional investment of $1,000 is made in machinery. It may be well to inquire as to the advisability of creating a special depreciation fund. Should a firm label a certain part of its cash receipts from the sale of product as a fund which can be used only for replacing specific units of fLxed assets used in pro- ducing the revenue? In general a negative answer might be given to the question. It would be better financial poHcy to use such funds in ordinary business operations. Cash tied up in a special fund such as this cannot be of as much service to a firm as it would be if invested in additional equipment or used as additional working capital, in case these things are needed. But if such increases in equipment are not needed, a fund may be advisable. One case in which this situation might obtain would be in a terminable enterprise such as a mining or timber business. If the fixed capital is invested in a mineral deposit in a specified place and there is no intention of extending the business to new fields, such funds would not be of service for additional equipment and might be kept in a fund until the termination of the enterprise. At this time the assets in the fund should have accumulated to a sufficient size to enable the cor- poration to pay off all securities. Again if a continuous enterprise has reached a relatively static stage in development, particularly with regard to its fixed plant, Soo PRINCIPLES OF ACCOUNTING a fund might be advisable. A water supply plant, for example, may reach a stage where no additional pumps or mains are necessary for a considerable period of time. The funds reserved by the depreciation charge cannot be put to a particularly profitable use in the extension and may be kept in a fund at least until new extensions are planned. DEPRECIATION FUND RETURNED TO INVESTORS In either of the cases Just mentioned a special fund would be justified. The total investment would remain unchanged but the form of assets held would be gradually changing from fixed physical property to cash funds. An alternative plan in either case would be to turn the funds thus freed from the fixed invest- ment back to the security holders. The argument for returning the assets under consideration to the investors runs something like this. The original investment was made to enable the enterprise to secure all of the necessary permanent equipment and working capital to conduct the specific business for which the organization was effected. A part of the investment is converted into cash in the ordinary operations of the business. Since this is not needed in the enterprise, to place this cash in a special fund is to compel the stockholders to change the form of investment from a mining business, for example, which is highly speculative, to a conservative invest- ment. In other words, the corporation is reinvesting its stock- holders' funds on a new basis. As applied to the terminable enterprise this argument has considerable force ; in fact it has the sanction of some few court decisions. It may be seen that the investment of the stock- holder gradually changes, when the depreciation fund is main- tained, from the assets of a mining concern to assets in the form of a savings account in a bank or in securities which usually bear a very low rate of interest. The stockholders may prefer, and with some reason, to have this fund as it accumulates paid over to themselves to invest as they see fit. In case such a procedure is followed, however, care must be exercised to inform the stockholders as to what constitutes a return of original investment and what is dividends on the THE DEPRECIATION ACCOUNTS 501 investment. Two different methods may be used to effect this result, (i) actually buying back some stock with the cash, or (2) paying the cash to all stockholders pro rata as a return of capital. The accounting entries in both cases are of importance. Referring to the balance sheet on page 495 again for an illus- tration, suppose that it is decided to pay the additional funds to stockholders by buying back $10,000 of the stock at par. The entries covering this transaction would be. Capital Stock $10,000 Cash $10,000 and after these entries are made, the balance sheet would show. Fixed Assets .... $100,000 Capital Stock .... $140,000 Current Assets . . . 50,000 Allowance for Depreciation 10,000 $150,000 $150,000 This same procedure would be followed each year until the end of the hfe of the enterprise by which time all of the stock would have been bought back and the affairs of the corporation closed. Legal restrictions would prevent this practice in some states where corporations are not allowed to purchase their own stock. Further it would be practically impossible to buy the stock back at par unless some provision were made in the articles of in- corporation ; and if it were necessary to pay a high premium for the repurchased stock, it would be impossible to return the investment on this basis. In addition to these objections there is a more fundamental reason why this method of returning the investment would usually be inadvisable. It would be necessary to select the stock of certain stockholders for can- cellation each year and these individuals would be obliged to forego their opportunities for high profits in future years in this enterprise and to seek new fields for investment long before they had planned to do so, while the chances for gain would remain in the hands of the favored few whose stock had not been called. Further, if there were any bonds outstanding, the margin of safety for the bondholders would continually de- crease. Securities of a concern which planned to retire stock in this manner could not be issued to advantage. S02 PRINCIPLES OF ACCOUNTING The more reasonable procedure then is to pay the funds over to the stockholders pro rata. In case .this is done, however, the stockholders should be apprised of the fact that the checks they are receiving are for a return of investment and not a dividend. All too often in the past mining concerns in making such payments to stockholders have included the amount in the dividend check, thus leading the stockholder to treat it as income in his private budget. This has resulted from the practice of ignoring depreciation altogether, which, of coursfe, cannot be coinmended. If the fund is distributed on a pro rata basis the entries record- ing that fact would be, Capital Returned f 10,000 Cash $10,000 and the resulting balance sheet would be, Fixed Assets .... $100,000 Capital Stock .... $150,000 Capital Returned . . 10,000 Allowance for Depreciation 10,000 Current Assets . . . 50,000 $160,000 ■ $160,000 Capital Returned is a valuation account, an offset to the pro- prietary account Capital Stock. This account would increase each year until at the expiration of the mine it would be equal in amount to the fixed assets item, which means that all of the investment in the form of property has been returned. Current assets remaining would be sufficient to pay off the balance of the claims of the stockholders. While the policy of returning capital may be advisable in some forms of terminable enterprises, it can seldom be commended for continuous concerns. To return capital to the stockholders of such a business would mean that at a later date — when a renewal must be made — the stockholders must be assessed an amount equal to the amounts previously returned. This not only would be inconvenient but would certainly lead to misunderstandings and probably to ^he failure to obtain the funds needed. Further it would cause the investment market to be very unsettled and increase the risk of stock purchases. For the continuous enter- THE DEPRECIATION ACCOUNTS 503 prise the cash should be retained in a special fund as explained in the preceding section or else used for additional assets in the business as will be further explained in the following section. THE POLICY OF REINVESTING THE FUND IN THE BUSINESS Normally the continuous enterprise is a growing concern. New capital is continually needed for additions to the plant, new equipment, additional working capital, etc. Permanent increases can ultimately be made only through the reinvestment of net earnings or through new investments by security holders. But temporarily the amount reserved by the depreciation charge can well be applied to such additions. In fact it is considered a good form of financiering to use the depreciation funds for additions, even though new capital must be raised for replacing the worn out units at the time of abandonment. It is moreover perfectly proper as the situation is the same as though the depre- ciation funds had been kept for the renewals and new capital raised for additions. The corporation in the meantime would have been reheved of the necessity of issuing new securities for some considerable period and probably would have made some net saving in interest accruals. If this policy were adopted by the company whose balance sheet is shown on page 495, and $10,000 were invested in new machinery, the entries would be, as for any purchase of a like character. Machinery $10,000 Cash $10,000 and the balance sheet after the purchase would show the follow- ing facts. Fixed Assets .... $110,000 Capital Stock .... $150,000 Current Assets . . . 50,000 Allowance for Depreciation 10,000 $160,000 $160,000 The net valuation of the fixed assets is $100,000, the same as it was at the start. But the property situation is somewhat different than before. The original assets, costing $100,000, 504 PRINCIPLES OF ACCOUNTING are still in use although depreciated by $10,000. The $10,000 obtained from revenues which covers this decrease in value of the original assets has been used for purchasing additional equipment. The depreciated value of the old assets plus the cost of the new machinery equals the original investment. The investment is kept intact by this method. The book value of assets (fixed assets minus the Allowance for Depreciation balance) will always be equal to the total amount invested. At the time an item is renewed the entries are simple. Sup- pose for example that a machine which cost $2,500 is sold for junk at the end of five years for $25. The only entries necessary as far as depreciation accounts are concerned are, Cash $ 25 Allowance for Depreciation 2,475 Machinery $2,500 This takes the value of the machine off the books entirely. There may or may not be funds immediately available to replace the abandoned machine. If cash is available the purchase can be made from such funds, but if the cash balance is not large enough to stand the purchase, additional funds must be obtained from stockholders or through borrowing. It might appear on the face as though this were borrowing to replace worn-out property. One looking at the matter superfi- cially might say that this company was borrowing money to pay for a worn-out machine ; but such a criticism is evidently unjust. The loan is not obtained for paying for the old machine, for this has been entirely paid for out of revenues during the Ufe of the machine and the amounts thus received invested in additional equipment. The amount borrowed may properly be considered as new investment in the business, the assets for which are already on hand. The assets of the concern are properly maintained. It may be that additional fixed assets are not needed in amounts equal to the accrual of depreciation but that additional working capital — current assets — are needed. Increasing the inventory of materials, supplies, etc., has the same effect as purchasing new items of permanent property. Some funds might be used for fixed assets and some for current, but the result is the same. In fact if all the funds are not needed for additions to either fixed THE DEPRECIATION ACCOUNTS 505 and current assets a part might be placed in a special fund until actually needed. This would be in effect a combination with the depreciation fund poHcy. Suppose, for example, that the $10,000 reserved by the depreciation charge in the illustrations used throughout the chapter could be used, $5,000 for additional equipment and $2,000 for additional materials, and that the other $3,000 was not immediately desired. This might be placed in a depreciation fund and the balance sheet would show, Fixed Assets .... $105,000 Capital Stock .... $150,000 Depreciation Fund . . 3,000 Allowance for Depreciation 10,000 Current Assets . . . 52,000 $160,000 $160,000 The fund might be kept in this way as a sort of reservoir for cash not needed in business operations immediately but which must be kept in some form in the possession of the company to make good the depreciation of fixed assets. As soon as additional cash is needed, this fund can be "tapped" and used for the pur- pose. The last illustration should make much clearer the point made in the earlier part of the chapter, that there is no necessary relationship between the Depreciation Fund account and the Allowance for Depreciation on the balance sheet. Either one nught appear without the other, both might appear equal in amount, or both might appear with unequal amounts as shown in this balance sheet. As a final consideration the point must once more be em- ■ phasized that depreciation is accounted for satisfactorily when Depreciation Expense is charged and either the specific property account or the Allowance for Depreciation account credited, and that until this entry is made depreciation is not properly accounted for. The question as to whether a fund shall be maintained, or whether capital shall be returned to investors, or whether the funds shall be reinvested in the property, is primarily one of financial poKcy. XXIII Methods of Measuring Depreciation The determination of the amount of depreciation to be entered in the formal depreciation accounts in case this policy is adopted is a matter of considerable importance. It was shown in the last chapter that physical measurement together with market quotations cannot be used for fixed assets in the same manner as for current assets. Some method which spreads the total depreciation over the service Hfe on a reasonable basis must be used. The question as to what is a reasonable basis in the ordinary situations and the methods which meet these conditions furnish the subject matter for this chapter. THE BASIS FOR MEAStJREMENT The most satisfactory basis for measuring the depreciation of a property item if it could be used would be actual inspection. If the appraiser could look at the property and make a reasonable estimate of its present value condition at each inventory date, this would give a sound basis for depreciation charges. But such precision is impossible in the vast majority of cases. The most that can be done by inspection is to estimate the service life of the item and this fact may be made the basis of an apportionment of the depreciation charges to the various expense statements during that term. Physical condition and accrued depreciation are continually being confused and for this reason the distinction between the two terms will be explained in some detail. This confusion of terms often leads to the following error in practice. The physical condition of a property item is expressed in a percentage figure ; that is, the appraiser either by physical measurement or other means of inspection finds that the prop- erty item is less efficient than when new and expresses the pres- So6 METHODS OF MEASURING DEPRECIATION 507 ent condition as a certain per cent of new. This percentage figure is then multiplied by the original cost (or cost of re- production new) to find the present value of the asset, and an illegitimate transition is made by mathematical computation from physical efficiency to value. The following, an actual case, illustrates this point. A law on the statute books of a certain state requires that every station- ary boiler must be absolutely scrapped at the end of twenty years from date of installation no matter how high its production efiiciency on that date. A corporation in this state had a boiler which cost $10,000 and was still in service in 1916 and valued on the books at $8,000 although on that date it had served for eighteen years. The manager said that it was still giving service at eighty per cent and therefore should be valued at eighty per cent of cost. This confusion of physical and value facts is quite common. Obviously a boiler which has only two years of life remaining is not worth four-fifths as much as another boiler, of the same cost, which has twenty years of life. What manager would be willing to pay $8,000 for this boiler in place and performing service if a new one could be obtained at a cost of $10,000 which would perform the same service for twenty years? In general, moreover, the relatively high percentage of efficiency of machinery up to the very date of displacement should make it clear that terms of relative efficiency cannot be directly transposed into terms of value. That this fact is not clearly understood was demonstrated again in the valuation of a certain telephone company's plant in the spring of 191 8. The valuation engineer testified in court that the telephone poles were worth fifty per cent of their cost new. In defense of his statement he submitted statistics showing that on the average the poles had rotted at the ground to a depth of one-half the radius. "^ If the value decreases proportionately with the progress of the rot, then the poles would not be worthless until rotted to the whole depth of the radius. But it would be impossible to allow the deterioration to approach such a limit ' In this case the mathematical error was as gross as the accounting error. If the poles had rotted to a depth of one half the radius, the deterioration amounted to seventy-five per cent instead of fifty per cent. So8 PRINCIPLES OF ACCOUNTING as even a slight wind would settle the matter long before the rot reached the center of the pole. The measurement referred to was improperly used. The productive efi&ciency, as implied above, cannot in the normal case be allowed to fall below a fairly high percentage of the condition when new. Fifty per cent in many cases is the lower Hmit and eighty or more is common. As soon as it is impossible to attain results set by these limits, the item is renewed. The following chart illustrates the point : 100 r-^ 90 The rates of per cent efficiency are shown on the perpendicular axis OA scaled from loo down to o. The years of service Hfe are shown on the horizontal axis OX from i to lo. It is assumed that the asset item being considered cannot be operated at all below seventy per cent efficiency. The curve shows the decrease in efficiency from date of purchase to abandonment. During the first year the efficiency drops below ninety, then from the first to the ninth years there is a very slight decrease, while in the tenth year there is a rapid decline and the item is scrapped as worthless. This, it is said, is the normal situation for machinery as the efficiency falls quite rapidly the first year down almost to the normal. Then the fall is scarcely noticeable until the last year when it falls below the limit set for abandonment and it is discarded. If depreciation were measured on the basis of effi- ciency, the value curve would coincide with the one shown. The METHODS OF MEASURING DEPRECIATION 509 charge for depreciation would be large the first year, then for most of the rest of the service life the charges would be small, and finally at date of abandonment a very large amount would be charged to depreciation. The purpose of depreciation accounts cannot be served in this way. This does not mean that the engineer's figures for productive efficiency are of no service at all in this connection. On the contrary they are indispensable, in most cases, though a different use should be made of them than that shown above. The func- tion of the appraiser is to determine the probable service life and this depends in some measure on the decrease in productive efficiency. At any one time, a judgment can be made as to how much Hfe is left in the item on the basis of present condition. The probable date at which this will fall below the point at which it would be better to discard is the information desired. Given this information together with the cost figures, and probable salvage value, depreciation may be measured on some other basis. Another basis for depreciation charges advocated by some accountants is the revenue figures. It is argued that a rather even flow of income is desired by security holders and that the amounts charged to expense for depreciation can be made Ught in years when gross revenues are small and heavy when gross revenues are large. This poHcy would tend to keep net revenues fairly stable. The amount to be charged might be found by taking a certain fixed rate of the gross revenue, a certain charge per unit of product, or just arbitrary sums which would be very small or nil some years and very large in others. This was the policy of railroads before the Interstate Commerce Commission's rulings compelled the roads to adopt a regular depreciation charge. In years when traffic was heavy and consequently revenues were high a great many renewals would be made, and then when the revenues were light equipment which was practically worthless would be retained in service awaiting a time when revenues would cover the charge. This policy is practiced in part under the present rules. The prop- erty units adopted for accounting purposes are so large that the repairs (replacements of parts of units) constitute a large part of total maintenance. These are charged to expense when incurred. By making repairs in prosperous years and failing Sio PRINCIPLES OF ACCOUNTING to make repairs in lean years, total maintenance can be made to vary with revenue. The argument always urged for this prac- tice is that fluctuations in earnings result in an unsettled condition in the security market. It must be admitted that fluctuation in the dividend rate produces an unfavorable effect on the securities of a corporation, and that it is desirable to keep the dividend rate fairly constant ; but it does not follow from this reasoning that net revenue must be kept fairly stable through manipulating the expense accounts. Net revenue is supposed to represent the difference between gross revenues and expenses for a period, and since both gross revenue and expenses are subject to changes from period to period, the net revenue figure should also change. To use the depreciation accounts to hold net revenue constant is using it to misstate the facts, for net revenue does fluctuate and this fact should not be covered up. As much injustice can be done security holders by presenting income sheets with stable income as by paying dividends of varying rates from year to year. The stockholder minimizes the amount of risk involved if he sees the net revenue figure kept fairly stable, and therefore Net Revenue should represent the facts as nearly as they can be determined. The fact that net revenue fluctuates does not mean that the divident rate must also fluctuate for dividends can be kept con- stant through the use of the surplus accounts. In prosperous years a part of the net revenue may be carried to surplus to await the year of depression when the surplus can be tapped for dividends. In this way net revenue may be correctly stated and dividends kept stable.^ It may be that depreciation charges should be somewhat larger in years when the equipment is being used more fully than in others, but the basis of the charge should be actual depreciation and not the revenue figure as the influence of revenue on values is only general except in the case of intangibles. Costs are the significant facts for tangible assets as has been shown before, and the discounting process does not apply to physical items. To repeat the conclusion drawn with respect to the two bases suggested, physical deterioration alone is not decisive nor is the 1 See Chapter XIII. METHODS OF MEASURING DEPRECIATION 511 gross revenue figure in measuring depreciation of physical assets. The former may be used by the engineer as a basis for estimating the service life, but when this figure is obtained the value decrease must be determined by some other schedule. It will be the purpose of the succeeding sections of this chapter to explain some of the methods used. STRAIGHT LINE METHOD The assumption on which the straight line method is based is that a property item loses an equal amount of value during each year of its service Hfe. An estimate of the probable service life is first made. This, as was stated in the preceding section, is based on an investigation of the physical factors. Further an estimate is made of the probable salvage value, the sale value of the scrap at date of abandonment. The difference between the original cost and salvage value is total depreciation and this amount divided by the service life (expressed in accounting periods) is the regular depreciation charge. Thus if a machine costs $100, and it is estimated that the salvage value will be $5 at the end of ten years, the total depreciation is $95, and the annual charge is $9.50. The reason for calling this a straight line method is evident. The following chart illustrates the situation : 70 60 50 40 ■ 30 ■ 20 ■ ID ■ - 512 PRINCIPLES OF ACCOUNTING The line OA represents the value expressed in dollars, the line OX the life in years. The original value is $ioo and the salvage value at the end of the tenth year is $5. The straight line AB drawn between the points A ($100 value at beginning of first year) and B ($5 value at end of tenth year) represents the value decline for the intervening period. An interesting comparison may be made between the chart on page 508 and this one. In the former the curve represents the decrease in efl&ciency and is typical of the normal physical asset. The line AB in this chart shows the decrease in value according to the straight line method. The two charts may be used for the two classes of facts for the same asset. There are two reasons why this method is found in quite general use. First its simplicity commends it to the average accountant. The figures are easily obtained and the entries can be made with very Httle computation. Second, in all probability the straight line does at least approximate the value decline. The values at two different dates are all that can be tested on the market, one at date of purchase and the other at date of abandonment ; the manager plans to use the item quite constantly throughout the intervening period ; and it is therefore reasonable to expect that the cost of using the item during one period would be approximately the same as for any other. This probably is the fact except for one factor which has not been taken into account. The complete utilization of the item takes time and hence interest must be considered. It was shown in an earlier connection that wherever a durable asset is used, impHcit interest enters into the calculation at some point. (See Chapter XV.) The straight line method fails to recognize this fact. That interest does and should enter into the com- putations may be shown in different ways. It was shown in the last chapter that when the depreciation charge is made a sum of assets is available which is equal to the charge but which cannot be used for dividends. This sum could be applied in one of three ways : (i) placed in a special fund; (2) returned to the investors ; or (3) reinvested in additional plant. No matter which one of these things is done, the invest- ment situation is changed. In the first case the amount retained is placed in a special fund but this special fund is placed where it METHODS OF MEASURING DEPRECIATION S13 will produce some revenue — at least savings bank interest. The original assets then are producing revenue and the funds set aside for depreciation are also producing revenue before they are needed for replacement purposes. In the straight line method this additional revenue is not considered in the depreciation charge. The recognition of this interest is simply another way of recognizing the impKcit interest in the valuation of the original asset. It takes time to obtain the revenues from the asset. A large part of the revenue the first year is net, a smaller part replacement of the investment. In each succeeding year, however, the net revenue (interest) element decreases and the return of investment increases. Another way of bringing out the point very clearly is this. The fund which is set aside is to be used for replacing the asset at the time it is worn out. This being the purpose the interest earned on the fund should be added to the fund and not considered as outside revenue. The following table shows the results of using the straight line method to accumulate such a fund to replace the $100 machine mentioned above when interest can be earned at the rate of five per cent. Yeak Depreciation Fund FmsT OF Yeak Interest on Fund Depreciation Charge Depreciation Fund End of Year I 0.00 0.00 9-5° 9-50 2 9- SO .48 9-50 19.48 3 19.48 -97 9-5° 29-95 4 29-95 1.50 9-5° 40.9s S 40.9s 2.0s 9-50 52.50 6 S2-,SO 2.62 9- SO 64.62 7 64.62 3-23 9- SO 77-35 8 77-35 3-87 9- SO 90,72 9 90.72 4-54 9- SO 104.76 10 104.76 S-24 9- SO 119-50 The fund actually accumulates to $119.50 while the depre- ciation fund required is only $95.00. The $24.50 difference is interest earned on the fund. The fund accumulated to more than was called for because the sum annually placed in the fund was larger than necessary. But the annual increase in the 514 PRINCIPLES OF ACCOUNTING fund was obtained through the depreciation charge. Depre- ciation charges then have been improperly distributed as be- tween years. Expenses have been stated too large at least in the early years and net revenue has accordingly been stated too low. This understatement of net revenue is finally corrected, of course, as shown by the fact that the fund is greater than needed at the renewal date, and the final result at the end of the ten-year period is the same as though interest had been recog- nized; but the periodical statements throughout the ten-year period contain this element of error. The same situation obtains in case the fund is returned to the stockholders, for here the interest earning on the fund is paid directly to the stockholders. The net revenue from operation in the early years is understated but the amount of the under- statement comes back in the form of interest received by the stockholder on the capital which has been returned to him. The interest calculation must be made even though the fund is not kept in the corporation's possession. Finally if the fund is reinvested in additional assets for the company, the same conditions arise. The new investment will be made only in case revenue can be earned sufficient to cover interest. In this case the revenue from the fund is received by the company only not specifically as interest, as it is a part of the general revenue of the concern. In any case then it would seem that interest must be considered in the depreciation charge. The chief methods advocated for taking care of the interest element are the sinking fund and the compound interest methods. These will be considered in the next two sections. Before going on to this discussion, however, it might be well to make one further statement in defense of the straight line method from the practical standpoint. Depreciation in the last analysis is an estimate. The service life as stated in advance is the judgment of the manager or valuation engineer ; in very few instances will the final results coincide with the original estimate ; and corrections must be made as soon as an error in judgment has been discovered. In all probability therefore the errors in estimate will in large measure at least offset the errors from omitting the interest calculation. The importance of this consideration is minimized as statistics of service Ufe become more METHODS OF MEASURING DEPRECIATION SIS accurate through the use of experience tables and as equipment becomes more standardized. The more accurate the estimates of service life, the more important it is to take the interest element into account. THE SINKING FUND METHOD The annual charge for depreciation under the sinking fund method is an annuity which will accumulate at a given rate of interest to the cost less salvage value at the time a property item is abandoned. An amount equal to the annual charge is placed in a special fund each year, hence this method can be used only when the special fund is maintained. As an illustration oi this method, the case of the machine illustrated under the straight line method may be used. That is, the machine costs $ioo, will last ten years and have a salvage value of $5. Further it may be assumed that the fund can be invested at five per cent convertible annually. The annuity which will accumulate to $95 (cost less salvage value) in ten years may be found by the use of formula (25) in Chapter XVI. This amounts to $7.55, and this sum is charged to Depreciation Expense each year and is credited to Allowance for Depreciation. The same sum is placed in a special fund to accumulate to the desired amount. The following table shows the situation from the first to the tenth years inclusive. (I) (2) Fund Begin- (3) Depreciation (5) C6) Fund End op ning OF Year Interest Annuity pay- ment Total Year I $ 0.00 $ 0.00 $ 7-SS $ 7-55 $ 7-55 2 7-55 •38 7 55 7-93 15.48 3 15.48 .78 7 55 8.33 23.81 4 23.81 I.19 7 55 8.74 32.55 5 32-SS 1.63 7 55 9.18 41-73 6 41-73 2.09 7 55 9.64 51-37 7 51-37 2-S7 7 55 10.12 61.49 8 61.49 3.08 7 55 10.63 72.12 9 72.12 3-6i 7 55 11.16 83.28 10 83.28 4.17 7 55 11.72 95.00 Total $19.50 $75 50 $95.00 5i6 PRINCIPLES OF ACCOUNTING The amounts in column (4) are charged to Depreciation Expense and credited to Allowance for Depreciation for each year. The same amount is placed in a special fund and the entries are a debit to Depreciation Fund and a credit to Cash. The total charge to expense in this way is $75.50 during the ten years. The additional $19.50 necessary to bring the fund up to the required amount is obtained through the interest earned on the fund as shown in column (3). It is customary to record the receipt of these funds as follows, Depreciation Fund $.38 Allowance for Depreciation . . . $.38 the amount of the entries being the figures shown for the different years in column (3). The debit is made to a fund account (asset) and the credit to a valuation account. This shows the fact that the operating expenses cover the annuity charges exclusive of interest while the remainder of the total depreciation is raised from outside sources. The fact that a lesser sum than the total depreciation is charged to expense accounts has often led to the erroneous conclusion that this is a cheaper method of accounting for depre- ciation than the straight Une or other methods. It is said that it costs the company only $75.50 to raise a fund of $95.00 and the expense figures are submitted as evidence. Such reasoning results from merely looking at the superficial aspects of the case. It is true that expense is charged with the smaller amount and that the fund accumulates to the larger, but in the entries which are made the accumulation of interest (which is a revenue) is credited to a valuation account. Failure to credit revenue to a revenue account has the same net effect on the available net revenue as though the revenue account had been credited and expense charged for the larger sum. To illustrate the point, the interest received might have been credited to the Interest account as follows and the increase in the fund through interest shown by the entries. Depreciation Fund $.38 Interest $.38 METHODS OF MEASURING DEPRECIATION 517 Now in order to increase the valuation account by the proper amount, these entries must be made, Depreciation Expense $.38 Allowance for Depreciation . . . $.38 If these two Journal entries were made for the sums shown in column (3) there could be no question about the total cost under the sinking fund method being equal to the total depreciation. Yet the net effect on the net revenue available for distribution to the equities is the same under the former case as in the latter. The absurdity of the claim can be seen, however, without resort to an accounting demonstration. If a certain amount must be available at a certain date in the future for any purpose it must be advanced in some form by the investors. Funds do not drop from the skies. Either new investments are made by the investor or revenue from a present investment is allowed to accumulate. Any other situation would be impossible in ordinary commercial practice unless a gift were made by some one other than an investor. The cost to the investor is equal to the total depreciation. The sinking fund method produces the results desired when a special fund is set aside. This special fund is advisable, as was shown in the last chapter, only (i) for a terminable enterprise to retire the securities at par when the assets are exhausted, or (2) for a continuous enterprise when the funds are not needed for additions and betterments. THE COMPOUND INTEREST METHOD The valuation committee of the American Society of Civil Engineers has given the name compound interest to a method which applies the sinking fund principle to cases where funds are used for additions to the property."- It is recognized that if the sums retained by the depreciation charge are re- invested in the property a revenue will result from the invest- ment. That is, by increasing any of the factors, the product * See Report of the Special Committee to Formulate Principles and Methods for the Valuation of Railroads and other Public Utilities, Publication of the American Society of Civil Engineers, Oct. 28, 1916, page 1861. 5i8 PRINCIPLES OF ACCOUNTING will increase, thus bringing in net revenue on the investment. The additional revenue thus obtained is the same in nature as the interest earned on the fund in the sinking fund method. In this case, however, the income on the fund is received in the general revenue resulting from the sale of product or service. It is not specifically earmarked, "interest on depreciation fund," but is a part of the gross revenue of the concern. It may be assumed with propriety that the amount of revenue which can be attributed to the fund thus reinvested is equal in amount to the interest which would be paid for a loan of capital for the same purpose. Since this is credited to gross revenue, the amount of the interest computation each year must be charged to Depreciation Expense. The method may be illus- trated by using the example given for the sinking fund method in the preceding section. The total depreciation on the machine is $95 and the period is ten years. It is assumed that the interest rate on capital borrowed for this tj^e of business is five per cent. The first step is to find the annuity which will accumulate to $95 in ten years at five per cent. This is, as was shown above, $7.55. This is the charge for depreciation the first year, thus, Depreciation Expense f 7.SS Allowance for Depreciation .... $7.55 No other specific entry is made but the amount thus reserved is used in business operations. Now at the end of the second year the same annuity charge is made for depreciation and in addi- tion the amount which is earned on the $7.55 previously charged, $.38. The entries then would be. Depreciation Expense $7.93 Allowance for Depreciation . . . $7.93 Then at the next year the entry will be $7.55 plus the interest on all that has been reserved up to this time. At each succeed- ing year the same method is applied to determine the amount of the charge. The amount of the charge to Depreciation Expense for each year is the sum of the annuity and the interest for the corresponding year under the sinking fund method. For the example being considered, these amounts are shown in column METHODS OF MEASURING DEPRECIATION 519 (5) of the table on page 515. The effect on the available net revenue is the same as under the sinking fund method for the same rate of interest. It is possible, of course, that the rate of interest used in the compound interest method may be higher than for the sinking fund method. In the former the rate is determined by the interest rate for investments in the indi- vidual concern while in the latter it is determined by the in- terest rate on conservative investments in other concerns. It is sometimes said that this is an increasing charge method as the expense for depreciation increases from year to year. But the person who makes this statement is simply looking at the growth of the expense charge entry and fails to take into consideration the fact that gross revenues are increasing (with respect to the asset item) at least proportionately. In other words, a part of the net revenue from the reinvested funds is considered as a part of the gross revenue of the old asset. The actual expense of keeping the asset in service caused by depre- ciation therefore is the same each year. This is probably the reason that the compound interest method was originally called the equal annual payment method in the preliminary report of the committee in 19 13. The question might be raised as to whether interest in this case is not being charged as an expense which should instead be charged against net revenue. That is, since the increase in the depreciation charge is obtained by an interest computation, the additional amount is interest. This, however, is not the case. Interest chargeable to net revenue is contractual interest, a distribution to the equities. There is no distribution to the equities in this case. The amount charged is a part of total depreciation which is an expense. Interest calculations are brought in simply as a method of computing expense charges between accounting periods. The amount is not a return on capital but a return of capital. The reason for using the interest computation has been shown. This is simply a recognition of the fact that time is consumed between the returns of the parts of the investment in a fixed asset and the use of the funds returned for replacement purposes. The productive use of these funds in the meantime in the enterprise is taken into account through the computations referred to. 520 PRINCIPLES OF ACCOUNTING The compound interest method is the most accurate for accounting for depreciation of a durable physical asset when the funds reserved are reinvested in the business. It makes a correc- tion of the straight line method in that it recognizes the interest element. One observation may be made in comparing these two methods. As the rate of interest employed in the compound interest method is reduced the charges approach the straight Hne charges as a limit. If the rate of interest were taken as zero as an extreme case the two methods would be identical. When the rate of interest which might be employed is very small and the possibility of error in estimating the service Hfe of an item is large, there is Kttle to choose between the two. With greater precision in estimating service life, however, the compound interest method is the more accurate. PRESENT VALUE OF FUTURE REVENTJE METHOD The present value of future revenue method may be used for measuring depreciation of any asset the revenue from which is known in advance. This is true of the intangible assets as a class, and as was shown in Chapter XVIII is also true of securities owned. The original value or purchase price is based upon the revenue to which the asset gives title. It is the present value of these sums at the market rate of interest which determines the purchase price. Then the value at the end of each accounting period throughout the life of the property item is the discounted value of the remaining future revenue items. Suppose, for example, that the X Company purchases a patent right from Y which gives an advantage over all competitors equal to $500 per year and that this advantage will be maintained for a period of ten years, after which the right expires. The purchase price of this asset will be the discounted value of the ten $500 revenues attributable to the patent right at the market rate of interest for this form of investment. If the rate were six per cent the pur- chase price and original value would be $3,680.04. The value at the end of the first year would be found by discounting the re- maining nine revenue items at six per cent which gives $3,400.85. The depreciation for the year is the difference between the two quantities or $279.19. The depreciation for each succeeding METHODS OF MEASURING DEPRECIATION 521 year would be found in the same way. The following table shows the book value at the beginning of each year based on the present value of the future revenues, the revenue received during the year, the depreciation charge, the net revenue from the item and the rate of net revenue to the book value for the year. (l) (2) (3) (4) (s) (6) Year Book Value Beginning OE Year Revenue Depreciation Charge During Year Net Revenue Rate op Net Revenue to Book Vaj-ue I $3,680.04 $500 $279.19 $220.81 6% 2 3,400.8s 500 295-95 204.05 6 3 3,104.90 500 313-71 186.29 6 4 2,791.19 500 332-53 167.47 6 5 2,458.66 500 352-48 147-52 6 6 2,106.18 500 373-63 126.37 6 7 i,732-5S 500 396.04 103.96 6 8 1,336.51 SCO 419.81 80.19 6 9 916.70 500 445.00 SS-oo 6 lO 471.70 500 471.70 28.30 6 Total . . . $S,ooo $3,680.04 $1,319-96 There are two facts of particular significance in this table. In the first place, the rate of net revenue to book value remains constant throughout the whole period as shown in column (6). This, of course, must necessarily be the case since the same rate is used each year for determining the present values of future revenue. If the market rate of interest for the type of asset being considered should change, however, there would be a change in the rate reahzed, a result brought about by using the new rate in obtaining the present values of the sums. In the second place column (4), showing the depreciation for each year, gives the same figures as would be obtained through using the compound interest method at the same rate of interest. That is, if the six per cent rate of interest were used for the com- pound interest rate for an asset which cost $3,680.04, had a service life of ten years and no salvage value, the depreciation charges would be the same as those shown for the present value of future revenue method. The reason for this may readily be seen. In this case $3,680.04 is the present value of an annuity of 522 PRINCIPLES OF ACCOUNTING $500 per year for ten years at six per cent and column (4) of this table is that part of the revenue items which represents the return of investment. The return of the investment in an annuity always progresses in conformity with the growth of a sinking fund.^ The compound interest charges also proceed in con- formity with the growth of a sinking fund. Therefore the depre- ciation charges under the present value of future revenue method and the compound interest method are the same in case the revenue from the asset is an annuity. The present value of future revenue method does not, however, always give the same results as the compound interest method. In case the revenues do not constitute an annuity, the methods differ. Suppose, for example, that some form of intangible asset is purchased which will bring in $25 the first year; $25, the second ; $20, the third ; $20, the fourth ; nothing, the fifth ; $18, the sixth ; $18, the seventh ; $14, the eighth ; $14, the ninth ; and $22, the tenth, and that the purchase price is made on a five per cent basis. The price would be the sum of the present values of each of the sums at a five per cent rate of interest, and this gives $138.45. The following table represents the same information for this asset on the present value of future reve- nue method as was given in the preceding table. (l) (2) (3) (4) (5) (6) Year Book Valve Beginning OF Year Revenue Depreciation Charge Net Revenue Rate op Net Revenue to Book Value I $138.45 $25.00 I18.08 $6.92 5% 2 120.37 25.00 18.98 6.02 5 3 101.39 20.00 14-93 5-07 5 4 86.46 20.00 15-68 4-32 5 S 70.78 0.00 —3-54 3-54 5 6 74-32 18.00 .14.29 3-71 5 7 60.03 18.00 15.00 3.00 5 8 45-03 14.00 11-75 2.25 5 9 33-28 14.00 12.33 1.67 S 10 20.9s 22.00 20.95 1-05 S Total . . . . $176.00 $138.45 $37-55 ^ See table for apportionment of annuity payments on page 377. METHODS OF MEASURING DEPRECIATION 523 The values in column (2) are found by obtaining the discounted values of the remaining revenue items at the beginning of each year. Column (3) is the revenue for each year, column (4), the depreciation (difference between book value beginning and end of each year), column (5), the net revenue, and column (6), the rate of net revenue to book value. Column (6) shows the rate to be constant again at five per cent. This would necessarily be the case if five per cent were used in the valuation throughout ten years. It should be noted that in the fifth year there is no revenue and that during that year the property appreciates by $3.54, and this gives a return of five per cent on the investment. It would seem that to increase the property valuation during a year when there is no revenue is improper, but if the assump- tion be accepted that the value is determined by the future revenues, the property actually appreciates during the fifth year. There are five remaining revenues at the beginning of the fifth year, the same five revenues are remaining at the end of the fifth year, but are all one year nearer and are, therefore, more valuable. The entries for the fifth year would be the reverse of those for other years. That is, the book value would be increased by a debit to Allowance for Depreciation and a credit to Revenue (the opposite of a charge to Depreciation Expense) thus, Allowance for Depreciation $3-54 Revenue (from Appreciation) ... $3.54 This is an extreme case, for it is doubtful whether many in- tangible assets are sold where the revenues of such unequal amounts are definitely known in advance. The case is possible, however, and the illustration serves to show how this method differs from the compound interest method. Changes in the amount of revenue directly attributable to the asset are the basis for changes in the value of the asset. In the case of the compound interest method, no attempt is made to determine the revenue attributable to the asset, and the depreciation charges are based on the cost figures. The present value of the future revenue method is the proper 524 PRINCIPLES OF ACCOUNTING one for use in the case of intangible assets, or other assets where the purchase and sale price depends on the discounting of the revenues applicable to the asset. It cannot be applied to physical property items, however, and this fact must be emphasized. It has been suggested that this method, producing as it does a uni- form flow of net revenue, should be applied in principle to the tangible assets in order to produce an even flow of net revenue from such property ; but this argument is unsound. In the first place it is impossible to forecast the revenues from a physical property item or even to determine the amount attributable to such an asset. This would prohibit the use of this method on a scientific basis. At best it would only be possible to vary the depreciation charges directly with the gross revenue figure and this would be indeed a rough approximation. Further it is not the purpose of depreciation accounts to equahze the net revenue figure as was stated earlier in the chapter. Net revenue from the use of productive agents does fluctuate from year to year and the accounts should show this fact. As well juggle the labor expense accounts to produce an even flow of net revenue as the depreciation accounts. Depreciation charges in the case of physical property items must be based upon cost figures without reference to revenue. MISCELLANEOUS METHODS The methods which have been described are the most im- portant. One or another will fit the ordinary cases which arise in practice. There are a great many other methods which have been suggested at various times, however, some of which will bear mentioning. It is sometimes suggested that repair charges be included in the calculation of the depreciation computation. Repairs, it is said, constitute a replacement of a part of the value of a prop- erty item and consequently make good some depreciation; and it is urged that in many cases it is found that the repair charges do not spread evenly over the service life of an item. A locomotive, for example, will have only minor repairs for a period of three or four years and then be placed in the shops for a METHODS OF MEASURING DEPRECIATION 525 general overhauling necessitating heavy repair charges. These charges make good a certain amount of depreciation of the pre- ceding four years, and it is said that they should be spread in the expense accounts of those years instead of being charged all in the one year as is done according to current practice. In general this plea is that the depreciation charge should be suflEi- cient to cover the repair costs as well as the renewal, and there is considerable force to this argument since in many cases in prac- tice the repair charges fluctuate very greatly from year to year. In general, however, the error consists in choosing too large a unit for accounting purposes. It was shown in the last chapter that the distinction between repairs and renewals is arbitrarily based on the definition of the unit. If it is found that the repair charges do vary disproportionately between periods, a change in the choice of the unit may remedy the situation. Instead of considering the locomotive as a unit, for example, the different parts may be accounted for on this basis. There must be some hne drawn for practical purposes, however, and it would be inadvisable to make the units so small that all repairs would be accounted for in this way as the distinction between repairs and renewals is of sufl&cient importance to warrant its retention. The armuity method is also worthy of mention because it is advocated by several accountants. This is very similar to the compound interest method. The difference consists in adding to the compound interest charge an amount to cover interest on the book value. This additional amount is charged to the Depreciation Expense account but is credited to Interest instead of Allowance for Depreciation. The following table will serve to make the method clear. This represents the book value, interest on the book value, depreciation, and the expense charge for each year in the case of a machine which costs $100, will last ten years, and has a salvage value of I5. The interest rate of five per cent is used in the computation. Column (4) shows the net depreciation, which corresponds to the charge under the compound interest method ; column (3) shows the interest on the book value for each year, and column (5) shows the amount charged to Depreciation Expense, the sum of the items in columns (3) and (4). 526 PRINCIPLES OF ACCOUNTING (l) (2) (3) (4) (5) Year Book Value Interest on Book Net Expense Charge Beginning of Yeah Value Depreciation (3)+(4) 1 fioo.oo $5.00 $7-55 $12.55 2 92-4S 4.62 7-93 12.55 3 84.52 4.22 8.33 12.55 4 76.19 3.81 8.74 12.55 S 67.4s 3-37 9.18 12.55 6 58.27 2.91 9.64 12.55 7 48.63 2-43 10.12 12.55 8 38.51 1.92 10.63 12.55 9 27.88 1-39 II. 16 12.55 • lO 16.72 .83 11.72 12-55 Total . . I30.50 $95.00 $125.50 The Journal entries for the first year would be, Depreciation Expense $12.55 Allowance for Depreciation . . . $7-55 Interest 5.00 Each succeeding year, the entries would be the same in form, the debit to Depreciation Expense always being $12.55 (hence the name annuity method), the amount in column (4) being credited to Allowance for Depreciation, and the amount in column (3) to Interest. It may easily be seen that the net effect of this method on the available net revenue and also on book value is the same as under the compound interest method. There is a fundamental error involved in the plan, however, and that is in including interest on invested capital in the expense ac- counts. The amount in column (3) is charged to expense and immediately credited as a net revenue item. It represents the services of the equities in investing these funds in machinery. To consider such services as expenses in the accounts is, as has been shown before, an illogical procedure. Several other rather arbitrary methods have been devised for spreading depreciation on what is supposed to correspond to the ability of the revenue to stand the charge. One of these is the fixed percentage of declining value method. A percentage figure is found which apphed consecutively to book value at the begin- METHODS OF MEASURING DEPRECIATION 527 ning of each year will reduce that figure from cost to salvage value during the service life. The charges during the first years are large but the amount continually decreases until the last year, as it is supposed that revenues can stand heavy charges during the early years and lighter ones during later years. Very little can be said for this method, since revenue should not be a controlling factor in fixing depreciation charges as has been shown before. A further discussion of different methods would be out of place in this text. Those given serve to illustrate the diver- gence of practice ; and, as was stated earlier, the methods described in the preceding sections are adequate for all cases. The particular conditions which make one or another form advisable were stated in the different sections. XXIV The Intangible Assets The point has been emphasized repeatedly in the preceding pages that property is a category which includes both material and immaterial items. It has been shown further that another important line of division groups all properties into fixed assets and current assets. Such items as prepaid insurance or similar deferred assets, and rights such as accounts receivable, are examples of current immaterial assets. Current assets of all types furnish less difificult problems of valuation than arise in the case of the fixed assets as has been explained. The treatment of current intangibles has already been sufficiently discussed, and the valuation of long-term rights such as bonds and similar securities was quite fully considered in Chapter XVIII. Thus far little attention has been given, however, to the fixed in- tangibles proper — ■ goodwill, going value, patents, etc. In the present chapter the nature and treatment of these assets will be discussed. the nature of goodwill The rates of return realized on the capital invested in pro- duction vary widely between different enterprises, — ■ even in the same industry. In the manufacture of furniture, for example, one firm will be earning five per cent on the investment, another six per cent, still another ten per cent, and so on. The conditions leading to business success are very complex, and hence it should be recognized that the amount of capital invested in any case is only one of the elements determining the amount of net revenue. Managerial ability, methods and processes, territorial location, trade name, selling organization — these and many other factors contribute to financial success. Some enterprises 528 THE INTANGIBLE ASSETS 529 possess a superior equipment as compared with their competitors in regard to such factors. Such enterprises may be said to have goodwill. Goodwill may then be defined as the capitaHzed value of the excess income which a particular firm, because of greater efl&ciency or any monopolistic advantages, is able to realize over a normal enterprise in the same industry and having the same capital investment. By a normal enterprise is meant an enterprise that is earning a rate of return high enough to attract a proper flow of capital to the industry in question. It may be assumed, for example, that the A Co. has f 1,000,000 of capital invested, and earns a net revenue of $80,000 per year. This gives a rate of eight per cent on the investment, which, it will be supposed, is the rate of return necessary to attract the investor to this field of production. The B Co. has also invested $1,000,000 in the same industry but earns $160,000 annually, giving a rate of sixteen per cent. Now it is evident that the property of the B Co., because of all the conditions that go with it, is worth twice as much from the standpoint of a prospective investor as the property of the A Co. ; for the final test of the value of any property from this standpoint is its earning power. The original investment is the same in both cases, but the advan- tages of the B Co. are such that it possesses twice the earning power of the other company. (Permanence of income, conditions of risk, etc., are also assumed to be the same in both cases.) The B Co. may then be said to have an intangible asset due to one or more factors that give it an advantage over the normal enterprise. Goodwill might be again defined, then, as the capitalization of a differential profit which a particular enterprise enjoys. Defined thus broadly goodwill includes the value of all such intangibles as patents, copyrights, trademarks, franchises, etc. Where such definite items exist, however, it may be desirable to restrict goodwill to the value of the more general monopolistic advantages such as location, and of the peculiar efficiency or prestige attaching to the particular enterprise. Illegitimate practices in restraint of trade may evidently lead to a large intangible item which might be considered a kind of goodwill. An exceptional rate of income permanently assured is not essential to the origin of goodwill. The assurance of huge earn- S30 PRINCIPLES OF ACCOUNTING ings for a few years, or even a single year, adds to the value of the property involved. Goodwill is often transferable, as is any asset. In some cases, however, goodwill is dependent upon the personnel of the pro- prietors. In such a case this asset measures the capital value of the business qualities and characteristics of a certain individual or group of individuals attached to a business enterprise. This situation occurs most frequently in sole-proprietor enterprises and in partnerships. The proprietors in such a case often give a value to their j&rm because of the personal esteem with which they are regarded by their customers. Or the business may be one which requires peculiar skill, in which case the success of the enterprise depends largely upon the knowledge of the business which the original owners possess. In all such cases it is not possible to transfer goodwill from one business to another unless the change is nominal as far as the personnel of the owners is concerned. When, however, goodwill depends upon a trade name, a copyright, market conditions, secret processes, etc., it is usually possible to transfer the asset from one enterprise to another. It is evident that the exact determination of the amount of goodwill in a particular case may be a matter of considerable difficulty. The definition given above involves the ascertaining of the normal competitive rate of income in the industry in question and the number of years during which the excess income can be expected to accrue. Whenever goodwill is purchased, however, such valuations are actually made. The difficulty of setting a reasonable value upon goodwill outside of an actual transaction is one reason for the prejudice against the recognition of this asset except as purchased. The problems of valuation arising in connection with -goodwill will be considered in the next section. THE VALUATION OF GOODWILL Although according to the definition given in the preceding section goodwill as an economic fact may originate without cost, it is not considered good practice to recognize this asset in the accounts unless it is purchased. This may seem at first sight an unreasonable view, but it is consistent with the principles of THE INTANGIBLE ASSETS 531 valuation developed in preceding chapters. Goodwill, as has been explained, is based upon an unusual rate of income. It is the capitalization of the peculiar advantages which a particular firm enjoys. If goodwill were generally recognized as an asset in the accounts of all enterprises in a given industry there would be no unusual rates of return. The most successful firm would earn no more than the ordinary competitive rate of return. As regards income rates all supra-marginal enterprises would be reduced to the level of the marginal business. The actual situation would seem to be obscured by such a practice. To capitalize an excess earning power and enter the result in the books as an asset would be a practice similar to the rec- ognition of interest accruing during construction. The objections already made to such a procedure can be applied with equal force to the capitalization of unusual earning power. Such a practice again means the accruing of the services furnished by the owners themselves (or the pecuHar advantages possessed by the owners) as an asset. This, it has been insisted, is not the function of the accounts. The accounts should follow the actual investment of the owners as it takes shape in various commodities and services purchased, but should not show the capitaHzation of the pecuHar functions and advantages inhering in the particular enterprise itself. The actual rate of return is the significant fact for the proprietor. He wishes to know just what the capital fund in his possession is yielding, and if the rate is reduced to a nominal level by the capitalization of a part of income the actual situation is covered up. This view is not inconsistent in any way with the theory that changes marketwise in the assets owned by an enterprise should be followed in the accounts. The recognition of depreciation and appreciation makes the capital accounts conform to the actual situation, and accounting for appreciation should not be confused with the capitaHzation of income. If the accounts are to present a correct showing of invested capital (actual assets donated included) and thus give the manager a basis for judg- ments in connection with the proper utilization of resources, all value changes must be recognized as far as this is practicable. But capitalized income is not an asset value in this sense. As was emphasized in Chapter XX and elsewhere the accounts 532 PRINCIPLES OF ACCOUNTING should show the Investor the actual rate of return realized on the economic resources possessed by the enterprise. If this rate is twenty per cent in a particular year the asset accounts should be consistent with this fact. If the rate is ten per cent the accounts should conform to the actual situation. Accounting which attempts to iron out the fluctuations in net revenue in a particular enterprise, or to reduce the rates reahzed by different enterprises to the same level, if not actually improper, is at least not to be commended. If, on the other hand, a particular enterprise buys the assets of another company and pays something in excess of the value of its plant and equipment in order to secure certain advantages which give an exceptional earning power, in this case an invest- ment is actually made in goodwill and it becomes an intangible asset on the books of the purchaser. It may seem that this shifts the basis of valuation, but this is not really the case. As was explained in Chapter XIX an enterprise which invests $100,000 in the construction of a plant has a property which should be entered in the accounts at that figure. If at the end of the construction period the completed plant is sold to another company for $106,000, the new company should value the property at $106,000, for it has purchased the service of the construction company. But this does not justify the capitaliza- tion of the construction company's service in its own accounts. Similarly an enterprise which because of exceptional advantages earns a very high rate of return is not justified in capitalizing a part of that return even though it may be possible to dispose of these advantages at a price under certain conditions. It is not intended to deny the importance of the capitalization process as an economic fact but it does not seem reasonable or practicable to capitalize in the accounts of an enterprise any part of its income. Goodwill is frequently made use of in accounting practice to validate security issues. Often the par value of the securities issued exceeds the actual value of the property acquired. In such cases it is common practice to label the amount of the discrepancy goodwill. This practice is evidently improper, for the goodwill in such a case is entirely fictitious. As was stated in a preceding chapter discount on stock should be used to represent the excess THE INTANGIBLE ASSETS 533 of the par value of stock and other securities issued over the value of the property acquired. Frequently some general title such as "property, goodwill, royalties, etc.," is used on the balance sheet. This is still more questionable, for such a heading does not show even the estimated amount of goodwill. Often when a partnership or corporation is taken over by another concern, something is paid for goodwill, even though this asset has not been previously recognized on the books of the original concern. If actual property is paid for this asset, then it is entirely proper to list it on the books of the buyer (especially if the purchase took place under competitive con- ditions) ; but it should be recorded in a distinct account and for the amount actually paid. Very often the payment made is in securities with only a nominal value, and hence the goodwill is fictitious. The later treatment of goodwill in the accounts raises some interesting questions. If the special advantages purchased are permanent the asset goodwill evidently need not be depreciated. Peculiar efficiency and monopoHstic advantages, however, are seldom permanent factors and hence the problem of depreciating goodwill arises in most cases. When the advantages purchased disappear, goodwill should be written down. If goodwill is based upon definite terminable rights such as leases or patents it should be amortized during the life of these rights. Such rights are not goodwill in a strict sense, however, and will be further considered in a later section of this chapter. If a decline in income is expected, and occurs because of the decay of physical property or because some condition or privilege upon which goodwill depends covers a definite period of years, then goodwill can be amortized as is any asset by depreciation charges against revenue based upon some appropriate method of apportionment. It is sometimes objected that it is unreasonable to write off goodwill when revenues are declining as this further impairs net revenue, and that goodwill accordingly should be charged against revenues in boom years or against, accumulated surplus as rapidly as possible. Such a practice can hardly be commended. Certainly the logical position to take is that the accounts should express as nearly as possible the actual situation. Goodwill should not be left on the books when it is known that the 534 PRINCIPLES OF ACCOUNTING asset no longer exists, and it need not be amortized unless depre- ciation actually occurs. To be consistent with the view that goodwill should not be recognized unless purchased it should be insisted that goodwill can never appreciate. Any added earning power over and above the return secured by the original purchase of goodwill is due to the peculiar efficiency or other advantages possessed by the new enterprise and should be reflected by a higher rate on the investment, and not by charges to the asset accounts. The peculiar advantages which one enterprise possesses as compared with another are reflected more or less accurately in the market price of its securities. The prices of stocks and bonds are naturally based to a considerable extent upon market income rates. The selling price of the stock of a metropolitan newspaper company, for example, may be far above the book value of the stock. The balance sheet of the B Co., for example, appears as follows : Property $1,250,000 Capital Stock .... $1,000,000 Surplus 250,000 $1,250,000 $1,250,000 The par of the B Co.'s stock is $100 and the book value is $125 per share. Total proprietorship as shown by the accounts is then $1,250,000. On the market, it will be assumed, this stock sells for $200 per share. According to the market valuation proprietorship amounts to $2,000,000. The difference of $750,000 between the two valuations may be called goodwill. If the balance sheet were revised by the recognition of this in- tangible it might appear as follows : Property $1,250,000 Capital Stock . . . $1,000,000 Goodwill 750,000 Surplus 250,000 Goodwill Surplus . . 750,000 $2,000,000 $2,000,000 As has been explained, however, no purpose is served by the recognition in the accounts of security prices or any phase of goodwill unless the item has been purchased. THE INTANGIBLE ASSETS 535 GOING VALUE The interval from the time a business enterprise is originally projected to the time the firm begins to earn a normal return on the investment may be divided into two periods : (i) the period extending from the time the first steps by the promoter are taken to the time when the concern begins to earn revenue; (2) the period extending from the time when revenue first accrues to the time when a normal return on the investment is realized. The first period constitutes the organization and construction period and is common to all enterprises ; while the second represents the pioneering or experimental period and does not confront all new enterprises in old established Hnes. The distinction between the two periods carmot always be sharply drawn, but it is an important general distinction to be kept in mind in analyzing the nature of going value. It was explained in Chapter XIX that the costs of promotion, incorporation fees, underwriters' charges, costs of preliminary advertising, etc., are all outlays essential to the finished plant and organization, ready for operation. Such charges are as legitimate capital outlays as the cost of labor and materials entering directly into the tangible property items. These items are a necessary cost of property and are intangible only in that it is not convenient to allocate them to specific tangible units although they are incident to the property as a whole. Going value, if used to express the sum total of general organization and construction costs, is a bona fide asset. Going value,^ however, is more commonly used to express the capitaHzed value of early capital losses and unrealized income. In the development of a new enterprise a considerable interval often elapses between the time that revenue actually begins to accrue and the time that a normal rate of income is earned. Sometimes the wheels have been turning for several years follow- ing the completion of the plant before the business is put upon a paying basis. This is particularly true of industries in what might be called the experimental stage. Many of the electric power companies, for example, failed to realize a normal rate ' Developmental value, pioneering value, experimental value, and going value are expressions which are used more or less synonymously. 536 PRINCIPLES OF ACCOUNTING of net revenue in the early years of the industry ; and in some cases actual capital losses were suffered. This was due to the lack of a brisk demand for the product, to the rapidity of mechani- cal changes in equipment, and to the high costs due to inexperienced management. On the theory that the investor is entitled to a fair return on his investment it has been urged that there is, in such cases, a developmental or going value represent- ing the capitalization of the early losses of the enterprise. This theory is of significance primarily in connection with the regulation of the rates of public utihties. The problem in such cases is so to adjust prices that the investor in such properties will neither be discriminated against nor advantaged as compared with his fellow investor in competitive lines which involve the same burdens as regards risk and other aspects of ownership. If the investor in competitive lines is able to recover pioneering losses, then the investor in public utihties should be allowed to do so. It is doubtful, however; if in competitive enterprises the investor is always able to recompense himself for early losses in later higher prices. If all investors in a certain industry suffered losses (or did not realize the normal return afforded by general business) for a given period, it might seem reasonable to conclude that prices would later be high enough to cover the early losses. Even in such a case this conclusion is questionable. Once the industry in question becomes estabUshed can the early investors charge higher prices because of previous losses? Would not capital flow from other lines into the now estabUshed industry and drive prices down to a point at which a normal return was realized? There is no definite assurance in the market situation that the investor in the specific enterprise will be able to recoup early losses in later prosperous years. One enterprise may prove ultimately successful while another enterprise may never yield a fair return. It is a familiar fact that in certain hazardous Hnes more capital is dissipated in unsuccessful ventures than is earned by successful companies. In other words from the standpoint of capital return the industry as a whole in such a case is operating at a net loss. Business losses whether due to experiments, changes in demand, inefficiency, or to any other cause, cannot be recovered by the specific enterprise bearing such losses (unless monopolistic THE INTANGIBLE ASSETS 537 conditions prevail). These are among the risks of ownership which require at least the prospect of net revenue to attract capital. Net revenue in general, it is true, is the economic burden which the community bears to secure the services of ownership. The possibility of losses during the developmental period or of ultimate failure is one of the reasons for the existence of a net return to the owners in prices. But net revenue is not guaranteed in all cases ; and if it were one of the reasons for the existence of the residuum over expense charges would be de- stroyed. Even if it were true that the normal competitive enterprise is able to realize an income in later years sufficient to offset the early lean years this would not be an adequate reason for capitaHzing early losses and entering the result as an intangible asset in the accounts. This would simply be the capitalization of a phase of income and is open to the same objections already urged against the* recognition of goodwill (unless purchased) and interest during construction. The capital funds of the enterprise are not accruing each year at the normal competitive rate of interest. It is true that the investor hopes to realize a sufficiently high rate later to make up for the lean periods, but even if the large earnings are definitely assured would it not obscure the actual situation to capitalize the earnings when still unreaKzed ? All such accounting, as previously explained, tends toward the eHmination of the fluctuations in the rate of in- come. In certain cases of publicly regulated enterprises, however, such an intangible asset may with reason be allowed. The determination of a fair rate of income is the important question in such cases. If the rates prescribed by law have been lower than the rates which would have normally been earned, or if the investor is restricted, in other words, to a non-speculative rate of return, then he should be allowed to recover early losses in later higher prices. One way of accomplishing this end is to allow the company to charge its customers prices which will yield a fair return not only on actual investment but upon capitalized losses and unrealized income as well. Even in such a case, however, the matter is a question for judicial as well as accounting opinion. There seems to be sufficient ground for 538 PRINCIPLES OF ACCOUNTING excluding developmental value from the accounts with the possible exception of this case. MISCELLANEOUS INTANGIBLES There are a number of specific conditions and rights which give rise to important intangible assets. Some of these assets can be included under the general head, goodwill ; but it usually is more desirable to use a distinct account for each asset. A brief discussion of a few of the more important examples will be given in this section. Special privileges granted by the state to specific enterprises often give rise to exceptional earning power and hence have an important value. Of these privileges the patent right is the most important. A patent is a grant by the state conferring exclusive privileges for a specified length of time in connection with the production and sale of some product^or exclusive right to some method or process of production. It gives to the grantee a monopoly in the manufacture and sale of some inven- tion or in the use of some device. The real test as to whether a patent has value or not is not its cost but its earning power as in the case of any fixed intangible. It is considered advisable, however, to enter a patent on the books at the cost of the experi- ments that gave rise to it, and the clerical fees necessary to secure it, in anticipation of the financial success of the device involved. When a corporation organizes and buys out an in- vention, for example, the patent right is entered at the purchase price. If the sale has been a bona fide transaction on a cash or an equivalent basis the success of the invention is usually reason- ably assured, and the price paid is the capitalized value of the expected earning power. Until the success of the enterprise has been actually tested it would seem somewhat unreasonable to list patents as an asset at anything above cost. There is less reason for objecting to the recognition of patent rights at actual market value, however, than to the entry of goodwill due to peculiar prestige and effi- ciency. A patent right is a definite possession, often highly marketable, and to capitalize its earning power in the accounts would not mean in any sense the accruing of the services or THE INTANGIBLE ASSETS 539 personal advantages of the proprietors as an asset. If a patent right comes to be worth a large amount although costing practi- cally nothing there is no very substantial objection to its rec- ognition at a conservative valuation. A firm, for example, may own no other property than a patent right which cost but a nominal sum and yet the lease of this right to other parties may give rise to a considerable income. It would be entirely legiti- mate in such a case to consider as an asset either the patent right or the contracts based upon this right. Patents are often used as an asset at organization to validate large issues of securities. If the success of the patent is reason- ably assured this practice can be justified. But hundreds of patents are taken out which never become the basis of profit- able enterprises. The real value of a patent depends upon the earning power which it gives to an enterprise, and it is when this earning power is known or assured that it can properly be considered as an asset. Since patents are terminable rights such assets should be amortized during the Hfe of the privilege in any case. Patents run for various terms of years. A mechanical patent runs for seventeen years in the United States and can be renewed under certain conditions. In the amortization of patents earning power and length of life are the important elements to be considered. If the rate of return realized falls because of other improvements such assets should be depreciated even if the privilege involved has not legally expired. When income can be determined in advance with reasonable accuracy a patent may be amortized by the present value of future revenue method. Trademark and copyright privileges give rise to assets similar to patent values. Another class of intangible assets is based upon leases and similar private contracts. These assets are more definite in character than most intangibles. Suppose, for example, that the owner of a mining property leases this property to an operating company for fifty years, the annual consideration being $5,000.^ The lease contract would represent an asset to the lessor similar to an annuity. The value of fifty annual sums ^ For convenience it will be assumed that at the end of fifty years the value of the property will be exhausted. S40 PRINCIPLES OF ACCOUNTING of $5,000 each on a six per cent basis is $78,809.30. Such a lease amounts virtually to a sale and the value of the lease may now appear on the lessor's books rather than the mining prop- erty. The balance sheet of the lessor •with respect to this single item would appear somewhat as follows : Lease $78,809.30 Lessor, Proprietor . . $78,809.30 The value of the lease should be amortized by the present value of future revenue method. The entries recognizing the item of depreciation for the first year would be : Lease Depreciation . , $271.44 Lease (or Reserve for Depreciation) $271.44 (The amount of depreciation may conveniently be found by subtracting six per cent of $78,809.30 from the amount of the annual payment.) When the annual rent is received the entries would be as follows : Cash $5,000 Rent $5,000 The gross revenue appearing in the Rent account less the item of depreciation gives $4,728.56, or six per cent on the original lease value.-' Where the lessee pays a lump sum in advance a somewhat different intangible asset arises on the books of the lessee. The amount of the prepayment is an asset since the service purchased will not be exhausted for several fiscal periods. Such an asset is another illustration of the deferred debit discussed in Chapter X. Suppose a railroad company, for example, leases the road of a small line for ten years, paying for the lease a lump sum of $250,000. The expenditure would be entered as follows : Lease $250,000 Cash $250,000 * The entries in this case might evidently be contracted to the following : Cash $S,ooo Lease $ 271.44 Net Revenue 4,728.56 THE INTANGIBLE ASSETS 541 Each year a portion of the original payment would be considered an expense. If the asset were amortized according to the com- pound interest method at six per cent the entries for the first year would be : Depreciation Expense .... $18,966.99 Lease (or Reserve for Depreciation) $18,966.99 In certain cases it might be urged that a lease constitutes an asset on the books of the lessee even when the consideration is an annual payment. Thus the lessee in the last case above mentioned might consider the right to use the leased property of considerable "strategic value," and hence deem the contract an asset. If such a lease were entered as an asset when no outlay is involved, the concurrent credit would necessarily be to Surplus or some proprietary account. Such a situation would be un- likely except in the case of small railroad Hnes and similar prop- erties where the location of the leased property is such that it has Httle value for more than one enterprise. In such cases competitive bidding for the property is lacking and the service may be secured for less than its real value. Whenever a franchise or charter granted by the state to a public utiHty enterprise gives to that firm monopolistic privileges, the franchise gives rise to an intangible asset. Its value depends upon the extent to which the company's earning power is in- creased by such exclusive privileges ; and, as in the case of any similar intangible, the ascertaining of that value may be a diffi- cult problem. The recognition of such an intangible in the accounts is open to some objection, however, since it tends to cover up the real rate earned by the enterprise. The capitaHzation of excess earning power due to public favor should not be added to invest- ment and made the basis of a claim for higher rates. Franchise values as well as developmental values are matters of significance only in connection with publicly regulated enterprises. PART FIVE THE CONSTRUCTION AND ANALYSIS OF FINAN- CIAL STATEMENTS XXV The Income Sheet Bepore the accountant's work is to be regarded as in any proper sense completed, the information contained in the ledger accounts must be summarized in some statement form which will make the meaning of the accounts reasonably clear to all interested parties. Even when sound accounting principles have been followed in making book records the efforts of the accountant are often vitiated by a failure to present the informa- tion in a form intelHgible to those who have no adequate knowledge of accounting. Too often, for instance, the income sheet and balance sheet are in the form of transcripts of ledger accounts prepared in the technical account form. Much of the accountant's skiU is most clearly shown in the preparation of these final statements. It is the evident function of the accountant to present this summarized information in adequate form for the guidance of the manager. It is almost as evident that it must be simple and straightforward enough for the average director to understand. It should also be added that the accountant has another type of interested party whose need for information he must satisfy, the investor. There is little wonder that as he has httle or no understanding of double-entry bookkeeping the average investor gives up in despair when he attempts to get enHghtenment from any account- ant's statement which is not both simple and unmistakably clear. The student needs but to recall his own experiences in attempting to master the intricacies of double-entry book- keeping to realize the difficulties encountered by the average individual not equipped with this knowledge. Therefore as one of the very real functions of the accounting statement may be to furnish enlightenment to the prospective or present 2N S4S 546 PRINCIPLES OF ACCOUNTING investor the accountant must hold himself responsible for state- ments adequate to this need. It will therefore be the purpose of Part Five to discuss the question of the proper presentation of accounting data. A knowledge of the accounting principles developed in the pre- ceding parts will be assumed in this discussion, but the point of view taken will be that the proper presentation of accounting data must answer the needs of the person who seeks information from the accounts but who has not a training in accounting technique. From this point of view the question as to what information is of importance can scarcely be regarded apart from the other vital question as to how this essential information may best be presented. As has been shown in previous connections, the principal types of accounting data are concerned with the historical situation as presented primarily in the income sheet and with the momentary condition on definite dates as presented in the balance sheet. There is a very close connection between these two statements but for convenience in presentation the analysis will be made in separate chapters on the basis of this classification. This chapter is concerned with the income sheet. PURPOSES OF INCOME SHEETS The data for the income sheet consist essentially of the information contained in the Expense and Revenue and Net Revenue accounts in the ledger. A rather large number of accounts are usually kept in each of these groups. A large corporation may have several hundred expense accounts and probably thirty to fifty revenue accounts as well as a dozen or more net revenue accounts. All of these accounts are for income sheet purposes but a simple list of each class such as is contained in the ten-column statement does not constitute a well organized exhibit. Such a list of accounts would be quite unintelHgible to an investor and often of little use to a board of directors for outlining broad business policies. Detailed income accounts are of service for some purposes but are cumbersome for others. Too often one long income sheet including all of the accounts representing expense, revenue, and net revenue THE INCOME SHEET 547 facts is prepared to cover all possible uses. This is decidedly bad practice. It is Just as much a part of the accountant's function to summarize the data in an interesting form as it is to insure that proper accounting principles have been adhered to. The same information may be presented in a variety of ways ; and in many cases a series of income sheets covering the same facts should be prepared to meet the needs of different interested parties. Among the various purposes to be served by the income sheet, probably the use of this statement by the investor is the most important. In order to judge the safety of the investment offered, the investor wishes to know the results of the past year's operations ; and it is generally recognized that the values of corporation securities depend largely on earning capacity in any case. This fact of earning power should be shown in the income sheet. Stockholders have often been forced to ac- cept the dividend rate as a basis for judging the earning capac- ity where income sheets either were not available or were not intelligible. This is unfortunate, for dividends do not tell the whole story. If part of the income is retained as surplus this increases the equity of the stockholder, and the probable future earning capacity, and hence makes the stock worth more than the capitalized dividends. Cases are known where stocks have been quoted on the market at as low as fifty per cent of a reason- able valuation based on earning capacity as would have been shown by an accurate income sheet. If some investors have the information and others do not it is easy to see how unfair advantage might be taken of this situation. Closely allied to the needs of the present investor are those of the prospective investor or creditor. If a person is about to invest in the securities of a concern, he should be supplied with a readable report of the past earnings. A corporation about to float a new issue of stocks or bonds issues a prospectus showing the experience of the past and an estimate of future income. The income sheet for such a purpose should be drawn up in such a form as to show the amount of income which would have been available for that particular class of security in the past. On the basis of such a statement, the prospective buyer can reasonably judge the amount of risk involved. The price 548 PRINCIPLES OF ACCOUNTING yielded on such an issue can be materially raised on the basis of adequate information over what it would be without. Another somewhat different type of investor should be reached with information on the income sheet. This is the speculator in corporation securities, the man who buys and sells shares for changes in the market price. Whatever may be said as to the desirableness of this type of investing, the fact remains that it is done and is countenanced by law. Further, this investor per- forms an economic function and should be supplied with all the information possible to perform his function efficiently. It was suggested in Chapter I that one of the chief causes for the business cycle is the inability of the business world generally to obtain rehable information with regard to past experience; and it may be added here that an adequate series of income sheets could be used as the basis for a barometer of business conditions. What the speculator needs is a periodic statement of the income available to the class of security on which he is speculating, and for him other details of income and expense are unimportant. The board of directors is naturally more interested in the results of internal operation than are any of the various investors so far mentioned. They are more apt to ask for comparisons of gross revenues with preceding years and likewise the amount of expenses, possibly itemized by departments or functions. The members of the board should, of course, be better equipped with technical information and as more details can be digested here a fuller income sheet can be given for their purposes. Even here, however, groups of accounts are of more importance than a long Hst of specialized accounts. The board of directors uses the operating accounts to judge primarily as to the feasibihty of continuing production, increasing the rate of production, and like questions. The net revenue items can be used to guide in a certain measure the financial poUcy, but whether increased invest- ments should be made through the issue of stocks or of bonds depends on the present proportion of fixed charges (interest) to total net revenue. The manager on the other hand requires a much more exten- sive analysis of the operating accounts, revenues and expenses. For his purposes a list of all revenue and all expense accounts should be prepared but net revenue items need not be so fully THE INCOME SHEET 549 stated. The more detailed the analysis of operating accounts, the better it serves for managerial purposes. It is for this purpose that the hundred or more expense accounts are kept. Very often special occasions arise for the preparation of special reports based on the income sheet information. The govern- ment, for example, may require information with regard to costs of operation in a public service industry, or even in a competitive industry if questions of discrimination arise. Again in cases of purchase of complete properties, the consohdation of com- peting concerns, or the establishing of holding companies income sheets arranged in special form are essential. In fact the number and kinds of cases in which the income sheet must be used in some form are practically unlimited. The point to be made is that the ledger accounts must be analyzed and the information arranged in such a form that it will furnish direct answers to specific questions. In the following sections several different forms of income sheets will be described. SUMMARY INCOME SHEETS As was stated in the preceding section, a very brief sum- marized statement is perfectly adequate for the use of the average investor. It is not necessary to give all the information obtain- able in a statement where but one or two significant figures would be amply sufficient. To take an extreme illustration the following would be income sheet enough for a preferred stock- holder who desires to know the margin of safety for his dividend payments : Net revenue before preferred stock dividends are paid $500,000 Preferred stock dividends 300,000 Balance $200,000 The first item in this statement does not appear as such in any ledger account. It is found rather by deducting all prior dis- tributions of net revenue from the total net revenue figure. Further it may be noticed that a free use of words is made to explain just what the $500,000 item is. In an income sheet every item should be carefully explained as the use of just a ledger 5SO PRINCIPLES OF ACCOUNTING account title is not sufficient for statement purposes. The information might even be written in paragraph form in order to make sure that the reader understands just what is meant. On the basis of such a brief statement as the one given above, together with a series of like statements for preceding periods, the preferred stockholder could arrive at a fair judgment as to the risk involved in his investment. Likewise the prospective investor and speculator can use such a statement as a guide in determining what action to take. The same form of statement might be made out for each class of security outstanding for the same reason. In each case it would simply involve a different combination for the figures in the Net Revenue account. A somewhat more detailed statement is usually desired by the investor, and surely by the board of directors, even^when the brief statement is used. Question invariably arises as to the gross business done, the expenses, taxes and fixed charges at least, together with any changes in the free surplus or undivided profits. Those questions can well be answered in a very brief summarized income and surplus sheet, somewhat as follows : Sales (gross revenue) $5,500,000 Expenses 4,600,000 Net revenue from operation $ 900,000 Dividends on securities owned 350,000 Total net revenue $1,250,000 Taxes 50,000 Net revenue to all private equities $1,200,000 Fixed charges (interest on bonds) 700,000 Net revenue to stockholders $ 500,000 Preferred stock dividends $300,000 Common stock dividends 1 50,000 Total dividend appropriations 450,000 Balance carried to surplus $ 50,000 Surplus on January ist 580,090 Appreciation of land for previous years 15,000 Total surplus $ 645,000 Exceptional loss charged to surplus 35,000 Balance of surplus on December 31st $ 610,000 THE INCOME SHEET 551 The meaning of each of the items in this statement is quite evident. The first item states that the sales or gross revenue for the year amounted to $5,500,000. This, of course, is the total of all gross revenue accounts in the ledger, or may be more con- veniently obtained from the total of the revenue column in a ten-column statement. The source of the second item is also obvious as this is the total of the expense column of the ten- column statement. The difference between the first two items is the net revenue from operations — the difference between the expense and revenue columns mentioned in the ten-column statement. The items down to this point constitute what is called the operating division of the income sheet. These facts concern the operations of the business as distinct from the distribution of net revenue. All gross revenue and expense items listed in an income sheet, no matter how detailed, make up the operating division. The proportion of expenses to gross revenue is looked upon by the investor as an important figure. It is on the basis of this figure that comparisons can be made as to the risk involved as between various lines of business. The percentage figure thus obtained (expenses divided by revenues) expresses the amount of each dollar of sales consumed in operating expenses and thus a sort of norm is estabhshed for different types of business. In the manufacturing business a rather high percentage is common, eighty per cent and up almost to one hundred per cent, showing that the margin left for meeting the contractual obligations is small. A fall in the demand for product is likely to affect the investor's interests relatively soon. This does not mean that profits may not be high in proportion to investment. In fact rates of net revenue to invested capital usually do run quite high because of the frequent turnover of the stock. The fact remains that when the operating ratio is very high, the risk is also relatively high. On the other hand railroad and public utiKties have a much lower operating ratio, usually from about fifty-five to seventy-five per cent. The amount of risk is not as great as changes in gross revenue would not affect the investor's claims as rapidly as if the ratio were larger. Net revenues in such cases are usually smaller in proportion to total investment because of the few turnovers possible. In the illustration given 552 PRINCIPLES OF ACCOUNTING the operating ratio is approximately eighty-five per cent. This is quite favorable for a manufacturing business. The next group of items, from "net revenue from operation" down to "balance carried to surplus" constitutes the net revenue division of the income sheet. This is an analysis of the Net Revenue account or of the net revenue columns in the ten- column statement. First are listed the credits to net revenue. In this case, dividends on securities owned constitute the sole item of this class. Other possible items would be interest on bonds owned, appreciation of certain assets and other accruals of net revenue for the period. Taxes are the first deduction from the total net revenue. The balance remaining constitutes net revenue available to the private equities. It has been shown earlier in the text that the proper place for the tax item is a matter of some uncertainty. Should it be considered an expense or as a distribution of net revenue ? It does not come within the general class of expense items, namely, expirations of commodities and services purchased, nor is it a distribution to private equities. Inasmuch as it partakes more of the characteristics of the net revenue items than of expense, it has been placed in the net revenue group of accounts in the classifications so far presented. It is sufficiently different from other debits to Net Revenue, however, to be accorded a special place in the income sheet and this is what was done here, but the essential fact is that the amount of net revenue left for the private investors can be obtained only by making the tax deduction as a separate item. First, then, the total net revenue is obtained in the manner already shown and second the amount of this net revenue which belongs to the private investors as a whole is found by deducting the tax accruals. The tax items are the one class of expenditures which are controlled entirely from authority outside of the business organization. All expenses are incurred as the result of managerial judgments, all distributions of net revenue to private equities are the result of financial programs entered into by the board of directors. The authority for taxes comes from governmental legislative bodies. In the case of a publicly owned property, all net revenue after payments of contractual interest can be considered as in the nature of a THE INCOME SHEET 553 tax. In this case proprietary net revenue is virtually a tax on the consumer. There are two general types of distributions to private equities, contractual deductions, usually called fixed charges, and appro- priations of the proprietary net revenue. It is convenient to make the next deductions on this basis. First the fixed charges consisting of interest on bonds, amounting in the illustration to $700,000, are deducted from net revenue accruing to the private equities, leaving the proprietary net revenue, or as it is called in this statement, " net revenue to stockholders " ; and it is from this figure that the board of directors makes its appropriations. In the case given the preferred and common stock dividends constituted aU of the appropriations made. Other possible appropriations, examples of which were given in Chapter XIII, would also be listed here. The financial policy of the corporation is evidenced by the proportion of fixed charges to total net revenue available to the private equities. In case the fixed charges are small in proportion to the private net revenue, the risk taken by the bondholder is Hght and bonds should float at a low rate of interest. On the other hand if fixed charges are high, risks are high, because of the lack of a large proprietary net revenue as a buffer, and the bonds would float at a higher rate of interest. These comparisons are of importance to all classes of investors. There are then at least four quite distinct net revenue figures in the income sheet, (i) net revenue from operation; (2) total net revenue; (3) net revenue to private equities; and (4) pro- prietary net revenue. The importance of the different items varies in different types of business, and in some cases the number might be greater than four, but each of those cited is distinc- tive and should be shown in some form in every completed income sheet. Finally the balance of net revenue not appro- priated is carried to the surplus sheet, and this completes the income sheet figures. The surplus sheet is practically a transcript of the Surplus account in the ledger. As stated in Chapter XIII this usually represents the excess of proprietorship over the par value of stock outstanding, although there may be in some cases several accounts of this nature. In any event the Surplus account 554 PRINCIPLES OF ACCOUNTING represents the accumulated unappropriated net revenue from date of organization and as such is a connecting hnk between the income sheet and the balance sheet. The balance from the income sheet is carried to Surplus and the balance of the Surplus account is listed in the balance sheet. Hence in the statement of an income sheet it is customary to append a surplus sheet as the connecting item. In the first place, the previous balance in surplus as shown on the balance sheet at the beginning of the period is placed just below the income sheet item "balance carried to surplus." In the illustration given above, this item is $580,000. Following this are listed all additions to surplus during the period, exclusive of that shown in the income sheet. The various occasions for credits to Surplus were explained in Chapter XIII. One type was shown in the illustration, an appreciation in the value of land which had accrued in previous years but was being recognized for the first time. The surplus statement takes care of all net increases in proprietorship for some previous periods. It must be emphasized again that the income sheet contains figures pertaining exclusively to a single accounting period and that all changes for other periods must be made in the surplus sheet. The sum of the three items mentioned (balance from income sheet, balance of surplus at beginning of period, and credits to surplus during the period) makes up the total surplus. This, of course, is equal to the total credit side of the Surplus account. Next all appropriations from surplus are made. In the illus- tration given an exceptional loss such as results from a flood or fire was shown. Another typical case would be an appropriation of dividends either cash or stock. The surplus is a part of pro- prietorship and, of course, can be disposed of as the directors decide. All decreases in proprietorship for past periods which are now recognized for the first time should be deducted here. Finally the net figure is the amount carried as surplus on the balance sheet at the end of the period. To summarize this discussion, the income and surplus sheets taken together give a complete history of operating and financial operations in so far as they have resulted in net changes in the equities for the accounting period. The income sheet deals exclusively with the accounting period and the surplus sheet is a THE INCOME SHEET 555 summary of the accumulation of surplus to date. The income sheet in turn has two distinct divisions: (i) operating, corre- sponding to theexpense andrevenue accounts, and (2) netrevenue, corresponding to the net revenue accounts. The extent to which the two divisions may be itemized is entirely a matter of expediency. In the illustration given the material was sum- marized in very brief form but the amount of information which may be given under any heading is limited only by the degree of specialization maintained in the ledger accounts. THE COMPARATIVE INCOME SHEET While an income sheet covering one year's operations gives valuable data for financial purposes, it will readily be recognized that the facts are of much more significance when comparisons can be made with other companies conducting the same line of business or with the previous experience of the same concern. Comparisons with another concern can be made only when it is assured that both have adhered to the same accounting principles and have used essentially the same classification of accounts. The great diversity of accounting practice at the present time prevents any wide use of such comparisons, though there is an evident tendency toward greater uniformity. The Interstate Commerce Commission has standardized the classification of accounts for the railroads and other pubKc utilities under its jurisdiction. State public utility commissions are doing the same for the utilities which they control, so that in the public utility field comparisons can very well be made between the income sheets of different companies. There have been move- ments by some of the manufacturing associations and retail organizations to effect the same results for industrials. The acceptance of uniform systems by individual concerns in this case is purely voluntary, however, and hence it will doubtless be some time before any very tangible results will be attained in the industrial field. Direct comparisons can be made, however, between income sheets covering different periods for the same concern, and these comparisons are of importance to all interested parties. Of 556 PRINCIPLES OF ACCOUNTING course, if the investor saves the successive income sheets as they are published he can make the comparisons himself. But in the first place reports are not saved as a general rule even by those investors who retain possession of their securities for long periods of time. Further the constant shifting of the ownership of securities makes such information unavailable to new investors unless a comparative statement is issued each time an income sheet is prepared. Comparative figures for each item in the income sheet should be given for several years so that the in- vestors can judge as to the normal operating condition of the concern. Some corporations make a practice of presenting a series of from two to ten annual income sheets in parallel columns, and this is a commendable practice. Even two successive in- come sheets are of convenience if the changes in the items are brought out clearly, perhaps in a third column showing in- creases and decreases. It might be well in some cases to add a considerable discussion in narrative form explaining the changes in so far as it is possible to do so. Some accountants object to placing an opinion as to the prospects of a concern on record, on the assumption that, given the same set of figures, the investor should be able to arrive at conclusions of his own. It would seem that a much more reasonable stand would be that the accountant should not only prepare the tabulated statements but should give whatever additional technical information he might be able to obtain. At least if this is not done by the accountant, some responsible officer of the concern should prepare some narrative statement based upon the income sheet. The following is a very brief comparative income sheet to- gether with an additional descriptive statement such as might be given to explain the changes in the figures given. The income sheets are for the X Company, a manufacturing enterprise, and cover the operations of the years J917 and 1916. Increases and decreases are shown in the third column. Decreases are designated by the prefix d and no designation is given the figures representing increases. THE INCOME SHEET SS7 1916 Increases or Decreases Gross revenue Expense Net revenue from operation Taxes Net revenue Interest Net revenue for stockholders Dividends Carried to surplus Surplus Jan. ist Loss on abandoned property Surplus Dec. 31st $4,500,000 3,800,000 $ 700,000 1 50,000 $ 550,000 3iS,o°o $ 235,000 215,000 $ 20,000 1,345,°°° $1,365,000 3S,ooo 51,330,000 $4,350,000 3,500,000 $ 850,000 95.00° $ 755,000 300,000 $ 455,000 215,000 $ 240,000 1,230,000 $1,470,000 125,000 $1,345,000 id) id) (d) $150,000 300,000 1 50,000 SS,ooo 205,000 15,000 220,000 (d) 229,000 115,000 id) 90,000 id) 15,000 Sales for the year 1917 were $4,500,000, an increase of $150,000 over the sales for 1916. This is due almost entirely to the fact that higher prices were charged for the products sold and not to an increased volume of busi- ness. The amount of product manufactured was very little in excess of that for last year. Expenses were $3,800,000, an increase of $300,000 over the same item in 1916. Large increases in wages as well as increased prices of raw materials explain this increase. The efficiency of the operatives has if anything increased during the year but not sufficiently to offset the increased wages and other prices. Net revenue, it wiU be noted, was only $700,000 as compared with $850,000 in the previous year. Inability to raise prices of finished product as rapidly as prices of raw materials and wages advanced is the cause of this situation. The management confidently believes that prices of finished product wiU rise sufficiently during the next few weeks to offset the tendency shown in this figure. Taxes were $150,000, an increase of $55,000 over the 1916 taxes. This, of course, is explained largely by the increased federal income and excess profits taxes for the year. There were also some increases in local taxes. The amount of net revenue left after deducting taxes was $550,000, a decrease of $205,000 from last year. Of course the tax policy of the government win enter largely into the question as to whether this figure can be ma- terially increased another year. The fixed charges, consisting of interest on bonds, increased $15,000 to $315,000. This increase was caused by the issue of $300,000 second mort- gage bonds, the funds being required for improvements and extensions. The regular dividend rate was maintained and a balance of $20,000 was carried to surplus. This, it is true, is quite a narrow margin but, as was 558 PRINCIPLES OF ACCOUNTING stated above, improved operating conditions are expected in the near future through increased prices, and there is every likelihood that the regular dividends wUl be earned. Further, even if the earnings should turn out to be low, the surplus balance is sufficient to maintain the regular dividend payments for some time. The necessity for tapping surplus, however, is unlikely. Such a statement as this expresses the opinion of the accountant or other ofiScial with regard to the facts represented in the com- parative income sheet. An expert opinion of probable future conditions is of considerable help to the investor, especially if he is not equipped to make743.368 Accounts payable 26,471,681 Employees' benefit fund 8,919,335 Surplus and reserves .'.-.• 174,497,695 ' $980,004,095 In the first of these statements it is possible to obtain but little information in regard to the telephone and telegraph property directly controlled by the holding company. In the second statement, however, the condition of the operating unit as a whole is shown. From this statement, for example, it may be seen that the telephone plant controlled by the company is valued at $797,159,487 and the bonded debt of this property amounts to $341,147,485. Further information in regard to the combined properties is available from this statement. XXVIII Statements of Insolvency The income sheet and balance sheet are the typical forms of statements for the going concern. In the case of insolvency or •bankruptcy, however, some special forms of statements are necessary. No new problems of accounting analysis arise in these connections but the statements generally prepared are sufficiently technical to warrant a brief discussion in this chapter. STATEMENT OF AFFAIRS A statement of affairs is drawn up at the time a concern is declared insolvent, for the purpose of indicating the probable amount to be reahzed by the various creditors. No regulation form has been universally adopted, but the court generally demands some form of statement from the receiver. The pro- cedure is somewhat as follows. A receiver is appointed to conduct the affairs of the concern on the date that it is declared insolvent. It is his function to wind up the business, convert the assets into cash, pay off the creditors according to their various claims, and finally, if there is any balance left, to dis- tribute that to the proprietors. It is at the time of taking up the affairs of the insolvent concern that the receiver prepares the statement of affairs. This is made on the basis of the concern's own balance sheet, as of the same date. It has been shown in previous connections that the book values of assets to a going concern are greatly in excess of the liquidation values, hence an estimate is placed on the probable amount to be realized from each asset. Next an investigation is made of the nature of the various claims of the creditors. Certain claims are entirely or partly S99 6oo PRINCIPLES OF ACCOUNTING secured by specific property items. These liabilities must be deducted from the valuations of the specific asset accounts, in order to determine the amount available for unsecured claims. Preferred claims, such as taxes and accrued wages, must be shown as deductions from unencumbered property items in the proper place. All of this information can be placed in statement form. In order to show the procedure more concretely, the balance sheet of an insolvent concern will be taken as the basis for a statement of affairs. Balance Sheet, X Company May 3: t, 1918 Assets Equities Land $ 135,200 Common stock $ 350,000 Buildings 320,224 Preferred stock 350,000 Equipment 482,052 Bonds 550,000 Bills receivable 19,708 Notes payable 318,600 Accounts receivable 13,867 Accounts payable 131,440 Finished goods 165,247 Accrued taxes 16,875 Raw materials 496,452 Accrued wages 115,400 Cash 29,153 Deficit ^ 170,412 [,832,31s $1,832,315 In addition to the balance sheet of the corporation, the receiver ascertains the following facts. The bonds are secured by a mortgage on the land, buildings, and equipment. All other claims are unsecured. Taxes and wages are of course preferred claims. It is estimated that the land will bring $140,000, buildings $215,000, and equipment $225,000 at forced sale. Further it is estimated that the bills receivable will net $16,708, accounts receivable $12,250, finished goods $160,000, and raw materials $230,000. On the basis of these facts, the statement of affairs exhibited on the following page may be prepared. In the first column on the asset side are placed the book values of all assets as shown on the balance sheet. The total of this column is equal to the total of the asset side of the balance sheet minus the deficit item. The deficit is not listed in this statement, STATEMENTS OF INSOLVENCY 60 1 Statement of Affairs, X Company Mays: r, 1918 Assets to he Realized Estimated Reait Book Valub IZABLE VaLDE FOR UnSECUHED n Creditors Land $ 135,200 $140,000 Buildings 320,224 215,000 Equipment 482,052 225,000 Rea,H7,a,ble value of land, bldgs., equip. $580,000 Less bonds secured by mortgages 550,000 $ 30,000 Bills receivable 19,708 16,708 Accounts receivable 13,867 12,250 Finished goods 165,247 160,000 Raw materials 496,452 230,000 Cash 29,153 29,153 Total $1,661,903 $478,111 Deduct the preferred claims — Accrued taxes $ 16,87s Accrued wages 115,400 132,275 Assets available for distribution to other xmsecured creditors $345,836 Deficiency 104,204 $450,040 Liabilities to be Liquidated Bonds completely secured by mortgage Notes payable Accounts payable Accrued taxes (preferred claims deducted from assets) Accrued wages (preferred claims deducted from assets) Total Book Liabilities ON Claims Unsecured Assets $ 550,000 318,600 $318,600 131,440 131,440 16,875 115,400 51,132,315 $450,040 6o2 PRINCIPLES OF ACCOUNTING as it is a valuation account, an offset to proprietorship. On the liability side in the first column are listed all balance sheet equities with the exception of the proprietary items — common and preferred stock in this case. Proprietorship accounts are omitted from this statement entirely. Next, the amount which each asset is estimated to realize is set down in a second column on the asset side. In case any such assets are pledged as security for specific liabilities the particular liabilities are deducted from the net valuation and the balance is carried to the coliram headed " Estimated realizable value for unsecured creditors." In this illustration, only one such case was given. The bonds were secured by a mortgage on the land, buildings, and equipment, hence $550,000 for bonds was deducted from the net valuation of these three items and the balance of $30,000 was carried into the last column. The total estimated value of the assets available to meet the claims of unsecured creditors amounts to $478,111. The claims of the preferred creditors (accrued taxes and wages) are deducted from this figure. This leaves a net amount of $345,836, available to unsecured non-preferred creditors. In the second column on the liability side the unsecured creditors' claims are listed. The total of this column, $450,040, minus the unpledged assets, $345,836, shows the estimated deficiency, $104,204. In the case of a corporation this loss is incurred by the unsecured creditors entirely unless some specific statute allows the corporation to assess the stockholders. This is usually not the case, however. In partnerships or single-proprietary enterprises, this deficiency can be made the basis of suit against the proprietors. In the illustration all of the proprietary equity is lost and the unsecured creditors lose the $104,204. The amount which each creditor will probably receive is found by dividing the unsecured assets, $345,836, by the unsecured claims, $450,040. This gives 76.8 per cent. In other words each of the unsecured creditors will probably realize seventy-six and eight-tenths cents on the dollar. The last column on the asset side and the last column on the equity side constitute what may be considered a type of balance sheet. It is, in fact, a forced liquidation balance sheet. It is prepared for the purposes of the creditors primarily in order that STATEMENTS OF INSOLVENCY . 603 they may determine with some degree of accuracy the extent of their losses in deaKng with the insolvent firm. The statement shown in the illustration was prepared according to the American form of balance sheet, — assets on the left-hand side and HabiHties on the right-hand side. Some accountants reverse this procedure and place HabiHties first and assets second. This appears to be a questionable procedure. One author suggests that the probable reason for this is that the statement of affairs is of EngHsh origin and that the American accountants who favor this form are simply following EngHsh practice.^ It is logical for the EngHsh accountants to use this form inasmuch as HabiHties are listed first and assets second on the balance sheet. A logical procedure in constructing American statements would be to place assets first and HabiHties second. . DEFICIENCY STATEMENT No changes are made in the ledger accoimts at the time of preparing a statement of affairs. This is made out entirely as an estimate to be used for the purposes of judgment as to the extent of deficiency. The receiver then winds up the business, seUs the assets for the best price he can get, pays the secured claims from the proceeds of the assets pledged, pays the preferred claims and finally pays what is left to the unsecured creditors. He keeps the accounts in the regular form and finaUy, at the time the whole business is Hquidated, makes out a statement showing the results of receivership. This is usually in the form of a deficiency statement. As each asset is sold Cash is debited for the proceeds and Deficiency accoxmt is debited for the difference between book value as shown by the last balance sheet and the proceeds, and the particular property account involved is credited. In case the proceeds exceed the book value of an asset the Deficiency account is credited for this amount. All expenses incurred by the receiver together with his own fee are charged to this account. The amount of the deficit, as shown in the last balance sheet, is debited to Deficiency and credited to the Deficit account. The ' See Hatfield, Modern Accounting, page 335. 6o4 PRINCIPLES OF ACCOUNTING balance in the Deficiency account, after these entries have been made, represents the total amount of loss to the equities. The stockholders' equities suffer first, and therefore an entry is made debiting Capital Stock and crediting Deficiency. In case the Deficiency account still shows a debit balance, this represents a final net insolvency which must be met by the unsecured creditors. If the amount reaHzed on the assets by the receiver actually corresponds with the estimate in the state- ment of affairs, the net insolvency, as shown by the Deficiency account, will be greater than the deficiency item in the statement of affairs by the amount of the receiver's expenses and fees. For purposes of illustration it will be assumed that the receiver did reaHze the amount shown in the statement of affairs (above section) and that his fee is $i,ooo and expenses $1,500. In this case the deficiency statement would be as follows : Deficiency Statement, X Company August 31, 1918 Losses on Realization of Assets : Buildings Equipment Bills receivable Accounts receivable Finished goods Raw materials $105,224 257,052 3,000 1,617 5,247 266,452 Total losses Less profit on sale of land $638,592 4,800 Net loss on assets $633,792 Expenses of Realization : Receiver's expenses Fee of receiver $1,500 1,000 2,500 Total loss and expenses of realization Deficit previously reported by company $636,292 170,412 $806,704 Stockholders' equities to meet losses : Common stock Preferred stock. $350,000 350,000 700,000 Net deficiency (loss to unsecured creditors) $106,704 STATEMENTS OF INSOLVENCY 605 The net deficiency shown by this statement, $106,704, is just $2,500 greater than the deficiency item in the preceding state- ment of affairs. This statement is in fact an income sheet for the receiver. He has shown losses and gains incident to the selhng of the assets of the concern. Some accountants have advocated the use of several accounts to show the information contained in this deficiency statement. Such accounts as " realization," " liquidation," " settlements," etc., are often used. It may be that in special cases these additional accounts are of use, but in the average case the one given in the illus- tration is sufficient. PART SIX SPECIAL FIELDS OF ACCOUNTING XXIX Cost Accounting As was suggested in Chapter I the problems of management give rise to a distinct and important branch of accounting, namely, cost accounting. In the preceding chapters the discussion of the accounting principles has been concerned primarily with the construction and analysis of accounts from the standpoint of the general interests of the equities involved — especially the proprietary equity — although the question of detail classification and comparison for managerial purposes has been introduced at various points. In the present chapter a brief statement of some of the essential features of cost accounting will be given. THE PROBLEMS OF MANAGEMENT Evidently the manager of a large scale and complex enterprise should have at his disposal if possible more extensive statistical information than that furnished by the ordinary system of double- entry accounts. It is true that the ledger accounts and the financial statements (especially the expense and revenue state- ment) furnish much data of value to the management, and that if the information presented by the expense and revenue state- ment is well classified, considerable light is thrown upon the process by which the resulting net revenue or loss is attained. In fact even the amount and rate of net revenue provides a crude test of eflSciency through comparison with the similar items of other establishments in the same field of industry, and with the results of other periods of operation in the same enter- prise. But in view of the present complexity of the industrial situation and the emphasis upon efficiency such information is rather inadequate for managerial purposes. From an ordinary 2R 609 6io PRINCIPLES OF ACCOUNTING income sheet the manager can get little clue as to the prospects of maintaining a creditable showing; and, if the net result of operation is unfavorable, it is Hkely that only on the basis of detail classifications of expense and revenue according to some appropriate functional plan can an intelligent investigation as to causes be made and rational poHcies seeking to remedy the situation be formulated. What are the more important questions of management which one may seek to solve with the aid of cost accounts and cost analysis ? In the first place it may be noted that many business firms produce more than one product. In such cases it is not sufficient that total revenue and total expense be correctly ascertained and compared. The expense of producing each distinct commodity or service, and the revenue accruing from the sale of the same, should be determined if possible. This is a relatively simple matter as far as revenues are concerned (see page 141), but usually the allocation of expense to a particular Hne of product is (as will be explained a Httle later) a very difficult problem. In so far as such a classification can be made, how- ever, its utility in directing production in a rational manner is evident. Some companies have discovered, after introducing a cost system, that one or more products were being produced at a loss. This fact had not been previously recognized because the loss thus suffered had been covered by profits on other lines. Similarly other firms have discovered that by specializing in a particular direction losses could be turned into profits. While this is the day of specialization, very few enterprises are producing a single commodity or service and hence the problem of allocating expenses to a particular line of product is an almost universal problem of management. In many cases circumstances are such that the production of a number of prod- ucts is unavoidable. This is usually the case where "by- products" are made. In such cases all costs are more or less joint. Even in these situations it is probably true that some allocation of costs is possible and desirable. It may be that in some industries, such as railroads, the problem is not capable of solution; and in such cases cost accounting is of doubtful efficacy. A classification of expenses in terms of the objects for which expenditures are made may be all that is possible COST ACCOUNTING 6ii in certain cases. The problem of expense allocation will be further considered in the next section. Although an enterprise may be producing but a single product, cost statistics may be necessary in order that the manager may have the information with which to make comparisons as to the efl&ciency of hke productive units. If the enterprise consists of a number of plants performing similar functions, the general manager will wish to ascertain the relative efficiency of each of the various plants. Obviously this cannot be determined by inspection. The expenses and revenues pertaining to each plant must be segregated if the cost per unit of product from each plant is to be ascertained. Not only are comparisons between plants necessary in such a case, but efl&cient management requires a knowledge of the comparative performances of departments, production centers, and even individual machines. Even a record of the individual performance of each employee is desirable, for such information is of importance in improving labor effi- ciency. Such statistical analysis may be carried very far in some cases — indeed far beyond accounting in any proper sense. There is always a point, however, at which the advantage to be derived from detail information is counterbalanced by the diffi- culty and cost of securing the information. Even if an enterprise is producing but one line in the ordinary sense, cost analysis may be of utility in still another connection. The determination of cost per order or job is often a matter of considerable importance. The ship-building company, for example, turns out units of product of different sizes, design, and cost ; and in many cases each unit is manufactured according to definite specifications. Similarly the building contractor constructs many types of buildings, the printing and publishing house makes many kinds of books, and the engine manufacturing company produces a variety of types of engines. In all these cases an analysis of costs in terms of specific jobs or orders may be an important factor in determining bids and in taking orders. The price-making function of cost accounting is often greatly exaggerated by cost enthusiasts, but in this connection the general utility of such statistical information is evident. Cost accounts may furnish a basis for bids without in any sense deter- mining prices. 6i2 PRINCIPLES OF ACCOUNTING In connection with the utilization of the economic resources at the disposal of the manager still other problems of importance arise. What are the proper combinations of the productive factors ? Or, in other words, what is the most effective process in view of all the market conditions? This may involve a comparison of the costs of various methods simultaneously in use, or of the costs of methods in use with those of possible methods. Many products can, of course, be produced by a number of processes. The manager must decide as to which is the most efficient. Certain castings, for example, can be sawed with hand tools at a simple work bench, or they can be cut by a practically automatic milHng machine. A^Thich process should be adopted? One method employs little capital and a large amount of current labor. The other process makes use of a high-priced machine and little direct labor. The cost per unit of output by each method should be ascertained. If labor is relatively high in price the second method may give a lower cost per unit. If the rate of depreciation on the necessary high- powered machine is high and repair and other maintenance charges heavy the first process may be the more profitable. Often it is necessary temporarily to use inferior methods con- currently with the most approved processes because of the nature of the equipment already purchased or because of certain unavoidable market conditions ; but the classification of expenses between the different processes, if properly carried out, should give information which would be useful in guiding replacement and improvement policies. The determination of the best method of remunerating labor is another problem of management. Statistical information concerning individual performances under different wage plans furnishes a basis for Judgment as to the method which gives the greatest stimulus to labor under particular conditions, and hence is the most profitable. On the basis of cost statistics the manager is able to set up standards of operation for all departments and phases of the enterprise. Such standards must, of course, be continually revised due to changing conditions. Further, it is necessary to compare such standards with the performances of other enterprises in the same field. But even if not applicable to COST ACCOUNTING 613 more than one enterprise, adequate standards as a goal for operating efficiency are of great assistance to the individual manager. In any discussion of managerial statistics the point should be emphasized that much data of importance to the manager is not accounting or financial data in any proper sense of the term. Physical statistics are often of more importance to the manager than value statistics. A record of labor efficiency is best stated in terms of physical facts. Ton-mile and car-mile statistics in railway operation are of value to the manager but are evidently not accounting data. Further, while cost data may be of considerable use to the manager such facts cannot be directly used by those ultimately in control in determining the efiiciency of management itself. The manager is not responsible for general economic conditions and hence has no control over material costs and labor prices. He is not responsible for all accidents, weather conditions, etc., and hence should not always be criti- cized because of high repair and maintenance charges. On the other hand the manager is supposed to exercise foresight and judgment in adjusting the needs of the enterprise to market conditions. Further, any significant variation in costs serves notice on those finally in control and calls for an explanation on the part of the operating management. The treatment of interest charges in cost accounts is a question which has attracted a great deal of attention. According to the view stressed at various points in the preceding chapters interest is always a distribution of net revenue and is not an operating expense. The point has been repeatedly emphasized that no phase of the service of ownership should be capitalized in any sense and appear in the accounts as either an asset or an expense charge. The determination of net revenue is perhaps the most important function of the accounts, and this figure is shown by the difference between accrued revenues and purchased commod- ities or services expired in producing that revenue. Admitting, however, that the analysis of interest given in the foregoing pages is correct as far as the purposes of general financial account- ing are concerned, it might still be urged that interest on invested capital should be treated as a cost for cost accounting purposes. In the first place it might be said that the viewpoint of the 6 14 PRINCIPLES OF ACCOUNTING hired manager is quite distinct from that of the owners. The interests of the manager are not opposed to the interests of the equities, but are rather subordinate to them. In a sense the manager must look upon the establishment from the standpoint of an outsider. Not only is the disposition of all services and commodities purchased under his direction, but the disposal of the services of ownership itself (waiting, risk-taking, etc.) rests in his hands. Hence the manager might view the cost of pro- duction in the- same light as does the economist who considers cost to mean the total economic cost, including interest and profits at the margin, necessary for the production of a particular product. Accordingly, in the comparison of periods of operation, different plants and departments, and processes of production, statistics showing total cost (including a fair return on the capital invested) per plant or per process are of importance. Particularly in comparing processes involving varying proportions of fixed capital and direct labor are such calculations of utiUty. Cannot the manager, however, make such a calculation in the same way as would the owner without setting up interest charges as costs ? In comparing methods is it not the one which yields the greatest return on the total capital invested which is the most desirable? This seems a fairly reasonable proposition, and to make comparisons in this way requires no fictitious expense charges in the cost accounts. Process A can be com- pared with process B on this basis by simply recognizing all depreciation, maintenance, and other actual operating costs in both cases, and computing the cost per unit of output for each method. Would it not obscure rather than clarify the actual situation for the manager if interest on invested capital were charged to expense in each case at some arbitrary rate ? At any rate if any interest charges are brought into the cost accounts at all the only logical procedure is to consider interest — and reasonable profits as well — on all the capital involved whether invested in fixed or working assets as a cost. If the outlay in question is a large one in which several equities are represented, it will be necessary to dptermine this cost on the basis of the different rates of return involved. In the case of a going concern where all the capital furnished is already amal- gamated in one fund used for a variety of purposes any such COST ACCOUNTING 615 determination of the rates involved in a specific part of the investment is impossible. In fact the use of interest charges in cost accounts on anything like a rational basis is a procedure which faces almost insurmountable practical obstacles. It is probably this fact rather than the logic of the case that is causing cost accountants to begin to recover from the interest obsession. Several recent discussions of the subject clearly show the impropriety of charging to expense arbitrary sums which will naturally bear no very close relation to rates actually realized year by year by the specific concern (which charges are adjusted by concurrent fictitious credits to revenue). The doctrine seems to have been due to a confusion of commercial concepts and practice with certain ideas of economic theory, and appears to be losing adherents. THE CLASSIFICATION AND DISTRIBUTION OF EXPENSE The central problem for the cost accountant consists in the classification and allocation of expense charges for managerial purposes on an appropriate functional basis or bases. The principal types of costs mentioned above in which the manager may be interested may be summed up as follows : (i) cost per plant or department; (2) cost per method or process; (3) cost per successive operation or stage in production; (4) cost per order or job ; and (5) cost per line or unit of product. A partic- ular system of cost accounts may be constructed with the idea of furnishing several such types of. information, or the system may be organized in such a way as to stress simply one important line of analysis. In the following discussion reference will be made primarily to the questions that arise in allocating costs to successive production stages and to particular Hnes of product. The total expense of operation may be classified into direct and indirect charges. For cost accounting purposes this is an im- portant line of division. All materials and services consumed which can evidently be assigned to the production of a particular line of product, or to a specific process, operation, or depart- ment, constitute direct charges. The wages of a machine operative, for example, are directly assignable charges provided workman and machine are devoted continuously to a particular 6i6 PRINCIPLES OF ACCOUNTING purpose. On the other hand all materials and services consumed which cannot be allocated to definite functions, except on some more or less arbitrary basis, represent the indirect expense. The salary of a general superintendent is such a charge. Rela- tively few types of expense can be placed wholly in either class. Labor, for example, in nearly all cases must be classified into direct and indirect labor; and the same may be said of raw material and many kinds of supplies and services. A further classification of expense conforms to the nature of the enterprise and the various stages of the productive process. Thus there is manufacturing expense and selling expense. The nature of the difficulties arising in making even such a simple functional division of expense charges was discussed in Chapter VII. The general and administrative expenses must either be grouped separately or apportioned arbitrarily between the manufacturing and selling departments. The line of demarcation between direct and indirect expense is not obvious in many cases. Miscellaneous supplies such as oil, waste, small parts, etc., for example, are usually considered as an indirect expense, although as a matter of fact many such items enter directly into specific units of product and could be allocated to such product if the amount of clerical work involved did not render this inexpedient. Again the wages of a particular workman may be in part direct charges and in part indirect. An operative, for example, may be transferred from one task to another during the day. Part of his time may be devoted to repair work on the main power plant, and part to the operation of a machine. Careful records must be kept in such cases of labor time and its uses, if reasonable results are to be attained in dividing labor costs between direct and indirect charges. Assuming that it is possible to distinguish between direct and indirect expense the problem of allocating indirect expense to specific departments, processes, and Hnes and units of product arises. The amount of indirect expense may be assigned to types of product in various ways. It may be spread over the entire output on some arbitrary basis, or it first may be appor- tioned between phases of the business, or it may be allocated directly to some smaller unit such as the job through the use of machine rates. Probably the latter procedure is the most COST ACCOUNTING 617 adequate, but it should be emphasized that whatever method is adopted some more or less arbitrary bases of distribution must be used. Where burden or indirect expense is worked into a machine rate the usual procedure is to divide the plant into appropriate production centers or machine units and use up the burden in determining the hourly cost to operate each unit. In making up these hourly costs different bases are used in distributing the different elements of the indirect charges. The cost of Ught, for example, may be distributed as a function of floor space. Cubic space, on the other hand, would seem a more reasonable basis for distribution in the case of the cost of heat. In some cases it is found convenient to work nearly all costs, direct and indirect, into machine rates. In others, direct material and labor costs are handled separately. Often some element of burden is found practically unassignable, on any rational basis, and is not allocated at all. Evidently if this un- assignable cost is relatively large the cost analysis is admittedly inadequate. A method of allocation frequently employed is the distribution of indirect expense in proportion to the direct. For example, if the direct expense incurred in producing a particular unit of product is two per cent of the total direct expense for the period, then according to this method two per cent of the total indirect expense of the same period would be charged to this product. Similar methods are the distribution of overhead on the basis of a single direct cost such as that of labor or materials. Such methods are in most cases unsatisfactory. Usually there is a marked divergence between the percentages of direct and in- direct expense involved in the production of particular units. Frequently a large percentage of direct expense goes with a small overhead charge. For example, the skilled workman receiving $S per day may be working at a task which requires for equip- ment only a work bench and hand tools, while another task requires an expensive automatic machine and the attention of an unskilled workman drawing $2 per day. As far as solving the problems of the manager is concerned a distribution of charges on any of these bases is practically useless. A large number of methods have been suggested for distributing 6i8 PRINCIPLES OF ACCOUNTING indirect expense.^ A description of these is beyond the scope of the present discussion. No set rules are feasible for all cases. The conditions in any particular case must be thoroughly investigated and the various items constituting indirect expense must be allocated on the most scientific basis possible. It is evident that the accuracy of cost analysis depends to a large extent upon the ease with which total expense can be divided into direct and indirect charges, and upon the pro- portion which these indirect charges bear to the total. Cost statistics undoubtedly are best adapted to manufacturing enter- prises. In public utilities, where overhead or indirect expense forms about sixty-five per cent of the total cost, on the average, the efficacy of cost accounting is not certain. A railroad, for example, uses roadbed, track, and terminals — a very large portion of its equipment — ^for the production of, a variety of services, and therefore a large portion of total expense is indirect, consisting of maintenance, depreciation, etc. The determination of the cost of a specific service under such conditions requires the use of arbitraries for such a large portion of the total charge as to make the result questionable. Nevertheless, much interest is developing in cost accounting for railroads, and it may be that a reasonably accurate system of costs is possible even for such enterprises. Up to the present time, however, the best results have been attained in other lines of industry. A consideration of almost any intensive method of costing will raise a question as to its feasibility because of its complex nature and probable cost of adoption and maintenance. Most systems require the listing of data on the subsidiary records by large numbers of employees, and unless the necessary cards and sheets are very conveniently constructed it is hard to get satisfactory results from the figures of scores or hundreds of operatives. In view of these facts a cost system is largely a nuisance unless the data finally secured are foimded on actualities and are not merely specious as is so often the case. The work of the cost accountant consists in a large measure in the construction of a system of records which conforms to the nature of the particular enterprise and is adapted to disclose the 1 The Proper Distribution of Expense Burden, by Church, is an admirable treatise on this subject. COST ACCOUNTING 619 facts necessary for the efl&cient management of that enterprise. Special ledgers and journals are necessary as well as subsidiary forms such as requisitions, production orders, time reports, process cards, store records, summary sheets, etc. It is in connection with the development of adequate stores accounting methods and devices for controlling and fixing the responsibilities of employees that cost accounting has perhaps had its greatest utility. In conclusion it may be noted that although the cost records are usually constructed so as to intermesh with the accounts proper it is evident that cost accounting (in its accepted connota- tion) is quite distinct from the problems of general financial accounting, and represents a part of the statistical side of scientific management and efficiency engineering. XXX Municipal Accounting The discussion thus far has been concerned exclusively with the private business iirm. It has therefore been necessary to emphasize the importance of the private equities. The munici- pal corporation is seldom thought of as a business enterprise, and for this reason it is often urged that scientific accounting principles do not apply. As an organization, however, a munici- pality may be compared to a business corporation. Both are corporations, receiving charters from the state. They are both governed and managed by a board — elected by the citizens in the case of the municipal corporation and by the stockholders in the business enterprise. They differ mainly in the purpose of organization. The city is organized for the purpose of render- ing services to the citizens without profit (or for other reasons), while the business corporation is organized for producing net income for its stockholders. In order to cast an intelHgent vote at the municipal elections, a citizen should have information in regard to the financial standing of the city and a history, of the results of financial transactions during the preceding period. The statements required for this purpose are much the same as those prepared for the business enterprise ; namely, the balance sheet and the income sheet. Furthermore, the governing board or the city manager requires information of a nature similar to that required by the manager of an industrial plant. This is needed in order that a rational judgment may be made as to the efficiency of the organization. The recent development of the commission manager form of government is a recognition of the fact that a city, after all, is much the same as a corporation and should be managed as such. Hence municipal cost accounts are of importance. 620 MUNICIPAL ACCOUNTING 621 That very few cities present financial statements that are adequate for the purposes mentioned is a well-known fact. The accounting systems for cities are generally of the primitive cash book class, that is, transactions are recorded only as cash is received or paid by the city, and the only statements which are prepared at the end of the year are those which show the amount of cash received and disbursed during the year. It is the purpose of this chapter to explain briefly the use of the standard accounting statements for the municipal enterprise. THE MUNICIPAL BALANCE SHEET The council is intrusted with the administration of certain properties, and unless a proper statement of the condition of these properties is given at the beginning and end of each year, the council cannot be held to a strict accountabiHty for its administration. The statement which should be used for this purpose is the balance sheet. The assets in this case would consist of all properties owned by the city, actual improvements to pubHc streets and parks, all uncollected taxes and assessments, and actual cash balances in the various funds. The Habilities would consist of the bonds outstanding and the current liabiUties incurred but not yet paid. The difference between the assets and the liabilities is the surplus. This represents the amount of permanent assets which have already been paid for. This item is the only account appearing on the balance •sheet which is not a strictly private equity. It represents the collective public equity in municipal property. Thus it may be seen that the property-equity classification appUes to the municipal accounts as well as to the private concern's accounts. Balance sheets prepared each year may be used for comparative purposes and will give a clear idea of the policy of the city. They will show whethpr a city is paying for its improvements as it goes, or is accumulating a debt to pay for current services. As long as the value of the assets exceeds the liabilities, the city is pajdng as it goes ; but when the liabilities exceed the assets, a debt is being laid up against the future. It would be a relatively simple matter for most cities to pre- pare a balance sheet each year, although the first one would 622 PRINCIPLES OF ACCOUNTING present some difficulties. An appraisal should be made of all land owned by the city by a person competent to judge of land values. This figure would constitute the land value on the first balance sheet. As new land is acquired, all costs of acquiring title should be debited to this land asset account, and as any land is disposed of by the city, the value as appearing in the balance sheet should be' credited. This would always leave the land account on the balance sheet at a figure representing the cost of the land owned. Of course permanent increment in land value may be taken into account in the same manner as was shown for the business enterprise. The buildings and structures may be appraised on the basis of cost to reproduce (or original cost if that figure is available) minus depreciation. The value of the buildings in the balance sheet should always be the* value at the date the balance sheet is prepared. This will insure that a proper portion of the cost of the buildings will be charged as expense each year. Further- more, this will have a good effect on the method of financiering. Suppose that a municipal building has been erected at a cost of $80,000 and it is shown by the Building account to be worth $40,000 at the end of the tenth year ; and that $80,000 of the bonds are still outstanding with no sinking fund to retire them. It will readily be seen that some source of revenue must be found to meet the $80,000 due in ten years. If the bonds were to run to maturity without a sinking fund to retire them, and if the building were to be destroyed at that time, the future citizens would be compelled to pay for a building which had been com- pletely consumed. Situations of the sort described often occur under present methods. Public improvements such as paving can also be valued on the basis of cost of reproduction less accrued depreciation and the same can be said of all other permanent property items. Once valuations have been placed upon the fixed asset items, the continued revaluations can be made at the end of each fiscal year just as though the property belonged to a private corpora- tion. Methods of accounting for depreciation apply with equal force to the assets of a municipal enterprise. The balance sheet is completed by placing the liabilities in a column opposite the assets. General ledger accounts may be MUNICIPAL ACCOUNTING 623 opened for each asset and equity item and subsequent entries made according to ordinary commercial accounting principles. The ease with which such a statement can be prepared and with which subsequent transactions can be recorded answers the objection so frequently urged against the municipal balance sheet ; namely, that it is next to impossible to prepare one. Another objection which should be considered seriously is that such a balance sheet is of no importance after it is prepared. It is urged that such a statement is not needed to guide the actions of the investor in municipal properties as in the case of the pri- vate concern, and that a simple schedule of property would be sufficient for managerial purposes. These statements ^ire both true. The private investor in municipal bonds is not concerned with the valuations of civic assets in the balance sheet ; he is con- cerned with the legality of the bond issue and the ability of the city to assess taxes sufficient to cover his claim. Admitting all this, it may still be claimed that the balance sheet serves a function. One of the principles of public finance is that each generation should pay its own operating expenses, and the balance sheet is the only definite statement which shows whether this is being accomplished or not. This fact alone is sufficient justifi- cation for insisting on the importance of such a statement. THE MUNICIPAL INCOME SHEET If current operating expenses are to be met out of current taxes, an income sheet is necessary. A budget is required of the city council at the beginning of each year in which the estimated expenses for the ensuing year are stated together with the amount of revenue required. On the basis of this budget the taxes are levied. Expense statements for previous years are the basis for budget estimates, hence it is essential that the expenses be correctly stated. The statement from which the budget is prepared in most cities at present is the cash statement. It was shown in Chapter X that such a statement does not show actual expenses and that in many cases its use leads to entirely erroneous conclusions. This being the case, it is clear that it should not be used for budget making. What is needed is a statement which shows 624 PRINCIPLES OF ACCOUNTING actual expenses, regardless of whether cash is paid for the same within the period or not, and the revenue accruing in the same period regardless of the amount of cash received — ■ in other words an income sheet. A cash statement is of importance in the municipal enter- prise. It can be used for checking the stewardship of the city treasurer. But this is the limit of its effectiveness and it should not be used as a substitute for expense and revenue accounts. Comparisons of the expenses of one city with those of another and also between expenses incurred by one administration with those of a preceding administration in the same city are of interest. For these purposes actual expenses are desired, not cash disbursements. Where cash statements are depended upon for these purposes it has often been the practice of certain retiring ofl&cials to make large purchases immediately before leaving office in order that the disbursements of the succeeding year will be large and reflect discredit on the new officials. Such practices would not be effective were expense statements used for comparative purposes. With a statement of expenses to be prepared each year, the various department heads attempt to show lower expenses for the same service performed or greater services for the same expenses reported by preceding years. This puts the city's affairs on a more business- like basis. For the purposes of direct administrative control it is essential to classify the expenses of each department so that standards of operation can be set up in much the same way as for the private enterprise.^ A further purpose of such a classification is to obtain unit costs of services which can be used in estimating the expenses incident to instituting new methods of operation. In the larger cities an elaborate system of cost accounts is essential to proper administrative control. The managing officer or even the departmental head is confronted with many, if not all, of the managerial problems mentioned in the last chapter. In the smaller cities a simple expense classification will often be of sufficient service. The following outHne suggests some of the more important 1 See Chapter XXV. MUNICIPAL ACCOUNTING 625 kinds of information which should be supplied by classified expense accounts. In a small city the items in the outline might be used as ledger accounts ; the list of accounts in this case would be complete. In the larger cities, each of these items would be subdivided in much-greater detail. I. Police Department. (a) Administration. (b) Patrol Expenses. (c) Traffic Regulation. (d) Enforcing Municipal Ordinances. (e) Maintaining Buildings and Equipment. (J) General Operating Expenses. Fire Department. (a) Administration. (b) Fire Prevention. (c) Fire Fighting Expense. (d) Maintaining Buildings. (e) General Operating Expenses. 3. Health Department. (a) Administration. (6) Statistical Expenses. (c) Inspection. {d) Hospital Service. (e) Sewage Disposal. (/) General Operating Expenses. The expenses of each of the other administrative departments would be subdivided in this same way. In the case of depart- ments furnishing commercial services such as the supplying of water, electricity or street railway service, it is necessary to classify both revenue and expense accounts. It is usually the purpose to charge the consumer for such services at approximately cost. Revenue and expense accounts should therefore be classi- fied in convenient form for comparative purposes. The follow- ing is an illustration of a classification for a water department which could be used by small cities. 626 PRINCIPLES OF ACCOUNTING Water Department. Revenue : Private service. (a) Metered. (b) Unmetered. Municipal service. (o) Fire protection. (b) Parks. (c) Public buildings, etc. Miscellaneous revenue. (a) Special work. (J) Meter rentals, (c) Sundry accounts. Expenses : General. (o) Administration. (6) Insurance, etc. Operating. (a) Operating management. (b) Collection system. (c) Distribution system. Maintenance. (a) Collection system repairs. (6) Distribution system repairs, (c) Depreciation on plant. THE MUNICIPAL BUDGET The power of control over city finances which is retained by the citizens is their right to approve or disapprove, at the municipal elections, of the council's method of administration. In order that this right may be exercised in an intelligent manner, a financial program should be approved by the citizens at the beginning of each fiscal year. The statement to be supplied by the city officials for this purpose should contain a report of the financial results of the previous year's activities, and the plans of the administration for the ensuing year, together with the costs and the contemplated means of raising the necessary funds. The ordinary practice of city councils is to publish a statement MUNICIPAL ACCOUNTING 627 of receipts and disbursements, together with an estimate of the cash to be raised during the following year through taxes. Although the name budget is often attached to such a statement, it furnishes httle of the information needed by the citizens, nor has it proved effective in placing a limitation on the expenditures of city councils. The most important function of municipal accounts is the furnishing of the material for the preparation of the budget. The statements which have been described are adequate for this purpose. The balance sheet shows the additions and improvements during the year, and may be used for estimating the cost of the improvements contemplated for the ensuing year. Each department head should supply the council with a state- ment of the future needs of his department to aid in making the estimates. The budget should be published for the benefit of the citizens. The usual method employed by city councils in apportioning the income is to make appropriations throughout the year as the municipal wants make themselves manifest, until no funds are left. Under this method the services which are not desired until late in the fiscal year are omitted rather than the ones which are least important. This practice would be prevented by the adoption of the budget each year. After it has been determined finally what items should remain in the budget in order to keep the tax rate within the limit, the budget should be embodied in an ordinance and passed by the council. It should be unlawful for the council to spend more than the budget ordinance allows for any service, thus insuring that the program entered upon at the beginning of the year will be strictly adhered to. Although the council should not be allowed to expend more than the budget allows, there should be some method provided by which an error in an estimate might be corrected and addi- tional funds granted for particular purposes. Cases might arise in which an underestimate was made that would cause a loss to the city if the project were not completed. The method of correcting the error should be so difficult, however, that the council would resort to it only in cases of extreme necessity. The budget thus adopted should prove an effective means of control over the city administration. It furnishes the information on 628 PRINCIPLES OF ACCOUNTING which to compare one administration with another, and presents a clear statement of what is to be done with the amount collected in taxes. The details of technique in maintaining a municipal accounting system on the plan shown in this chapter are somewhat com- plicated. The tax collections are made into specific cash funds and the city is usually prohibited by state statutes from using the cash from any one fund for other purposes than those listed as covered by the fund. It becomes necessary therefore to make a considerable number of what maybe called internal book entries. Accounts called Budget Allowances, Available Cash Balance, Encumbered Balances, Unencumbered Balances, etc. are neces- sary to record all possible transactions. It would be beyond the scope of a general text in accounting to explain the details of this technique. It is sufficient here to emphasize the importance of sound accounting principles in the municipality. XXXI Railroad Accounting The controversy concerning the relative merits of public and private ownership in the field of quasi-monopolistic industry, and the present decided tendency toward the extension of govern- mental control in this direction, have given rise to distinctive economic and accounting problems. These facts, together with the physical pecuHarities of pubUc utility enterprises, make public utihty accounting a special field of considerable importance. In the field of pubHc utilities the railways constitute the most important industry. Further, in this industry both public regulation and accounting practice are most highly developed. In this brief discussion of public utility accounting, accordingly, attention will be directed chiefly to the railways. THE I. C. C. CLASSIFICATIONS The Hepburn Act of 1906, which gave to the Interstate Commerce Commission the right to prescribe uniform accounting methods for transportation agencies engaged in interstate traffic, recognizes the fact that public regulation of industry can be made more effective through the control of the accounts. Further- more, this law recognizes that intelligent and just regulation is possible only on the basis of the information furnished by an extensive analysis of the accounts. Under the authority of this act the Commission has constructed uniform systems of accounts for the public utilities under its jurisdiction. The most important example of one of these systems is that pre- scribed for steam railways. This system is classified into six groups of accounts as follows : (i) investment in road and equip- ment; (2) operating expenses; (3) operating revenues; (4) income; (5) profit and loss; and (6) balance sheet. A brief 629 630 PRINCIPLES OF ACCOUNTING examination of the classifications of this system will serve to suggest some of the characteristics of railway accounting. The classification, investment in road and equipment, includes the accounts which represent the cost of the fixed assets used in operation. This classification provides for three "general" and seventy-seven "primary" acfcounts. The general or sum- mary accounts are : Road ; Equipment ; and General Expendi- tures. Example of primary accounts under Road are : Engineering ; Land for Transportation Purposes ; Ties ; Rails ; Station and Office Buildings ; Roadway Buildings ; Shops and Engine Houses ; Telegraph and Telephone Lines ; etc. Equipment covers the following subsidiary accounts : Steam Locomotives ; Other Locomotives ; Freight-train Cars ; Passenger-train Cars ; Floating Equipment ; Work Equipment ; and Miscellaneous Equipment. Those under General Expendi- tures are : Organization Expenses ; General Officers and Clerks ; Law ; Stationery and Printing ; Taxes ; Interest during Con- struction; and Other Expenditures — General. The railroads are not restricted to the use of the primary accounts prescribed by the Commission — a greater or less number may be used according to the needs of the particular case, but no option is allowed as to the character of the items entering these accounts. Previous to 1907 (when the prescribed classifications went into effect) it had been the practice of many railroad companies to enter in the property accounts an amount equal to the par value of the securities issued, to avoid showing discounts on securities . on the balance sheet. Unreasonable construction company profits also often contributed to inflated property values on the first balance sheet. Furthermore, the accounting treatment of the property items after construction has varied more or less with the success of the enterprise. Thus roads making large earnings often charged improvements to expense. Other roads with small earnings continued to inflate property values by charging replacements to capital. Consequently the value of the property as shown by the accounts often does not approximate actual values as far as construction prior to 1907 is concerned. This situation is unfortunate since the value of the property used is a particularly important matter in railway accounting. The problem of valuation is of more significance in the case of public RAILROAD ACCOUNTING 631 utilities than in competitive industry because of the accepted theory that rates should yield a fair return on the investment. The purpose of the present federal valuation project is in part at least an attempt to correct the figure, investment in road and equipment, as it now stands upon railroad balance sheets. It would seem to be the purpose of the entries in the accounts of this classification to maintain the balances of these accounts at the actual value of the property used for furnishing transportation services. In this respect, however, the rules of the Commission have been conservatively formulated. This is particularly noticeable in connection with the rules covering the replacement of certain kinds of property. When an item of abandoned prop- erty such as ties is replaced, for example, the rules prescribe that "the excess cost of metal ties applied in place of wooden ties over the cost at current prices of replacing in kind the wooden ties removed shall be charged to road equipment account No. 8, 'Ties.'" ^ In other words in a period of rising prices the amount appearing in the Ties account may be less than the actual cost of the ties in use. Suppose, for example, that the current prices of wooden ties represent an advance of twenty per cent over the cost of the ties being replaced, and that the cost of the metal ties used is still ten per cent higher. The application of this ruling would evidently mean that the accounts would show but a ten per cent increase in property, although the new ties actually cost thirty per cent more than the property removed. If the property is replaced in kind, but at a higher price, the property account would represent the cost of the original item rather than of that now in use. In case the property is replaced in kind but at a lower price there would again be no adjustment in the asset account and an overstated property value would be shown. These rules are evidently not in agreement with those explained in Chapter XXII which state the correct procedure for ordinary replacement accounting. Even if accrued market changes are ignored it would seem sound practice to follow actual investment values in recording replacements as in accounting for new con- struction ; for otherwise the company building a new extension in a year of high prices is allowed a high property valuation 1 Qlassijication of Operating Revenues ani Operating Expenses for 1914, p. 42. 632 PRINCIPLES OF ACCOUNTING while a company making extensive replacements in kind in the same year is allowed no increase. As stated above it would seem especially important in the case of public utility enterprises that the accounts should be as sensitive as possible to changes in the price level, for in this way changing capital costs can be recognized and the rates allowed adjusted to meet the new situation. The rulings mentioned in a period of rising prices would work to the disadvantage of the investor. In a period of falling prices such regulations are detrimental to the interests of the public. In either case the accounts fail to represent the value of the property marketwise ; and even if the basis for valuation is to be the sacrifice of the investor the fluctuations in monetary values must be accounted for to obtain this result, as was explained in Chapter XX. It must be remembered, however, that the fact of price reg- ulation in itself makes the market of less significance. Prices on the cost side are still competitive, but on the revenue side are more or less fixed. Such a situation reqmres the recognition of other considerations than the market in making valuations. Further, although it is usually conceded that American railways are not at present highly over-capitaHzed as a rule, it is recognized that a more or less arbitrary conservatism is necessary to offset tendencies among railway managements in the other direction. The question of valuation in public utility enterprises will be further considered in the next section. The classification, investment in road and equipment, includes only the accounts with property used for transportation services as was stated above. It is a familiar fact, however, that many railway enterprises own other assets such as investments in subsidiary and other companies, sinking funds, mineral lands, commercial power plants, hotels, etc. The accounts with such items are included in the balance sheet classification. The operating expense classification has the following general accounts : Maintenance of Way and Structures ; Maintenance of Equipment ; Traffic ; Transportation — Rail Line ; Trans- portation — Water Line ; Miscellaneous Operations ; General ; Transportation for Investment — Credit. These accounts are subdivided into two hundred and ten primary accounts. Under the head of maintenance of way and structures there are seventy- RAILROAD ACCOUNTING 633 nine primary accounts. Examples of these accounts are : Superintendence ; Roadway Maintenance ; Roadway Deprecia- tion ; Bridges, Trestles, and Culverts ; Ties ; Ties — Deprecia- tion; etc. There is a maintenance or repair account for each important type of property, and usually an accompanying de- preciation account. In many cases under maintenance of equipment three expense accounts are provided in connection with an important type of property, for example : Freight-train Cars — Repairs ; Freight-train Cars — Depreciation ; and Freight-train Cars — Retirements. The last named account is charged with the amounts necessary to adjust the difference between the book value (less scrap value) of the property units retired from service and the amount of accrued depreciation in the reserve account applicable to the units retired. The general account Traffic covers such primary accounts as Superintendence, Advertising, Traffic Associations, Industrial and Immigration Bureaus, Insurance, etc. Under Transportation — Rail Line there are fifty primary accounts. These accounts in- clude under the appropriate heads the charges for wages and salaries, supplies, etc., in connection with actual operation. The expenses of "miscellaneous operations" include the cost of dining and buffet service, of operating hotels, elevators, stock- yards, etc. "General Expenses" covers administrative salaries, legal and valuation expenses, general insurance, supplies, and similar items. The last general account mentioned. Trans- portation for Investment — Credit, is not really an expense account at all but is an adjustment or clearing account which is credited with "fair allowances representing the expense to the carrier of transporting, on transportation trains, men en- gaged in and material for construction." The amounts so credited are concurrently charged to the appropriate property accounts. In this classification the line between expense and capital is very carefully drawn, but it is evident from the above discussion of the treatment of replacements that the rules of the Commission do not apportion charges between capital and revenue in strict harmony with accounting theory. Thus when rails are replaced with more valuable types operating expense is charged with the cost of replacing the old rails in kind rather than with the 634 PRINCIPLES OF ACCOUNTING value of the abandoned units as represented in the property account. The operating expense classification is constructed primarily to meet the needs of the operating manager, and to fix the respon- sibilities of employees. The general purpose of this classification is to exhibit the cost of rendering the service of transportation. It is noticeable, however, that the primary accounts used conform to the important classes of commodities and services purchased and consumed, and to the important types of equipment and other properties in use, and that little attempt has been made to classify expenses on an elaborate functional basis. This division of accounts, for example, does not even present the cost of passenger traffic as distinct from the cost of freight traffic; and there is clearly little attempt in this classification to construct the accounts so as to reveal the cost of carrying a particular kind of freight. As was explained in Chapter XXIX cost accounting for railway enterprises is of very doubtful efficacy. The indirect expense — the depreciation and maintenance of road and equipment used for various pur- poses, for example — is so large a fraction of the total expense as to make any apportionment of charges merely a specious division. In the matter of depreciation charges considerable leeway is allowed the railroad companies. No set rule or rules for measur- ing depreciation are prescribed. The carrier itself is allowed to estimate the annual depreciation charge, but is required to charge one-twelfth of this estimated amount to the operating expense of each month. In case the amount of abandoned property is far in excess of the reserve for depreciation for the type of property involved, the company may, upon specific authority from the Commission, carry the item on the balance sheet as a deferred expense to be distributed in the operating expenses of succeeding periods. The Commission may also grant the company permission, under the rulings, to charge an unusual loss item to Profit and Loss. In view of what was said about the treatment of deferred debits in Chapter X it would seem more proper to always make these adjustments through a surplus or profit and loss account. According to the theory, however, that the railway investor is entitled to revenues RAILROAD ACCOUNTING 635 sufficient to cover such losses the carrying of abandonments as deferred assets may be justified.' The operating revenue classification is divided into four general accounts as follows : Transportation — Rail Line ; Trans- portation — Water Line ; Incidental ; and Joint FaciKty. The primary accounts are thirty-nine in number. Examples of these accounts are : Freight ; Passenger ; Excess Baggage ; Mail ; Express ; Switching ; Special Service ; Dining and Buffet ; Parcel Room ; Demurrage ; Telegraph and Telephone ; etc. The Joint Facility account is used to record adjustments of revenues between companies in connection with the operation of joint tracks, yards, terminals, etc. The fact that railway opera- tions in the United States are in many respects bound into a single system is illustrated by these special revenue accounts. Standardized equipment and through trafific necessitate joint property and joint operating records ; and the work of the railway accountant is naturally considerably modified by these inter-company relations. The revenue classification is not as elaborately developed as is that of operating expenses. It might be considerably expanded and better serve the needs of the traffic officials. The con- struction of a system of revenue accounts on a functional basis is not a very difficult matter as was explained in an earher chapter. In the rulings covering the revenue classification the importance of recognizing accruals is emphasized. This is noteworthy in view of the fact that railroad revenues are so largely on a cash basis. It is recognized that even in such a case the record of cash transactions is not a satisfactory guide in accounting for revenues. The classification of income accounts prescribed for railways corresponds roughly to the net revenue section of the general income sheet discussed in previous chapters. There are some noticeable differences between the two, however. The railway income accounts are not confined to net items. The total of operating revenues is shown in a special account in this classifi- cation as is also the total of operating expenses. Special accounts are provided for non-operating income such as hire of freight 1 For a further discussion of the treatment of abandonments and other phases of railway property accounting see Adams, American Railway Accounts. 636 PRINCIPLES OF ACCOUNTING cars, rent from locomotives, income from lease of road, dividend income, income from funded securities, etc. Accounts are pro- vided for the corresponding deductions from income including taxes. The inclusion of rent items as debits and credits to income accounts is not in agreement with the construction of the net revenue classification as it has been outlined in preceding chapters. Rent or hire as ordinarily understood is a gross item, and accordingly constitutes either expense or revenue as the case may be. According to the rulings of the Commission, however, the rent accounts included in this classification shall be charged or credited only with that portion of the payment or receipt which is net income. The balance in each case is to be apportioned between depreciation and maintenance charges in the case of a payment, and is to be credited to these expense accounts in the case of a rent receipt. Such a division of rent would be a matter of little significance in ordinary commercial accounting for evidently any sale of a commodity or service contains an item of net income ; but in railroad accounting it is particularly important that the actual expense of operation be revealed for rate-making purposes, and hence such a practice may be justified in this case. The profit and loss classification covers essentially the accounts which show surplus adjustments. Special accounts are provided for unusual gains such as donations, for unusual losses, dividend appropriations, surplus appropriations, etc. One questionable procedure at this point may be noted. The railroads are allowed to "charge to profit and loss account No. 617, 'debt discount extinguished through surplus, ' all or any portion of the discount and expense on funded debt remaining at any time un- extinguished." This procedure is inconsistent with the theory that the income sheet should exactly represent the fiscal period. If discount on funded debt is not accumulated through the annual interest charges, net proprietary income will not be correctly stated each year. The prescribed arrangement -of the income and profit and loss items in the railway income sheet is shown in the illustration given in Appendix C. The balance sheet classification includes the regular property and equity accounts. Among the property accounts are Invest- RAILROAD ACCOUNTING 637 ment in Road and Equipment and miscellaneous property accounts such as Improvements on Leased Railway Property, Sinking Funds, Cash, Investments in Affiliated Companies, Loans and Bills Receivable, Rents Receivable, etc. The equity accounts cover the stocks and bonds outstanding, the appro- priated surplus accounts, the profit and loss balance, current and deferred liabilities, valuation reserves, etc. A peculiar account. Grants in Aid of Construction, is used to cover the donations made by states, municipalities, and other public corporations appHed to the construction or acquisition of prop- erty the cost of which is chargeable to investment in road and equipment. The prescribed form of the railway balance sheet is shown in Appendix C. The asset side is divided into four main groups of items : investments ; current assets ; deferred assets ; and un- adjusted debits. As in most balance sheets valuation items are not carefully segregated. Items of discount and abandoned property appearing under unadjusted debits are virtually deduc- tions from proprietorship. Rents and insurance premiums paid in advance, on the other hand, are clearly deferred assets. Similarly on the liability side a current liability such as taxes accrued and a capital habiUty such as premium on funded debt are included with valuation reserves for depreciation under the head of unadjusted credits. It is noticeable that two columns are provided for each side of this balance sheet. One purpose of the "short" column is to show contingent items such as the guaranteed securities of other companies which are not included in the final totals. Treasury stocks and bonds are also shown in this way. Only the actual amount outstanding is shown in the "long" column in each case. It might be advisable to show the depreciation reserves also on the asset side in order to indicate their nature as property deductions. A point of interest in connection with the liability accounts is the distinction made between matured obligations unpaid and unmatured obligations accrued. In determining the immediate financial condition of a company it is evident that this is a matter of some importance. 638 PRINCIPLES OF ACCOUNTING RATE REGULATION AND ACCOUNTING When public control of industrial enterprises extends as far as the direct regulation of prices the importance of sound account- ing analysis for such cases is in some respects greatly emphasized. In industries where prices are fixed by competition the pubHc has comparatively little immediate interest in enforcing correct accounting practice. Competition is confidently expected to set a proper level of prices regardless of how the accounts are kept. In such cases it is the present or prospective owners and the circle of business men connected with the enterprise in financial or industrial relationships whose interests are served by sound accounting.^ The enterprise which is proceeding on the basis of extensive statistical information in regard to the property and equity facts which represent its financial status is, of course, better able to survive the rigors of business competition than an enterprise which operates more or less bhndly. But overstate- ment or understatement of property or expense, and consequent inaccurate income and balance sheets, cannot affect prices to the consumer (in any immediate or direct sense) where compe- tition fijces these prices. In the case of public utilities, however, the state undertakes to control rates, and — as was suggested above — reasonable rate regulation is impossible without proper accounting and equitable valuations. It is urged that the pubHc utility investor is entitled to a "reasonable return on a fair value" of the property. Just what this well-worn phrase means is a matter of some dispute. Is the "fair value" cost, cost less depreciation due to physical causes, or present value as determined by both operating and market conditions ? And how is the reasonable return to be determined ? It has been urged throughout this book that the accounts should register current property values as far as this is possible or prac- ticable. It has been explained that depreciation is a matter of value decline and does not depend entirely upon physical causes. Further, it has been shown that unless value changes in both directions are made matters of accounting record the accounts ' Public interest is, of course, advanced by an efficient utilization of the economic resources of the community. To the extent that accounting makes possible effi- ciency in production, accordingly, its function is social as well as private. RAILROAD ACCOUNTING 639 do not show either the capital cost of production or the real sacrifice of the investor. But the ruHngs of the Interstate Com- merce Commission, as was explained above, emphasize original cost as the proper basis for the valuation of public utiUty prop- erties. It has been argued that this is not the most rational viewpoint as applied to general competitive industry. The ques- tion now arises as to whether original cost is the proper basis for determining property values in the case of public utilities. One of the chief arguments in favor of maintaining original cost in the accounts is based on the contention that this figure represents the sacrifice of the investor. As was explained in Chapter XX this would be true only in a regime of static prices. In order to follow actual original investment it would be neces- sary to account for monetary fluctuation. In so far as changes in the prices of the commodities and services required in pro- ducing transportation services conform to general price move- ments it would seem that current prices should be brought on the books as far as possible if sacrifice is to be the accepted basis for valuation. In the case of competitive industry, however, it is not original investment which represents the significant figure, for such a basis for valuation assumes that the speculative opportunities and accidents of the actual business situation are eliminated. Has original investment greater significance in the case of public utilities? To answer this question it is necessary to consider the attitude of the rate-making authorities. It has been the tendency of courts and commissions to restrict the rate of net income allowed the public utilities as compared with normal returns in other lines. This is not necessarily unfair discrimination against the utility investor as a "reasonable return" on a railway property need not be the same as in other lines. If the speculative risks were removed, due to governmental control,^ such properties would normally yield a lower rate than competitive industry. Thus far, however, the policies of the commissions and the attitude of the courts have been somewhat in the direction of infringing upon the rights of the investor. Insistence upon original cost as a basis for fair value has worked to the dis- ' In taking over the railroads during the present war crisis it is interesting to note that the government has promised the owners an adequate return. 640 PRINCIPLES OF ACCOUNTING advantage of the investor in this period of rising prices, and this disadvantage has not been compensated for by the ehmination of the possibiHty of loss. To offset this disadvantage intangibles based on interest charges during construction, pioneering losses and other elements have in some cases been allowed. This situation appears to be unreasonable. It would seem to be a more equitable procedure to take the standpoint of present value and allow a return on this value which would not put the investor in public utilities at a disadvantage as compared with the investor in competitive enterprises involving the same burdens of ownership. The other equitable alternative would be to guarantee a fair return to all pubhc utility enterprises. This would seem out of the question, however, without actual gov- ernment ownership or a very complete control ; for if rates were high enough to yield a fair return to all enterprises the public might be paying for gross inefficiency and poor business Judgment in some cases. The merely nominal significance of original cost in certain cases is emphasized by the fact of depreciation. Allowance for depreciation must of course be made in determining a fair prop- erty value for rate-making purposes. The public should not be required to pay a rate on capital returned to the investor. It would therefore seem to be of particular importance that depre- ciation be carefully recorded in the accounts of pubHc utility enterprises. The use of the replacement policy of accounting for depreciation tends to obscure the situation here. In a rail- road enterprise it is of course impossible to keep all the items of property in the original condition. Every item is gradually becoming worthless from the time it is first put into service until retirement. The property as a whole, accordingly, may not be at one hundred per cent value condition although kept at a high point of efficiency by repairs and renewals. If the repairs and replacement policy of charging depreciation is followed, the books may show a property value equal to one hundred per cent of the investment although the present value is but ninety per cent of cost new. A rate based on the book value in such a case would seem to be illegitimate, particularly if it means that ten per cent of the investment has been returned to the stockholders as profits. RAILROAD ACCOUNTING 641 If reasonable allowance is made for accrued depreciation, however, the real situation is more clearly presented. When a depreciation fund is maintained the difference between the original cost and the depreciated value is in this fund. It has not been returned to the stockholders, but is earning a rate of return independent of regular operation. When the fund is invested in additions to the property the depreciation on all the property in use deducted from the original cost of such property will leave as a result the actual investment. Or, if the amount of depreciation is returned to the stockholders, the allowance for depreciation is nevertheless made in the accounts and the accounts show the actual present investment. Ignoring possible value changes in the other direction there can be no controversy, when this policy of depreciation accounting is properly carried out, regarding the propriety of deducting depre- ciation to obtain fair value. It has been attempted in this brief statement only to suggest some of the important questions that arise in public utility valuation and rate making. In conclusion the statement made in Chapter XXIV in connection with the discussion of going value should be reiterated. As long as the situation remains in the present state of uncertainty many questions of valuation must be left to the regulating authorities and need not affect the account- ing analysis. Accounting which conforms, however, to the natural economic principles operating in the competitive situation can hardly be said to be improper for any case. 2T XXXII Auditing In a broad sense any examination of the financial records of a business enterprise constitutes an audit. The work of the professional accountant consists largely in auditing and in the construction of systems of accounts and underlying records suitable to the needs of particular industries and enterprises. A brief consideration of the auditing side of this broad practical field will be given in this chapter. THE PURPOSES OF AUDITS An audit may be conducted for the general purpose of test- ing the clerical accuracy of the bookkeeper's work and the ac- counting analysis upon which it is based ; or it may be under- taken for some more specific end, such as the determination of financial condition, the detection of fraud, the determination of rights at dissolution, etc. A large number of corporate managements feel obliged to have their records audited regularly to give authenticity to the statements issued to the stockholders and public. The annual report in such a case has a certificate from the auditing ac- countants appended, declaring the condition of the company to be as represented. Too often in the past such audits have been only perfunctory and hence have had little or no real value. As the accounting profession becomes inore highly organized, however, it is coming to be recognized that a certifi- cate of audit from a reputable accounting firm carries consider- able weight with the stockholders and others interested. A company may have its books audited in order to present a verified statement to actual or prospective creditors as to 642 AUDITING 643 solvency conditions. In making loans banks often require such certified statements. In the case of single-proprietorships and partnerships, where the books are often very improperly kept, the owners find it necessary to call in the professional auditor at intervals to prepare statements of income and financial condition. Further, the auditor, or cost expert, is often called upon to determine costs and furnish information concerning specific problems of management. Frequently an audit, or investigation, will be initiated by a group of stockholders or other interested parties if for any reason it is suspected that the books are improperly kept, or if the state- ments presented by the company in its reports do not show sufficient information on some particular point. A dispute between the minority and majority stockholders of a railroad cdmpany furnishes an illustration of an audit conducted in the interest of a particular group of investors. In this case the majority stockholders were represented by a holding company. The holding company wished to purchase the equity of the minority stockholders in the subsidiary hne. The question arose as to what should be the purchase price of this stock. An extensive examination of the records in this case revealed the fact that the actual value of the stock was considerably above the current market price per share. The holding company, owning a majority interest, had had active financial control of the enterprise and it had been the policy of the parent company to use the subsidiary line as a feeder to its main properties. The income on the investment in the smaller road had been obtained primarily from the added traffic derived from the con- trol of this road, rather than from dividends on the stock held. Consequently the controlling interest had had Httle object in declaring large dividends. It was shown further that it had been the policy of the managemtent to understate net revenue by charging improvements to expense, and thereby creating secret reserves. These facts had resulted in building up the proprietary equity in the business to an extent not reflected on the stock market or in the accounts. The investigation resulted in the sale of the minority stock on a more equitable basis. The following case presents a somewhat similar situation. In the case of a certain corporation an agreement was entered 644 PRINCIPLES OF ACCOUNTING into between the preferred and common stockholders at the time of organization which provided that the preferred stock should have exclusive voting privileges until five consecutive annual dividends of seven per cent were paid on that stock. During ten years, although there had been a favorable showing of gross revenue throughout this period, net revenue was not sufficient to pay the dividends required for the consummation of the above agreement. A group of common stockholders instituted an investigation of the company's accounting methods to determine whether or not net revenue had been correctly stated. In this case also it was found that net revenue had been understated through errors in accounting analysis. Sinking fund install- ments, and many items of new construction in addition to actual depreciation, had been charged to the expense accounts. Had these amounts been properly charged net revenue would have been sufficient to allow the payment of seven per cent on the preferred stock each year. Thus the common stockholders had been prevented, through errors in accounting judgment, from exercising their rightful control of the business for a period of five years. Outside interests often desire to have the financial records of a business examined. The purposes of such examinations are varied, and many peculiar problems present themselves in specific cases. The following case furnishes an illustration. In a certain town both a municipal enterprise and a private con- cern were furnishing electric light and power. The municipal company (which was also the city water company) was cutting prices for electricity far below cost to the private concern. The latter company had reason to believe, that the municipal enterprise was not allocating costs properly between the water and light departments. An audit of the municipal company's books which was finally instituted discovered that the water rates were covering a considerable portion of the expense properly assignable to the production of hght. The state and federal governments are responsible for a large number of examinations. The books of banking institutions are regularly examined by government auditors. Such audits are undertaken primarily to prevent embezzlements and other improper use of the depositors' funds. Frequent failures due to AUDITING 64s peculations covering a period of years show that these examina- tions are not always sufficiently thorough; but there can be Httle doubt that such regulation in general has a salutary effect upon banking practice. In the case of the railroads the Interstate Commerce Com- mission has the power to examine the books of an enterprise under its jurisdiction at any time. In many states the public utilities commissions have similar powers. The following case illustrates a type of problem which frequently presents itself to the state commissions. A power company petitioned a certain commission for permission to issue $10,000,000 in capital stock. An appraisal showed the value of the physical property to be $7,000,000 but the company argued that a going value of $3,000,000 existed because of early losses. Assuming the legiti- macy of such an intangible, the task for the auditors in this case would be the examination of the financial records covering the period in question in order to determine the amount of net revenue or loss for each year. The recent federal tax legislation has forced a recognition of the importance of proper accounting. Many firms and corporations are requiring the assistance of professional accountants in preparing income and balance sheets to be used as a basis for reporting tax returns. Tax laws, moreover, do not always conform to consistent accounting principles, and some adjust- ments may be necessary even if the accounts are kept on an entirely rational basis for private purposes. The charging of allowances for proprietors' salaries to expense, referred to in Chapter XI, is an illustration of such an adjustment. Audits are often necessary at times of organization, reor- ganization, merger, dissolution, etc. In the case of insolvency experts are usually called in to prepare schedules of assets and habihties and a showing of the proprietary balance and its distribution if there is any such balance. Also in connection with the administration of estates and similar matters certified statements from auditors are often required. It should be evident from this brief statement that the field of auditing is a broad one and might be said to include the ana- lytical or interpretative side of professional accountancy. 646 PRINCIPLES OF ACCOUNTING THE ESSENTIALS OF AUDITING The illustrative cases mentioned above emphasize the fact that although one of the purposes of the general audit is the verification of the clerical work it is a much more important function of the auditor to discover whether or not sound ac- counting principles have been observed. The checking of post- ings and column totals is not a particularly illuminating process. In fact, column totals may check, debits may equal credits, and still flagrant violations of accounting principles may exist. If repair outlays, for example, are charged to property instead of to expense, the accuracy of the clerical work may be unquestioned, but nevertheless a serious accounting error has occurred which affects one of the most important figures shown by the records, net revenue. This does not mean that the auditor should neglect numerical and other clerical inaccuracies. Such errors are serious from a certain viewpoint. The bookkeeper, for example, may carelessly credit the wrong customer's account with the amount of a pay- ment, or may credit a creditor's account instead of an account receivable, or may even omit one side of the entry entirely; and any such error might cause considerable confusion and a misunderstanding between the parties to the transaction im- properly recorded. But all such clerical mistakes tend to be more or less self-corrective, and their location and adjustment is a secondary part of the auditor's work. It has been implied in the foregoing discussion that it is the task of the auditor to make examinations of financial records. The point should be emphasized, however, that an important purpose of an audit is the discovery of facts not recorded. There may be no record of accrued liabilities, for example, or certain revenue items may be omitted, Further, some of the assets owned may not appear in the accounts. It is the function of the auditor to locate all such items and include them in the state- ments prepared so that a true picture of the financial condition of the enterprise under audit may be presented. Contingent assets and liabilities are important matters for the auditor to consider. Contingencies are not accounting transactions in the ordinary sense and need not be entered in the AUDITING 647 regular financial accounts ; for obviously it is the function of the accounts to present a record of actual transactions and value changes and not of anticipated occurrences. But an ordinary balance sheet statement of assets and equities is not an entirely satisfactory statement for the prospective creditor or investor. The probable future financial condition of the enterprise is a matter of importance ; and contingent assets and liabilities, if they represent definite possibilities, have a bearing upon this condition. Indorsed notes, guarantees in connection with the sale of goods, pending damage claims, guarantees of principal or income in connection with the security issues of subsidiary companies — these are common examples of contingent liabilities. Possible stock assessments, claims against railroad companies or other disputed rights, are examples of contingent assets. A satisfactory auditor's report will include a statement of all such items. While it may not be reasonable to consider the auditor a valuation expert, nevertheless he must pass upon and test valuations. In connection with securities, accounts receivable, patents, goodwill, and other intangibles, it is usually the auditor, after consultation with the manager or owner, who sets the actual valuations. Further, he must be familiar with depreciation rates and methods of taking inventory. Above all the auditor should take a conservative position in regard to all valuation. It is a natural tendency of business managements to overstate values in their anxiety to make a favorable showing. The development of income and excess profit taxes has offset this tendency to some extent, but it still exists. T-his does not mean that the auditor need adopt an illogical policy. Rules for valuations should be logically formulated but conservaiively^ applied. In view of the present prejudice in favor of an illogical basis for valuations (see Chapter XX) it may be wise for an auditor to follow prevailing practice in presenting the audited balance sheet proper. By means of footnotes and supple- mentary statements, however, the auditor may make clear to all interested the actual financial condition of the enterprise as he finds it. If the auditor's report does not present actual condition in some way such a report cannot serve the purposes intended. 648 PRINCIPLES OF ACCOUNTING As was explained in the preceding section an audit is usually conducted for some definite purpose. The auditor's report, accordingly, should be prepared in such a way as to throw the greatest possible Hght upon the particular problem involved. A balance sheet of a certain company, for example, prepared for a banker who is considering making a short-term loan to the company, should show the liquid assets as the first group of asset items; and the current liabiUties should be similarly segregated in a prominent position so that a comparison between the two groups can easily be made. The stockholder, on the other hand, may be more interested in the fixed assets and the amount of the proprietary equity. If this is the case these facts should be clearly set forth. Accurate classification in view of a particular purpose is an important phase of auditing. If there are several interests involved the auditor may prepare a whole sheaf of income and balance sheets, each of which statements stresses a certain aspect of the business, and certain relations between the financial data involved. (See the chapters on statements.) This does not at all mean, however, that the pro- fessional accountant should twist or misconstrue the facts in the interest of a particular client. Often the auditor has to deal not only with clerical inaccuracies and errors in accounting analysis but also with fraud. The most common fraud is the misappropriation of cash or similar assets. It is especially because of this fact that an auditor should exercise tact and discretion in his relations with the officials and employees of the enterprise whose books are being examined. It is his duty to obtain the facts even if these facts are not to the advantage of his client. AVhen embezzlements are made by an officer or employee who has access to the records it is quite possible that the theft may be covered up so ingeniously as to make detection very difficult. The manipulation of sales and accounts receivable figures is the means most commonly employed to eliminate the evidence of defalcations. Mis- appropriations are particularly hard to detect in the case of small businesses where a single officer or employee has access to or control over all the records. The system of internal check in force in large offices tends to prevent such occurrences. The various methods of detecting errors and fraud are a part of the AUDITING 649 technique of auditing, however, and a consideration of these matters is beyond the scope of this discussion. It should be evident from this brief statement of the nature and purposes of auditing that the successful auditor needs a thorough training in theory and an extensive practical accounting expe- rience. He needs an exhaustive knowledge of accounting principles since the examination of the financial statistics of a modern business enterprise involves the knowledge of all the accounting principles upon which such records are based and to which they should conform ; and he evidently requires a thorough familiarity with the particular types of records used in various kinds of business such as manufacturing, trading, banking, etc. Each industry — and even each particular enterprise — has its own pecuHar accounting problems and requires a more or less^ unique system of records. A knowledge of the main features of business operation in the various important fields and of the accounting technique suited to these special cases can only be secured in an adequate degree through actual experience. Again, the work an auditor is called upon to do involves many questions of business law and finance; and hence a general knowledge of these subjects is invaluable. Finally, the auditor should be able to express his findings with such clearness and simplicity that they may be readily appreciated by any interested parties. APPENDICES The Treatment of Cash Discounts The cash discount accounts as ordinarily kept have been classed in this text as valuation accounts. The Purchase Dis- counts account shows the amount by which merchandise or material costs have been overstated, and the Sales Discounts account shows the deduction from the gross sales figure resulting from the allowances made for prompt cash payments. At several points in the preceding pages the nature of discounts has been discussed and the question of the proper location of such items in the summary statements was briefly considered in Chapter IX. While the analysis that has been given is essentially correct the method of making the entries used may be criticized because it fails to recognize neglected discounts in the accounts. The common method of making the entries also makes the valua- tion at which the merchandise or materials purchased is carried in the accounts depend upon whether or not the purchaser takes the discounts offered. This last criticism is not so im- portant as it might seem at first sight because merchandise and raw materials usually pass so rapidly through the business process that these items soon become costs ; and it is certainly true that a firm which does not take its discounts has a higher merchandise cost than one which does. The recognition of neglected discounts, however, is a matter of some theoretic importance at least. While it is true that in many cases the amount of cash discounts is relatively unimportant it must be recognized that accounting attempts to present the actual facts as accurately as possible. With this idea in view it may be well to examine an alternative method of treating cash discounts. A possible method would be to provide special accounts for discounts neglected but none for discounts taken."^ According ' Cf. Cole, Accounts, Their Construction and Interpretation, Chapter Twenty-one. 6S3 6S4 PRINCIPLES OF ACCOUNTING to this method it is more important to know how much has been lost in discounts than how much has been taken ; and this fact evidently cannot be determined from the ordinary discount accounts. The fact that a discount has been neglected indicates that the firm is operating with insufficient working capital and is therefore unable to meet its bills promptly. The amount of the neglected discount is in fact an interest payment as was pointed out in Chapter XIV. The firm is paying its creditor interest for carrying the account. Accordingly, since interest is neither a property item nor an expense, but is rather a charge against net revenue, it is obviously incorrect to charge discounts to the merchandise accounts. According to this method goods purchased are always entered at the discounted price. This procedure can best be explained by an illustration. Suppose a firm buys merchandise with a gross price of $i,ooo, two per cent off if paid in ten days. The discounted price is then $980. The entries at the date of purchase would accordingly be : Merchandise $980 Accounts Payable $ 980 When payment is made, if within ten days, the entries would be : Accounts Payable $980 Cash $ 980 If the bill were not paid within the specified discount period, however, the entries covering the payment would be as follows : Accounts Payable $980 Neglected Purchase Discounts .... 20 Cash $1,000 The Neglected Purchase Discounts account would be closed into Net Revenue (or Expense and Revenue) as is any interest account. By this method merchandise purchases will always be entered at the cash price regardless as to whether prompt pay- ment is made or not. No adjustment of expense is required because of discounts taken, but an interest charge is made for all discounts neglected. APPENDIX A 655 It is sometimes objected to this method that the invoice price should be credited to Accounts Payable at the date of purchase. In other words where alternative terms of settlement are allowed the gross liability should be carried in the accounts. It might be argued against this objection that no real purpose is served by carrying the gross invoice price through the accounts. The actual accounting liability at the date of the transaction is the cash price and this increases only through lapse of time. This situation is not peculiar to accounts payable ; the same is true of notes and bonds. If, however, it be desired in the case of accounts payable to adhere to the almost universal custom of listing liabilities in the accounts at face or gross amount the invoice price may be carried in the accounts without changing the results of this method. At the date of purchase, for example, the entries for the above illustration might be : Merchandise $ 980 Purchase Discounts Offered .... 20 Accounts Payable $1,000 Purchase Discounts Offered is a valuation account which shows the amount by which the item appearing in Accounts Payable exceeds the actual present liability. At the date of payment if the discount is taken the entries would be : Accounts Payable $1,000 ' Cash $ 980 Purchase Discounts Offered 20 If the discount were not taken the entries would be : Accounts Payable $1,000 Cash $1,000 In the case of discounts on sales the same analysis would hold. Here the Neglected Sales Discounts account would show a credit balance which would represent an interest revenue. That is, the customers who failed to meet their bills promptly would be paying interest on their accounts. While this method of treating purchase and sales discounts 6s6 PRINCIPLES OF ACCOUNTING conforms more nearly to correct accounting principles it is very seldom used ; and, as already explained, present practice in this connection accomplishes essentially correct results. It is also somewhat unreasonable, in view of the nature of discount rates, to consider neglected discounts as either income or deduc- tions from income. Further, this method requires an estimate at the end of each accoimting period of the amounts of both purchase and sales discounts, applicable to accounts unpaid and not yet due, which will finally be taken ; and the difficulties involved in this procedure are such as to render this method, as a rule, inexpedient. B Inteeest Tables SH 6s8 PRINCIPLES OF ACCOUNTING Table I Amount to which i will accumulate in n periods s= (i+ iy ii% i*% 2% I 1.012 5000 i.ois 0000 1.020 0000 2 1.025 1563 1.030 2250 1 .040 4000 3 1.037 9707 1.045 6784 1. 06 1 2080 4 1.050 9453 1.061 3636 1.082 4322 S 1.064 0822 1.077 2840 1. 104 0808 6 1.077 3832 1.093 4433 1. 126 1624 7 i.ogo 8505 I. 109 8449 1. 148 6857 8 1. 104 4861 1. 126 4926 1. 171 6594 9 1. 118 2922 1. 143 3900 1. 195 0926 lO 1. 132 2708 1. 160 5408 1.218 9944 II 1. 146 4242 1. 177 9489 1-243 3743 12 I. 160 7545 1. 195 6182 1.268 2418 13 1. 175 2639 1.213 5524" 1.293 6°66 14 1.189 9547 1-231 7S57 1.319 4788 IS 1.204 8292 1.250 2321 1.345 8683 i6 1. 219 889s 1.268 985s 1-372 7857 17 1.235 1382 1.288 0203 1.400 2414 i8 1.250 5774 1.307 3406 1.428 2463 19 1.266 2096 1.326 9507 1.456 8112 20 1.282 0372 1.346 8550 1.485 9474 21 1.298 0027 1.367 0578 1.515 6663 22 1. 3 14 2885 1-387 5637 1-545 9797 23 I-330 7171 1.408 3771 1.576 8993 24 1.347 3SII 1.429 5028 1.608 4373 2S 1.364 1929 1.450 9454 1.640 6060 26 1-381 2454 1.472 7095 1.673 4181 27 1.398 5109 1.494 8002 1.706 8865 28 1.415 9923 1. 517 2222 I. 741 0242 29 1.433 6922 1.539 9805 I-77S 8447 30 1.451 6134 1.563 0802 1. 811 3616 31 1.469 7585 1.586 5264 1.847 5888 32 ±.488 1305 1.610 3243 1.884 5406 33 1.506-7321 1.634 4792 1.922 2314 34 I-S2S 5663 1.658 9964 1.960 6760 3S I.S44 6359 1.683 8813 1.999 8896 36 1.563 9438 1.709 1395 2.039 8873 37 1-583 4931 1.734 7766 2.080 6851 38 1.603 2868 1.760 7983 2.122 2988 39 1.623 3279 1.787 2102 2.164 7448 40 1.643 619s I. 814 0184 2.208 0397 41 1.664 1647 1. 841 2287 2.252 2005 42 1.684 9668 1.868 8471 2.297 2445 43 1.706 0289 1.896 8798 2.343 1894 44 1.727 3542 1-92S 3330 2.390 °S3i 4S 1.748 9461 1.954 2130 2-437 8542 46 1.770 8080 1.983 5262 2.486 6113 47 1.792 9431 2.013 2791 2.536 3435 48 1-815 3S49 2.043 4783 2.587 0704 49 1.838 0468 2.074 1305 2.638 8118 5° I. 861 0224 2.105 2424 2.691 5880 2j% 1.025 0000 1.050 6250 1.076 8906 I. 103 8129 1. 13 1 4082 I-I59 6934 I. 188 6858 1. 218 4029 1.248 8630 1.280 0845 1.3 1 2 0867 1.344 8888 1.378 5110 1.412 9738 1.448 2982 1.484 5056 1. 521 6183 1-559 6587 1.598 6502 1.638 6164 1.679 5819 1. 721 5714 1.764 6107 1.808 7260 1.853 9441 1.900 2927 1.947 8000 1.996 4950 2.046 4074 2.097 5676 2.150 0068 2.203 7569 2.258 8509 2.315 3221 2-373 2052 2-432 5353 2-493 3487 2-555 6824 2.619 5745 2.685 0638 2.752 1904 2.820 9952 2.891 5201 2.963 8081 3-037 9033 3. 113 8509 3. 191 6971 3.271 4896 3-353 2768 3-437 1087 3% 1.030 0000 1.060 9000 1.092 7270 1.125 5088 1. 159 2741 1.194 0523 1.229 8739 1.266 7701 1-304 7732 1.343 9164 1.384 2339 1.425 7609 1-468 5337 1.512 5897 1.557 9674 1.604 7064 1.652 8476 1.702 4331 I.7S3 5061 1.806 1112 1.860 2946 1.916 1034 1-973 5865 2.032 7941 2.093 7780 2.156 5913 2.221 2890 2.287 9277 2.356 5655 2.427 2625 2.500 0803 2.575 0828 2.652 3352 2.731 9053 2.813 8625 2.898 2783 2.985 2267 3.074 783s 3.167 0270 3.262 0378 3.359 8989 3.460 6959 3.564 5168 3-671 4523 3-781 5958 3-895 0437 4.011 8950 4.132 2519 4.256 2194 4-383 9060 APPENDIX B 659 Table I Amount to which i ■will accumulate in n periods s= {l+i. )" 3j% 4% 44% 5% 6% « 1.035 0000 1.040 0000 1.045 0000 1.050 0000 1 .060 0000 I I.071 2250 1. 08 1 6000 1.092 0250 1. 102 5000 1. 1 23 6000 2 1. 108 7179 1. 1 24 8640 1. 141 1661 1. 157 6250 1. 191 0160 3 I.147 5230 1. 169 8586 1. 192 5186 i.ai5 5063 1.262 4770 4 1. 187 6863 1. 216 6529 1.246 1819 1.276 2816 1.338 2256 5 1.229 2S53 1.265 319° 1.302 2601 1.340 0956 I.418 5191 6 1.272 2793 1.315 9318 1.360 8618 1.407 1004 i.503 6303 7 1.3 1 6 8090 1.368 5691 1.422 1006 1.477 4554 1.593 8481 8 1.362 8974 1.423 3118 1.486 0951 1. 551 3282 1.689 4790 9 1.410 5988 1.480 2443 1.552 9694 1.628 8946 1.790 8477 10 1-459 9697 1.539 4541 1.622 8530 1. 710 3394 , 1.898 2986 II 1.511 0687 1. 601 0322 1.69s 8814 1.795 8563 2.012 1965 12 1.563 9561 1.665 0735 1.772 1961 1.885 6491 2.132 9283 13 1.618 6945 1. 731 6764 1. 851 9449 1.979 9316 2.260 9040 14 1.675 3488 1.800 9435 1.935 2824 2.078 9282 2.396 5582 15 1.733 9860 1.872 9812 2.022 3702 2.182 8746 2.5403517 16 1.794 6756 1.947 9005 2. 113 3768 2.292 0183 2.692 7728 17 1.857 4892 2.025 8165 2.208 4788 2.406 6192 2.854 3392 18 1.922 5013 2.106 8492 2.307 8603 2.526 9502 3.025 5995 19 1.989 7889 2. 191 1231 2.411 7140 2.653 2977 3.207 1355 20 2.059 4315 2.278 7681 2.520 2412 2.785 9626 3-399 5636 21 2.131 5116 2.369 9188 2.633 6520 2.925 2607 3.603 5374 22 2.206 1 145 2.464 7155 2.752 1663 3.071 5238 3.819 7497 23 2.283 3285 2.563 3042 2.876 0138 3.225 0999 4.048 9346 24 2.363 2450 2.665 8363 3.005 4345 3.386 3549 4.291 8707 25 2.445 9586 2.772 4698 3.140 6790 3-555 6727 4.549 3830 26 2.531 5671 2.883 3686 3.282 0096 3.733 4563 4.822 3459 27 2.620 1720 2.998 7033 3.429 7000 3.920 1291 5.1 II 6867 28 2. 711 8780 3. 118 6515 3.584 0365 4.116 1356 5.418 3879 29 2.806 7937 3.243 3975 3.745 3181 4.321 9424 5.743 4912 30 2.905 0315 3-373 1334 5-9'^5 8575 4.538 0395 , 6.088 1006 31 3.006 7076 3.508 0587 4.089 9810 4.764 9415 6.453 3867 32 3.111 9424 3.648 3811 4.274 0302 5.003 1885 6.840 5899 ii 3.220 8603 3.794 3163 4.466 3615 5.253 3480 7.251 0253 34 3.333 5904 3.946 0890 4.667 3478 5.516 0154 7.686 0868 35 3.450 2661 4.103 9326 4.877 3785 5.791 8161 8.147 2520 36 3.571 0254 4.268 0899 5.096 8605 6.081 4069 8.636 0871 37 3.696 0113 4.438 813s 5.326 2192 6.385 4773 9-154 2523 38 3.825 3717 4.616 3660 5.565 8991 6.704 7512 9-703 5075 39 3.959 2597 4.801 0206 5.816 3645 7.039 9887 10.285 7119 40 4.097 8338 4.993 0615 6.078 1009 7.391 9881 10.902 8610 41 4.241 2580 5.192 7839 6.351 615s 7.761 5876 11-5570327 42 4.389 7020 5.400 4953 6.637 4382 8.149 6669 12.2504546 43 4.543 3416 5.616 5151 6.936 1229 8.557 1503 12.985 4819 44 4.702 3586 S.841 1757 7.248 2484 8.98s 0078 13.764 6108 45 4.866 941 1 6.074 8227 7.574 4196 9.434 2582 14.590 4875 46 5.037 2840 6.317 8156 7.915 2685 9.90s 9711 15-465 9167 47 5. 213 5890 6.570 5282 8.271 4556 10.401 2696 16.393 8717 48 5.396 0646 6.833 3494 8.643 671 1 10.921 3331 17-377 5040 49 5.584 9269 7.106 6833 g.032 6363 11.467 3998 18.420 1543 50 66o PRINCIPLES OF ACCOUNTING' Table II Present value of i due in n periods P=—l— (i + i)" ~ii ^i% ^i% ^% ^% 3% ' 1 o.g87 6543 0.985 2217 0.980 3922 0.975 6og8 0.970 8738 2 0.975 4611 0.970 6617 o.g6i 1688 0.951 8144 0.942 5959 3 0.963 4183 0.956 3170 0.942 3223 0.928 5994 0.915 1417 4 0.951 5243 0.942 1842 0.923 8454 0.905 9506 0.888 4870 5 0.939 7771 0.928 2603 0.905 7308 0.883 ^543 0.862 6088 6 0.928 1749 0.914 5422 0.887 9714 0.862 2969 0.837 4843 7 0.916 7159 0.901 0268 0.870 5602 0.841 2652 0.813 0915 8 0.9053985 0.887 71 1 1 0.8534904 0.8207466 0.7894092 9 0.894 2207 0.874 5922 0.836 7553 0.800 7284 0.766 4167 10 0.8831809 0.8616672 0.8203483 0.781 1984 0.7440939 11 0.872 2775 0.848 9332 0.804 2630 0.762 1448 0.722 4213 12 0.86x5086 0.8363874 0.7884932 0.7435559 0.7013799 13 0.850 8727 0.824 0270 0.773 0325 0.725 4204 0.680 9513 14 0.840 3681 0.811 8493 0.757 8750 0.707 7272 0.661 1178 15 0.829 9932 0.799 8515 0.743 0147 0.690 4656 0.641 8619 16 0.8197463 0.7880310 0.7284458 0.6736249 0.6231669 17 0.809 6260 0.776 3853 0.714 1626 0.657 1951 0.605 0164 18 0.799 6306 0.764 91 16 0.700 1594 0.641 1659 0.587 3946 19 0.789 7587 0.756 6075 0.686 4308 0.625 5277 0.570 2860 20 0.780 0085 0.742 4704 0.672 9713 0.610 2709 0.553 6758 21 0.770 3788 0.731 4980 0.659 7758 0.595 3863 O.S37 5493 22 0.760 8680 0.720 6876 0.646 8390 0.580 8647 0.521 8925 23 0.7514745 0.710 0371 0.6341559 0.5666972 0.5066917 24 0.742 1971 0.699 5439 0.621 7215 0.552 8754 0.491 9337 25 0.733 0341 0.689 2058 0.609 5309 0.539 3906 0.477 6056 26 0.723 9843 0.679 0205 0.597 S793 0.526 2347 0.463 6947 27 0.715 0463 0.668 9857 0.585 8620 0.513 3997 0.450 1891 28 0.706 2185 0.659 0993 0.574 3746 0.500 8778 0.437 0768 29 0.697 4998 0.649 3589 0.563 1123 0.488 6613 0.424 3464 30 0.688 8887 0.639 7624 0.552 0709 0.476 7427 0.411 9868 31 0.680 3839 0.630 3078 0.541 2460 0.465 1148 0.399 9871 32 0.671 9841 0.620 9929 0.530 6333 0.4S3 7705 0.388 3370 33 0.663 6880 0.611 8157 0.520 2287 0.442 7030 0.377 0262 34 0.655 4943 0.602 7741 0.510 0282 0.431 9053 0.366 0449 35 0.6474018 0.5938661 0.5000276 0.421 3711 0.3553834 36 0.6394092 0.5850897 0.4902232 0.411 0937 0.3450324 37 0.631 5152 0.5764431 0.4806109 0.4010670 0.3349829 38 0.623 7187 0.567 9242 0.471 1872 0.391 2849 0.325 2262 39 0.616 0185 0.559 5313 0.461 9482 0.381 7414 0.315 7535 40 0.608 4133 0.551 2623 0.452 8904 0.372 4306 0.306 5568 41 0.600 9021 0.543 1156 0.444 0102 0.363 3469 0.297 6280 42 0.593 4835 0.535 0893 0.435 3041 0.354 4848 0.288 9592 43 0.586 1566 0.527 1815 0.426 7688 0.345 8389 0.280 5429 44 0.578 9201 0.519 3907 0.418 4007 0.337 4038 0.272 3718 AS 0.5717729 0.511 7149 0.410 1968 0.3291744 0.2644386 46 0.564 7140 0.504 1527 0.402 1537 0.321 1458 0.256 7365 47 0.557 7422 0.496 7021 0.394 2684 0.313 3129 0.249 2588 48 0.550 8565 0.489 3617 0.386 5376 0.305 6712 0.241 9988 49 0.544 055? 0.482 1298 0.378 9584 0.298 2158 0.234 9503 50 0.5373391 0.4750047 0.3715279 0.2909422 0.228 0171 APPENDIX B 66 1 Table II Present value of i due in n periods (i -h JY 3l% 4% 4i% S% 6% B 0.966 1836 0.961 5385 0.956 9378 0.952 3810 0.943 3962 I 0.933 5107 0.924 5562 0.915 7300 0.907 0295 0.889 9964 2 0.901 9427 0.888 9964 0.876 2966 0.863 8376 0.839 6193 3 0.871 4422 0.854 8042 0.838 5613 0.822 7025 0.792 0937 t. 4 0.841 9732 0.821 9271 0.802 4510 0.783 5262 0.747 2582 ' 5 0.8135006 0.7903145 0.7678957 0.7462154 0.704 9605 -■ 6 0.7859910 0.7599178 0.7348285 0.710 6813 0.6650571 7 0.759 4116 0.730 6902 0.703 1851 0.676 8394 0.627 4124 8 0.733 731° 0.702 5867 0.672 9044 0.644 6089 0.591 8985 9 0.708 9188 0.675 5642 0.643 9277 °-6i3 9133 o-SS8 3948 10 0.6849457 0.6495809 0.616 1987 0.5846793 0.5267875 II 0.661 7833 0.624 5970 0-589 6639 0.556 8374 0.496 9694 12 0.639 4°42 0.600 5741 0.564 2716 0.530 3214 0.468 8390 13 0.617 7818 0.577 4751 O.S39 9729 0.505 0680 0.442 3010 14 0.596 8906 0.555 2645 0.516 7204 0.481 0171 0.417 2651 15 0.5767059 0.5339082 0.4944693 0.458 1 115 0.3936463 16 0.5S7 2038 0.513 3732 0.473 1764 0-436 2967 0.371 3644 17 0.538 3611 0.493 6281 0.452 8004 0.415 5207 0.350 3438 18 0.520 1557 0.474 6424 0.433 3018 0.395 7340 0.330 5130 19 0.502 5659«' 0.456 3869 0.414 6429 0.376 889s 0.311 8047 20 0-485 57°9^ 0.438 8336 0.396 7874 0.358 9424 0.294 1554 21 0.469 1506 0.421 9554 0.379 7009 0.341 8499 0.277 5051 22 0.4S3 2856 0.405 7263 0.363 3501 0.325 5713 0.261 7973 23 0.437 9S7I 0.390 1215 0.347 7035 0.310 0679 0.246 9785 24 0.423 1470 0.37s "68 0.332 7306 0.295 3028 0.232 9986 25 0.4088377 0.3606892 0.3184025 0.2812407 0.219 8100 26 0.395 0122 0.346 8166 0.304 6914 0.267 8483 0.207 3679 27 0.381 6543 0.333 4775 0.291 5707 0.25s 0936 0.19s 6301 28 0.368 7482 0.320 6514 0.279 0150 0.242 9463 0.184 5567 29 0.356 2784 0.308 3187 0.267 0000 0.231 3774 0.174 iioi 30 0.344 2303 0.296 4603 0.255 5024 0.220 3595 0.164 2548 31 0.332 5897 0.285 0579 0.244 4999 0.209 8662 0.154 9574 32 0.321 3427 0.274 0942 0.233 9712 0.199 8725 0.146 1862 33 0.310 4761 0.263 5521 0.223 8959 0.190 3548 0.137 giis 34 0.299 9769 0.253 4155 0.214 2544 0.181 2903 0.130 1052 35 0.289 8327 0.243 6687 0.205 0282 0.172 6574 0.122 7408 36 0.280 0316 0.234 2968 o.ig6 1992 0.164 4356 0.115 7932 37 0.270 5619 0.225 2854 0.187 7504 0.156 6054 0.109 2389 38 0.261 4125 0.216 6206 0.179 665s 0.149 1480 0.103 0555 39 0.252 5725 0.208 2890 0.171 9287 0.142 0457 0.097 2222 40 0.244 0314 0.200 2779 0.164I 5251 o'.i3S 2816 o.ogi 7190 41 0.23s 7791 0.192 5749 0.157 4403 o'.i28 8396 0.086 5274 42 0.227 8059 0.185 1^82 0.150 6605 0.122 7044 0.081 6296 43 0.220 1023 0.178 0463 0.144 1728 0.116 8613 0.077 0091 44 0.212 6592 0.171 1984 0.137 9644 o.iii 2965 0.072 6501 45 0.205 4679 0.164 6139 0.132 0233 0.105 9967 0.068 5378 46 0.198 5197 0.158 2826 0.126 3381 o.ioo 9492 0.064 6583 47 0.191 8065 0.152 1948 0.120 8977 0.096 1421 0.060 9984 48 0.185 3202 0.146 3411 0.115 6916 0.091 5639 0.057 5457 49 0.179 0534 0.140 7126 o.iio 7096 0.087 2037 0.054 2884 50 662 PRINCIPLES OF ACCOUNTING Table III Sum to which an annuity of i per year will accumulate in n periods _ (i + iY - I in i 1 I.OOO OOOO I.OOO OOOO I.OOO OOOO I.OOO OOOO I.OOO oooo 2 2.0125000 2.0150000 2.0200000 2.0250000 2.0300000 3 3-037 6562 3.045 2250 3.060 4000 3.07s 6250 3.090 gooo 4 4-075 6269 4.090 9034 4.121 6080 4.152 5156 4-183 6270 5 5.1265723 5.1522669 5.2040402 5.2563285 5-3091358 6 6.igo 6544 6.229 5509 6.308 1210 6.387 7367' 6.468 4099 7 7.268 0376 7.322 9942 7.434 2834 7.547 4301 7.662 4622 8 8.358 8881 8.432 8391 8.582 9691 8.736 IIS9 8.892 3360 9 9-463 3742 9-559 3317 9-754 6284 9.954 5188 10.159 1061 10 10.581 6664 10.702 7217 10.949 7210 11.203 3818 11-463 8793 11 11-713 9372 11.863 2625 12.168 7154 12.483 4663 12.807 7957 12 12.860 3614 13.041 2114 13.412 0897 13.795 5530 14.192 0296 13 14.021 1159 14.2368296 14.6803315 15.140 4418 15.6177904 14 15-196 3799 15-450 3820 15-973 9382 16.518 9528 17.086 3242 15 16.386 3346 16.682 1378 17-293 4169 17-931 9267 18.598 9139 16 17-S91 1638 17.932 3698 18.639 2853 19.380 2248 20.156 8813 17 18.8110534 19.2013554 20.0120710 20.8647304 21.7615877 18 20.046 191S 20.4893757 21.412 3124 22.3863487 23.4144354 19 21.296 7689 21.796 7164 22.840 5586 23.94.6 0074 25.116 8684 20 22.562 9785 23.123 6671 24.297 3698 25.544 6576 26.870 3745 21 23.845 0158 24.470 5221 25.783 3172 27.183 2741 28.676 4857 22 25.143 0785 25.837 5799 27.298 983s 28.862 8559 30.536 7803 23 26.4573669 27.2251436 28.8449632 30.5844273 32.4528837 24 27.788 0840 28.633 5208 30.421 8625 32.349 0380 34-426 4702 25 29.135 4351 30.063 0236 32.030 2997 34-157 7639 36-459 2643 26 30-499 6280 31-513 9690 33-670 9057 36-011 7080 38-553 0423 27 31.880 8734 32.986 6785 35-344 3238 37-912 0007 40-7°9 6335 28 33-279 3843 34-481 4787 37-051 2103 39-859 8007 42-930 9225 29 34-695 3766 35-998 7009 38.792 234s 41-856 2958 45-218 8502 30 36.129 0688 37-538 6814 40-568 0792 43-902 7032 47-575 4157 31 37-580 6822 39-101 7616 42.379 4408 46.000 2707 50.002 6782 32 39.0504407 40.6882880 44.2270296 48.1502775 52-5027585 33 40-5385712 42.2986123 46.111 5702 50-3540344 55-0778413 34 42-045 3033 43-933 0915 48-033 8016 52-6x2 8853 57.730 1765 35 43-570 8696 45-592 0879 49-994 4776 54.928 2074 60.462 0818 36 45-1155055 47-2759692 51.9943672 57-3014126 63.2759443 37 46.679 4493 48.985 1087 54-034 2545 59-733 9479 66.174 2226 38 48.262 9424 50.719 8854 56.114 9396 62.227 2966 69.159 4493 39 49.866 2292 52.480 6837 58.237 2384 64.782 9791 72-234 2328 40 Si-489 5571 54-267 8939 60.401 9832 67.402 5535 75.401 2597 41 53.1331765 56.0819123 62.6100228 70.0876174 78.6632975 42 54-797 3412 57-923 1410 64.862 2233 72.839 8078 82.023 196s 43 56.482 3080 59.791 9881 67.159 4678 75.660 8030 85.483 8923 44 58.1883369 61.6888679 69.5026571 78.5523231 89.0484091 45 59.9156911 63.6142010 71.8927103 81.516,1312 92.7198614 46 61.664 6372 65.568 4140 74.330 5645 84.554 0344 96.501 4572 47 63.435 4452 67.551 9402 76.817 1758 87.667 8853 100.396 5009 48 65.2283884 69.5652193 79.3535193 90.8595824 104.4083960 49 67.043 7431 71.608 6976 81.940 5897 94.131 0720 108.540 6479 50 68.8817899 73.6828280 84.5794015 97.4843288 112.7968673 APPENDIX B 663 Table III Sum to which an annuity of i per year will accumulate in n periods i — I 3i% 4% 4i% 5% 6% n 1 .000 0000 1. 000 0000 I. 000 0000 1. 000 0000 1 .000 0000 I 2.03s °°°° 2.040 0000 2.045 0000 2.050 0000 2.060 0000 2 3.106 2250 3. 121 6000 3.137 0250 3.152 5000 3.183 6000 3 4.214 9429 4.246 4640 4.278 1911 4.310 1250 4.374 6160 4 5.362 4659 5.4163226 . , 5.470 7097 5.525 6312 , . 5-6370930, 5 6.550 1522 6.632 9755 6.716 8917 6.801 9128 6-975 3185 6, 7-779 407s 7.898 2945 8.019 1518 8.142 0085 8-393 8376 7 9.051 6868 g.214 2263 9.380 0136 9.549 1089 9.897 4679 8 10.368 4958 10.582 7953 10.802 1 142 11.026 5643 11.491 3160 9 II-73I 3932 12.006 1071 12.288 2094 12.577 8925 13.180 7949 10 13. 141 9919 13.486 3514 13.841 1788 14.206 7872 14.971 6426 II 14.601 9616 15.025 8055 15.464 0318 15.917 1265 16.869 9412 12 16.113 0303 16.626 8377 17-159 9132 17.712 9828 18.882 1377 13 17.676 9864 18.291 9112 18.932 0194 19.598 6320 21.015 0659 14 19.295 6809 20.023 5876 20.784 0543 21.578 5636 23.275 9699 15 20.971 0297 21.824 5311 22.719 3367 23.657 4918 25.672 5281 16 22.705 0157 23.697 5124 24.741 7069 25.840 3664 28.212 8798 17 24.499 6913 25.645 4129 26.855 0837 28.132 3847 30.905 6525 18 26.357 180S 27.671 2294 29.063 5625 30.539 0039 33-759 9917 19 28.279 6818 29.^778 0786 31.371 4228 33-065 9541 36.785 5912 20 30.269 4707 31.969 2017 33-783 1368 35.719 2518 39.992 7267 21 32.328 9021 34.247 9698 36.303 3780 38.505 2144 43.392 2903 22 34.460 4137 36.617 8886 38.937 0300 41-430 4751 46.995 8277 23 36.666 5282 39.082 6041 41.689 1963 44.501 9989 50.815 5774 24 38.949 8567 41.645 9083 44-565 2101 47.727 0988 54,864 5120 25 41.313 1017 44.311 7446 47.570 6446 51.1134538 59.156 3827 26 43.759 0602 47.084 2144 50.711 3236 54.669 ^264 63-705 7657 27 46.290 6273 49.967 5830 53-993 3332 58.402 ^828 68.528 1116 28 48.910 7993 52.966 2863 57-423 0332 62.322 7119 73-639 7983 29 51.622 6773 56.084 9377 61.007 0697 66.438 8475 79.058 1862 30 54.429 4710 59-328 3353 64.752 3878 70.760 7899 84.801 6774 31 57.334 5025 62.701 4687 68.666 2452 75.298 8294 90.889 7780 32 60.341 2101 66.2og 5274 72.756 2263 80.063 7708 97.343 1647 33 63.453 1524 69.857 9085 77.030 2565 85.066 9594 104.183 7546 34 66.674 0127 73.652 2249 81.496 6i8o 90.320 3074 III-434 7799 35 70.007 6032 77.598 3138 86.163 9658 95.836 3227 119. 120 8667 36 73-457 8693 81.702 2464 91.041 3443 101.628 1389 127.268 1187 37 77.028 8947 85-970 3363 96.138 2048 107.709 5458 135.904 2058 38 80.724 9060 90.409 1497 101.464 4240 114.095 0231 145.058 4581 39 84.550 2777 95-025 5157 107.030 3231 120.799 7742 154.761 9656 40 88.509 5375 99.826 5363 112.846 6876 127.839 7630 165.047 6836 41 92.607 3713 104.819 5978 118.924 7885 135-231 75" 175-950 5446 42 96.848 6293 110.012 3817 125.276 4040 142-993 3387 187.507 5772 43 101.238 3313 115.412 8770 131. 913 8422 151. 143 0056 199-758 0319 44 105.781 6729 121.029 3920 138.849 9651 159.700 1559 212.743 5138 45 110.484 0314 126.870 5677 146.098 2135 168.685 1637 226.508 1246 46 115-3509725 132.945 3904 153.672 6331 178.1194218 241.098 6121 47 120.388 2566 139.263 2060 161.587 9016 188.025 3929 ■ 256.5645288 48 125.601 8456 145-833 7343 169-859 3572 198.426 6626 272.958 4005 49 130.997 9102 152.667 0837 178.503 0283 209.347 9957 290.335 9046 SO 664 PRINCIPLES OF ACCOUNTING Table IV Present value of an annuity of i per year for n periods I I- On = — (i + ly n li% li% 2% 2i% 3% 1 0.987 6543 0.98s 2217 1 0.980 3922 0.975 6098 0.970 8738 2 1.963 1154 1. 955 8834 1.941 5609 1.927 4242 1.913 4697 3 2.9265307 2.9122004 2.8838833 2.8560236 2.828 6114 4 3.878 0580 3.854 3846 3.807 7287 > 3.761 9742 3.717 0984 5 4.817 8350 4.782 6450 4.713 4595 4-645 828s 4-579 707.2 6 5.746 0099 5.697 1872 5.601 4309 5.508 1254 5.417 1914 7 6.662 7258 6.598 2140 6.471 9911 6.349 3906 6.230 2830 8 7-568 1243 7.485 9251 7.325 4814 7-170 1372 7.019 6922 9 8.4623450 8.3605173 8.1622367 7.970865s 7.7861089 10 9.34s 5259 9-222 1846 8.982 5850 8.752 0639 8.530 2028 11 10.217 8034 10.071 1178 9.786 8480 9.514 2087 9.252 6241 12 11.079 3120 10.9075052 10.5753412 10.2577646 9.9540040 13 11.930 1847 11-731 5322 11-348 3737 10.983 1850 10.634 9553 14 12.770 5527 12.543 3815 12.106 2488 11.690 9122 11.296 0731 15 13.600 S4S9 13-343 2330 12.849 2635 12.381 3777 11.937 9351 16 14.420 2923 14-131 2641 13-577 7093 13-055 0027 12.561 1020 17 15.229 9183 14-907 6493 14-291 8719 13.712 1977 13-166 1185 18 16.029 5489 15-672 5609 14-992 0312 14.353 3636 13-753 5131 19 16.819 3076 16.426 1684 15.678 4620 14-978 8913 14-323 7991 20 17-599 3161 17-168 6388 16.351 4333 15-589 1623 14.877 4749 21 18.369 6949 17.900 1367 17.011 2092 16.184 5486 15-415 0241 22 19.130 5629 18.620 8244 17.658 0482 16.765 4132 15.936 9166 23 19.882 0374 19.330 8614 18.292 2041 17-332 iios 16.443 6084 24 20.6242345 20.0304054 18.9139256 17.8849858 16,9355421 25 21.357 2686 20.719 6112 19-523 4565 18.424 3764 rt.413 1477 26 22.081 2530 21.398 6317 20.121 0358 18.950 6111 17.876 8424 27 22.7962993 22.0676175 20.7068978 19.4640109 18.3270315 28 23.5025178 22.7267167 21.2812724 19.9648887 18.7641082 29 24.2000176 23.3760756 21,8443847 20.4535499 19.1884546 30 24.888 9062 24.015 8380 22.396 4556 20.930 2926 19.600 4413 31 25.569 2901 24.646 1458 22,937 7015 21,39s 4074 20,000 4285 32 26.241 2742 25.267 1387 23.468 3348 21.849 1780 20.388 7655 33 26.904 9621 25.878 9544 23.988 5636 22.291 8809 20.765 7918 34 27.5604564 26.4817285 24.4985917 22.7237863 21. 131 8367 35 28.2078582 27.0755946 24.9986193 23.1451573 21.4872201 36 28.8472674 27.6606843 25.4888425 23.5562511 21.8322525 37 29.478 7826 28.237 1274 25.969 4534 23.957 3181 22.167 2354 38 30.102 5013 28.805 0516 26.440 6406 24.348 6030 22.492 4616 39 30.718 5198 29.364 5829 26.902 5888 24.730 3444 22.808 2151 40 31.326 9332 29.915 8452 27.355 4792 25.102 77^0 23.114 7720 41 31.927 8352 30.458 9608 27,799 4895 -=*-2S-466 ia20 23.412 4000 42 32.521 3187 30.994 0500 28.234 7936 25.820 6068 23.701 3592 43 33-107 4753 31.521 2316 28.661 5623 26.166 4457 23.981 9021 44 33.6863954 32.0406222 29.0709631 26.5038495 24.2542739 45 34.258 1682 32.552 3372 29.490 1599 26.833 0239 24.518 7125 46 34.8228822 . 33.0564898 29.8923136 27.1541696 24.7754491 47 35-380 6244 33-553 1919 30.286 5820 27.467 4826 25.024 7078 48 35-931 4809 34-042 5536 30.673 1196 27.773 1537 25.266 7066 49 36.47s 5367 34-524 6834 31-052 0780 28.071 369s 25.501 6569 50 37.012 8757 34-999 6881 31-423 6059 28.362 3117 25.729 7640 APPENDIX B 66s Table IV Present value of an annuity of i per year for n periods (i + iy 3j% 0.966 1836 1.899 6943 2.801 6370 3.673 0792 4.515 0524 5-328 5530 6. I 14 5440 6.873 955S 7.607 686s 8.316 6053 9.001 5510 9-663 3343 10.302 7385 10.920 5203 11.517 4109 12.094 1168 12.651 3206 13.189 6817 13-709 8374 14.212 4033 14.697 9742 15.167 1248 15.620 4105 16.058 3676 16.481 5146 16.890 3523 17.285 3645 17.667 0188 18.035 7670 18.392 0454 18.736 2758 19.068 8655 19.390 2082 19.700 6842 20.000 6611 20.290 4938 20.570 5254 20.841 0874 21.102 4999 21.355 0723 21.599 1037 21.834 8828 22:062 6887 22.282 7910 22.49s 4S°3 22.700 9181 22.899 4378 23.091 2443 23.276 5645 23.455 6179 4% 0.961 5385 1.886 0947 2.775 °9io 3.629 8952 4.451 8223 5.242 1369 6.002 0547 6.732 7449 7-435 3316 8.110 8958 8.760 4767 9-385 0738 9.985 6478 10.563 1229 II. 118 3874 11.652 2956 12.165 6689 12.659 2970 13-133 9394 13,590 3263 14.029 1599 14.451 1153 14.856 8417 15.246 9631 15.622 0799 15.982 7692 16.329 5857 16.663 0632 16.983 7146 17.292 0333 17.588 4936 17-873 551S 18.147 6457 18.411 1978 18.664 6132 i8.go8 2820 19.142 5788 19.367 8642 19.584 4848 19.792 7739 19-993 0518 20.185 6267 20.370 7949 20.548 8413 20.720 0397 20.884 6536 21.042 9361 21.195 1309 21.341 4720 21.482 1846 4J% 0.956 9378 1.872 6678 2.748 9644 3.587 5257 4.389 9767 5.157 8725 5.892 7009 6.595 8861 7.268 7905 7.912 7181 8.528 9169 9. 1 18 5808 9.682 8524 10.222 8253 10-739 5457 11.234 0150 11.707 1914 12.159 9918 12.593 2936 13.007 9365 13.404 7239 13.784 4248 14-147 7749 14-495 4784 14.828 2090 15.146 6114 15-451 3028 15.742 8735 16.021 8885 16.288 8885 16.544 3910 16.788 8909 17.022 8621 17.246 7580 17.461 0124 17.666 0406 17.862 2398 18.049 9902 18.229 6557 18.401 5844 18.566 1095 18.723 5498 18.874 2103 19.018 3831 19.156 3474 19.288 3707 19.414 7088 19.535 6065 19.651 2981 19.762 0078 5% 0.952 3810 1.859 4104 2.723 2480 3-545 9505 4.329 4767 5.075 6921 5-786 3734 6.463 2128 7.107 8217 7.721 7349 8.306 4142 8.863 2516 9-393 5730 9.898 6409 10.379 6580 10.837 7696 11.274 0662 11.689 5869 12.085 3209 12.462 2103 12.821 1527 13.163 0026 13.488 5739 13.798 6418 14.093 9446 14.375 1853 14.643 0336 14.898 1273 15.141 0736 15.372 4510 15.592 8105 15.802 6767 16.002 5492 16.192 9040 16.374 1943 16.546 8517 16.711 2873 16.867 8927 17.017 0407 17.159 0864 17.294 3680 17.423 2076 17.545 9120 17.662 7733 17.774 0698 17.880 0665 17.891 0157 18.077 1578 18.168 7217 18.255 925s 6% » 0.943 3962 I 1.833 3927 2 2.673 0119 3 3.465 1056 / 4 4.212 3638 - 5 4.917 3243' .6 S.582 3814 7 6.209 7938 8 6.801 6923 9 7.360 0870 10 7.886 8746 II 8.383 8439 12 8.852 6830 13 9.294 9839 14 9.712 2490 15 10.105 8953 16 10.477 2597 17 10.827 6035 18 11.158 1165 19 11.469 9212 20 11.7640766 21 12.041 5817 22 12-303 3790 23 12.550 3575 24 12.783 3562 25 13.003 1662 26 13.210 5341 27 13.406 1643 28 13.590 72IO 29 13.764 8312 30 13.929 0860 31 14.084 0434 32 14.230 2296 33 14.368 141 1 34 14.498 2464 35 14.620 9871 36 14.736 7903 37 14.846 0192 38 14.949 0747 39 15.046 2969 40 15.1380159 41 15.224 5433 42 15.306 1729 43 15.383 1820 44 15.455 8321 45 15.524 3699 46 15.589 0282 47 15.650 0266 48 15-707 5723 49 15.761 8606 50 666 PRINCIPLES OF ACCOUNTING Table V Sinking fund or annuity which, invested at the end of each period, will amount to 1 in n periods i ~(i + t)"- I 1 I.OOO 0000 I.OOOOOOO I.OOOOOOO I.OOO OOOO I.OOOOOOO 2 0.4968944 0.4962779 0.495049s 0.4938272 0.492,6108 3 0.329 2012 0.328 3830 0.326 7547 0.325 1372 0.323 5304 4 0.245 3610 0.244 4448 0.242 6237 0.240 8179 0.239 0270 5 0.195 °62i 0.194 0893 0.192 1584 0.190 2469 0.188 3546 6 0.161 5338 0.160 5252 0.158 5258 0.156 5500 0.154 5975 7 0.1375887 0.1365562 0.1345120 0.1324954 0.1305063 8 0.119 6331 0.1 18 5840 0.1 16 5098 0.114 4673 0.112 4564 9 0.105 6705 0.104 6098 0.102 5154 o.ioo 4569 0.098 4339 10 0.094 5031 0.093 4342 0.091 3265 0.089 2588 0.087 2305 11 0.085 3684 0.084 2938 0.082 1779 0.080 1060 0.078 0774 12 . 0.077 7583 0.076 6800 0.074 SS9^ 0.072 4871 0.070 4621 13 0.071 3210 0.0702404 0.068 1 183 0.0660483 0.0640295 14 0.065 8051 0.064 7233 0.062 6020 0.060 5365 0.058 5263 15 0.061 0265 0.059 9444 0.057 8255 0.055 7665 0.053 7666 16 0.056 8467 0.055 7^51 0-0S3 6501 0.051 5990 0.049 ^108 17 0.0531602 0.0520797 0.0499698 0.0479278 0-04S 9525 18 0.049 8848 0.048 8058 0.046 7021 0.044 6701 0.042 7087 19 0.046 9555 0.045 8785 0.043 7818 0.041 7606 0.039 8139 20 0.044 3204 0.043 24S7 0-041 1567 0.039 1471 0.037 2157 21 0.041 9375 0.040 8655 0.038 7848 0.036 7873 0.034 8718 22 0.039 7724 0.038 7033 0.036 6314 0.034 6466 0.032 7474 23 0.037 7967 0.036 7307 0.034 6681 0.032 6964 0.030 8139 24 0.035 9866 0.034 9241 0.032 8711 0.030 9128 0.029 0474 25 0.034 3225 0.033 2634 0.031 2204 0.029 27S9 0.027 4279 26 0.032 7873 0.031 7320 0.029 6992 0.027 7687 0.025 9383 27 0.031 3668 0.030 3153 0.028 2931 0.026 3769 0.024 5642 28 0.030 0486 0.029 ooii 0.026 9897 0.025 0879 0.023 2932 29 0.028 8223 0.027 7788 0.025 7784 0.023 8913 0.022 1147 30 0.027 6785 0.026 6392 0.024 6499 0.022 7776 0.021 0193 31 0.026 6094 0.025 5743 0.023 S963 0.021 7390 0.019 9989 32 0.025 6079 0.024 577' 0.022 6106 0.020 7683 0.019 0466 33 0.024 6679 0.023 6414 0.021 6865 0.019 8594 0.018 1561 34 0.0237839 0.0227619 0.0208187 0.0190067 0.0173220 35 0.022 9511 0.0219336 0.0200022 0.0182056 0.0165393 36 0.022 1653 0.021 1524 0.019 2328 0.017 4516 0.015 8038 37 0.021 4227 0.020 4144 0.018 5068 0.016 7409 0.015 1116 38 0.0207198 0.019 7161 0.0178206 0.016 0701 0.0144593 39 0.0200536 0.0190546 0.017 1711 0.015 4361 0.0138438 40 0.019 4214 0.018 4271 o«3i6 5557 0.014 8362 0.013 2624 41 0.018 8206 0.017 8311 0.015 9719 0.014 2679 0.012 7124 42 0.018 2491 0.017 2643 0.015 4173 0.013 7288 0.012 1917 43 0.017 7047 0.016 7246 0.014 8899 0.013 2169 o.oii 6981 44 0.017 1856 0.016 2104 0.014 3879 0.012 7304 o.oii 2298 45 0.016 6goi 0.015 7198 0.013 9096 0.012 2675 o.oio 7852 46 0.016 2167 0.015 2512 0.013 4S34 O.OII 8268 o.oio 3625 47 0.015 7641 0.014 8034 0.013 0179 O.OII 4067 0.009 9605 48 0.015 33°7 0.014 3750 0.012 6018 O.OII 0060 0.009 5778 49 0.014 9156 0.0139648 0.0122040 0.0106235 0.009 2131 50 0.0145176 0.0135717 O.OII 8232 0.010,2581 0.0088655 APPENDIX B 667 Table V Sinking fund or annuity which, invested at the end of each period, will amount to 1 in n periods i (I + iY — I 3i% 4% 4i% 5% 6% » 1. 000 0000 1. 000 0000 1. 000 0000 1. 000 0000 1. 000 0000 I 0.491 4005 0.490 1961 0.488 9976 0.487 8049 0.485 4369 2 0.321 9342 0.320 3485 0.318 7734 .0.317 2086 0.314 1098 3 0.237 2511 0.235 4900 0.233 7436 0.232 0II8 0.228 5915 4 0.186 4814 0.184 6271 0.182 7916 0.180 9748 0.177 3964 S 0.152 6682 0.150 7619 0.148 8784 0.147 0175 0.143 3626 6 0.128 S44S 0.126 6096 0.124 7015 0.122 8198 0.1 19 1350 7 o.iio 4766 0.108 5278 0.106 6096 0.104 7218 o.ioi 0359 8 0.096 4460 0.094 4930 0.092 5745 0.090 6901 0.087 0222 9 0.08s 2414 0.083 2909 0.081 3788 0.079 5046 0.07s 8680 10 0.076 0920 0.074 1490 0.072 2482 0.070 3889 0.066 7929 II 0.068 4839 0.066 5522 0.064 6662 0.062 8254 0.059 2770 12 0.062 0616 0.060 1437 0.058 2753 0.056 4558 0.052 9601 13 0.056 5707 0.054 6690 0.052 8203 0.051 0240 0.047 5849 14 0.051 8251 0.049 941 1 0.048 1138 0.046 3423 0.042 9628 IS 0.047 6848 0.045 8200 0.044 0154 0.042 2699 0.038 9521 16 0.044 0431 0.042 1985 0.040 4176 0.038 6991 0.03s 4448 17 0.040 8168 0.038 9933 0.037 2369 0.035 5462 0.032 3565 18 0.037 9403 0.036 1386 0.034 4073 0.032 7450 0.029 6209 19 0.035 3611 0.033 5817 0.031 8761 0.030 2426 0.027 1846 20 0.033 0366 0.031 2801 0.029 6006 0.027 9961 0.025 004s 21 0.030 9321 0.029 1988 0.027 S4S6 0.025 9705 0.023 0456 22 0.029 °i88 0.027 3091 0.025 6825 0.024 1368 0.021 2785 23 0.027 2728 0.025 5868 0.023 9870 0.022 4709 0.019 6790 24 0.025 6740 0.024 0120 0.022 4390 0.020 9525 0.018 2267 2S 0.024 20S4 0.022 5674 0.021 0214 0.019 5643 0.016 9043 26 0.022 8524 0.021 2385 0.019 7195 0.018 2919 0.015 6972 27 0.021 6026 0.020 0130 0.018 5208 0.017 1225 0.014 5925 28 0.020 4454 0.018 8799 0.017 4146 0.016 0455 0.013 5796 29 0.019 3713 0.017 8301 0.016 3915 0.015 0514 0.012 6489 30 0.018 3724 0.016 8553 0.015 4434 0.014 I32I O.OII 7922 31 0.017 4415 0.015 9486 0.014 5632 0.013 2804 O.OII 0023 32 0.016 5724 0.015 i°36 0.013 7445 0.012 4900 O.OIO 2729 33 o.oiS 7S97 0.014 3148 0.012 9819 O.OII 7554 0.009 5984 34 0.014 9983 0.013 5773 0.012 2704 O.OII 0717 0.008 9739 35 0.014 2842 0.012 8869 O.OII 6058 O.OIO 4345 0.008 3948 36 0.013 6132 0.012 2396 O.OIO 9840 0.009 8398 0.007 8574 37 0.012 9821 • O.OII 6319 O.OIO 4017 0.009 2842 0.007 3581 38 0.012 3877 O.OII 0608 0.009 8557 0.008 7646 0.006 8938 39 o.oii 8273 O.OIO 5235 0.009 3431 0.008 2782 0.006 461S 40 o.oii 2982 O.OIO 0174 0.008 8616 0.007 8223 0.006 0589 41 o.oio 7983 0.009 54°2 0.008 4087 0.007 3947 0.005 6834 42 o.oio 3254 0.009 0899 0.007 9823 0.006 9933 0.005 3331 43 0.009 8777 0.008 6645 0.007 5807 0.006 6162 0.005 0061 44 0.009 4534 0.008 2625 0.007 2020 0.006 2617 0.004 7005 45 0.009 °S" 0.007 8820 0.006 8447 0.005 9282 0.004 4148 46 0.008 6692 0.007 5219 0.006 5073 0.005 6142 0.004 1477 47 0.008 3065 0.007 1806 0.006 1886 0.005 3184 0.003 8977 48 0.007 9617 0.006 8571 0.005 8872 0.005 0396 0.003 6636 49 0.007 6337 0.006 5502 0.005 6021 0.004 7767 0.003 4443 SO Railway Statements Income Statement Of the X Railroad Company For the year ended December 31st, 1915 Operating Income : 'Freight $140,654,856 Railway Operating Revenues Passenger Mail Express AU other transportation Incidental .... Joint facUity — Credit . Joint facility — Debit . Total 38,611,085 3,372,458 4,204,727 3,806,402 6,203,637 8,998 $196,628,167 Railway Operating' Expenses Maintenance of way and struc- tures Maintenance of equipment . Traffic Transportation .... Miscellaneous General Total Net Revenue from Railway Operations Railway Tax Accruals . . . Uncollectible Railway Revenues Railway Operating Income ^25,328,512 38,641,078 2,386,064 68,650,005 2,653,146 5,077,754 ,594,403 46,280 Revenues from Miscellaneous Operations $342,650 Expenses of Miscellaneous Operations . . 216,420 Net Revenue from Miscellaneous Operations Total Operating Income 668 142,736,559 $53,891,608 7,640,683 $46,250,925 126,230 $46,377,155 APPENDIX C Joint facility rent income . $ 1,511,004 669 Income from lease of road . 173,786 Miscellaneous rent income . 829,881 Miscellaneous non-operating physical property . . . 75,395 Dividend income .... 13,334,499 Non-Operat- Income from funded securities 790,395 ing Income Income from unfunded se- curities and accounts . . 2,255,459 Income from sinking and other reserve funds . . . 1,307,888 Release of premiums on funded debt 3,936 Miscellaneous income . . . 93,072 Total non-operating income 20,375,315 Gross Income $66,752,470 'Hire of equipment — debit balance $ 1,325,955 Joint facility rents . . . 1,084,556 Rent for leased roads . . 8,574,859 Miscellaneous rents . . . 711,049 Deductions Miscellaneous tax accruals . 41,943 from Gross Separately operated proper- Income ties — loss .... 33,717 'M.^t.\^\J^^^\^ Interest on funded debt . . 11,834,384 Interest on imfunded debt 287,906 Amortization of discount on funded debt 35,400 Miscellaneous income charges .... 306,549 Total deductions from gross income 24,236,318 Net Income $42,516,152 Disposition of Net Income : Income applied to sinking fund and other reserve funds f 1,946,341 Dividend appropriations of income . . . 29,552,219 Income appropriated for investment in physical property : Expended for revision of grades, align- ment, and tracks, elimination of grade crossings, betterment of equipment, water supply, etc 7,286,849 670 PRINCIPLES OF ACCOUNTING Construction expenditures on leased and branch roads directly operated, borne by the X Railroad Company . . . . $3,239,912 Stock discount extinguished through income . 200,000 42,225,321 Balance transferred to credit of Profit and Loss $290,831 Profit and Loss Statement Amount to credit of Profit and Loss December 31. 1914 131,751,125 Credit balance transferred from income . . 290,831 Profit on road and equipment sold .... 8,600 Delayed income credits 12,200 Unrefundable overcharges 650 Donations 26,500 $32,089,906 Deduct : Surplus applied to sinking and other reserve funds $1,522,000 Dividend appropriations of surplus .... 626,000 Debt discoimt extinguished through surplus . 484,680 Miscellaneous appropriations of surplus . . 142,000 Loss on retired road and equipment . . . 716,450 Delayed income debits 37,798 Balance to credit of Profit and Loss December 31st, 1915 $28,560,978 General Balance Sheet of the X Railroad Company December 31, 1915 Assets Investments : Investment in Road and Equipment : Road $306,815,457 Equipment 188,972,593 General expenditures 68,152 $495,856,202 Improvement on Leased Railway Property since Jime 30th, 1907 : Leased lines road $18,125,575 Leased lines equipment 160,670 Leasecf lines general expenditures . . . 1,288 18,287,533 APPENDIX C 671 Sinking funds $3,469,022 Less X R.R. Co. obligations 1,391,100 2,077,922 Miscellaneous physical property 2,132,020 Investments in affiliated companies : Stocks $164,784,523 Bonds 31,712,865 Notes 75,522,918 Advances 12,611,467 284,631,773 Other investments : Stocks $65,412,599 Bonds 538,946 Notes iS,74S Miscellaneous 12 65,967,302 Current Assets : Cash $13,778,292 Time drafts and deposits 28,004,263 Special deposits 336,916 Loans and bills receivable 50,406 Traffic and car-service balances receivable . 16,732,166 Net balance receivable from agents and conductors 6,490,728 Miscellaneous accounts receivable . . 9,122,087 Material and supplies ... ... 16,989,418 Interest and dividends receivable . 1,695,642 Rents receivable 56,081 Deferred Assets : 93,255i999 Working fund advances $ 193,291 Insurance and other funds . $34,291,172 Less X R.R. Co. obligations 4,028,500 30,262,672 Other deferred assets 34,345 30,490,308 Unadjusted Debits : Rents and insurance premiums paid in advance I 78,163 Discount on capital stock 8,217,600 Discount on funded debt . .... 1,113,267 Property abandoned chargeable to operat- ing expenses 139,846 Other unadjusted debits 2,241,464 Securities issued or assumed held in treasury $62,250 11,790,340 Total $1,004,489,399 672 PRINCIPLES OF ACCOUNTING Liabilities Stock : Capital stock $509,265,700 Less — Held by X. R.R. Co. . . $32,350 Held f 0( acquisition of stock of acquired and affil- iated companies .... 29,650 62,000 $509,203,700 Premium realized on capital Stock from January ist, 1909 5,717,647 Governmental Grants : Grants in aid of construction 516,000 Mortgage, Bonded and Secured Debt : Funded Debt of the X R.R. Co. Consolidated mortgage dollar bonds, 5%, due September ist, 1919 f 4,998,000 Consolidated mortgage doUar bonds, 4%, due May ist, 1943 2,561,000 Consolidated mortgage sterling bonds, si%, due July ist, 1945 3,326,130 Consolidated mortgage sterling bonds, 4%, due May ist, 1948 19,400,000 Ten-year convertible gold bonds, 4%, due May ist, 1920 . . . $20,000,000 Less — Held in sinking or other funds 6,000 19,994,000 Consolidated mortgage gold bonds, 4i%, due August 1st, i960 49,000,000 General mortgage gold bonds, 45%, Series "A," due June i, 1965 $65,000,000 Less — Held in sinking or other funds 625,000 64,375,000 Real estate purchase money bonds, 4%, due May ist, 1923 2,000,000 165,654,130 Fimded Debt of Acquired Companies Assumed by the X R.R. Co. Orchard VaUey Ry. Co. general mtg. 4% gold bonds, due March ist, 1942 $20,000,000 Less — Held in sinking or other funds . . . 870,000 $ 19,130,000 Cambwin and Clearfield Ry. Co., general mortgage 4% coupon registered APPENDIX C 673 bonds, due February ist, 1955 $2,000,000 Less — Held in sinking or other funds 1,460,000 540,000 Washington and JeSerson Ry. Co., first mortgage, 6% bonds, due Jan. ist, 1927 2,073,000 Junction R.R. Co. general mortgage, 3!% bonds, due April ist, 1930 $725,000 Less — Held by X R.R. Co 143,000 582,000 Urban and North Western R.R. Co. gen. mtg. 5% bonds, due Jan. ist, 1930 1,021,000 Lawrence and Erie R.R. Co. general mortgage 6% bonds, due July ist, 1920 $8,680,000 Less — Held in sinking or other funds .... 500,000 8,180,000 Pittsburgh and Charleston Ry. Co., first mtg. 4% bonds, due Nov. i, 1943 . 18,005,000 Simbury and Wabash Ry. Co., second mtg. 6% bonds, due May ist, 1938 . . 1,349,500 Western Ry. Co. consohdated mtg. 4% bonds, due June ist, 1928 .... 5,536,600 56,417,100 Guaranteed Stock Trust Certificates : Harrisville R.R. 4% stock trust ctfs., due July ist, 1921 $6,770,000 New York and Vineyard R.R. 4% stock trust ctfs., due June ist, 1948 ' . $7,478,250 Less — Held by X R.R. Co. $ 250 Held in sinking fund or other funds 200,000 200,250 7,278,000 14,048,000 Equipment trust obligations $17,743,016 Less — Held in sinking or other funds . . . 160,000 17,583,016 Mortgages and ground-rents payable $3,i96,3S9 Less — Held in sinking or other funds . . 883,200 2,313,159 674 PRINCIPLES OF ACCOUNTING Current Liabilities : Loans and bills payable $ 3,009,000 Traffic and car-service balances payable . . 14,380,033 Audited accounts and wages payable . . . 18,561,804 Miscellaneous accounts payable 8,678,051 Interest matured unpaid 807,955 Dividends matured unpaid 58,565 Funded debt matured unpaid 1,609,440 Unmatuired interest accrued 2,116,066 Umnatured rents accrued 267,371 Deferred Liabilities Unadjusted Credits : Tax liability . , $ 6,266,370 Premium on funded debt 191,446 Operating reserves 1,866,496 Accrued depreciation — road 7,592 Accrued depreciation — equipment .... 20,036,904 Other imadjusted credits 3,142,085 49,488,285 224,377 31,510,893 Corporate Surplus : Additions to property through income and surplus since June 30th, 1907 . . . $83,631,500 Funded debt retired through income and sur- plus 1,372,832 Sinking fund reserves 3,467,049 Miscellaneous fund reserves 34,593, 720 Appropriated surplus not specifically invested 187,013 Total appropriated surplus Profit and Loss — Balance Total 123,252,114 28,560,978 $1,004,489,399 D Selected Bibliography ^ Elementary Bookkeeping and Accounting CThe student especially interested in the study of elementary accounting principles and the details of bookkeeping and office methods will find any of the following books fairly satisfactory texts.) Baker, 20th Century Bookkeeping and Accounting. Bogle, Everyday Bookkeeping. Kester, Accounting — Theory and Practice. Vol. I. Klein, Bookkeeping and Accounting. Lyons, Accounting — Complete Series. Miner and ElweU, Principles of Bookkeeping. Principles of Accounting (The following list includes some of the more important books which attempt to present the general principles of accounting and the funda- mentals of the double-entry system.) Bentley, Science of Accounts. Cole, Accounts, Their Construction and Interpretation. Dickinson, Accounting — Practice and Procedure. Esquerre, Applied Theory of Accounts. Oilman, Principles of Accounting. Hatfield, Modern Accounting. Mitchell, Accounting Principles. Racine, Accounting Principles. Sprague, The Philosophy of Accounts. Wildman, Principles of Accounting. Corporation Accounting and Finance Bentley, Corporation Finance and Accounting. Bennet, Corporation Accounting. Lyon, Capitalization. ' This list of books is not intended to be at all exhaustive, but it includes repre- sentative titles under each of the various heads given. 67s 676 PRINCIPLES OF ACCOUNTING Investment Mathematics and Accounting Sprague and Perrine, The Accountancy of Investment. Skinner, The Mathematics of Investment. Depreciation and Valuation Dicksee, Depreciation, Reserves and Reserve Funds. Dicksee and Tillyard, Goodwill and its Treatment in the Accounts. Leake, Depreciation and Wasting Assets. Saliers, Principles of Depreciation. Cost Accounting Church, Manufacturing Costs and Accounts. Evans, Cost Keeping and Scientific Management. Nicholson, Cost Accounting — Theory and Practice. Rowe, Cost Accounting for Manufacturing. Scovell, Cost Accounting and Burden Application. Webner, Factory Accounting. Public Service and Municipal Accounting and Valuation Adams, American Railway Accounting. Bureau of Municipal Research, New York Cit}', A Handbook of Municipal Accounting. Cleveland, Municipal Administration and Accounting. Eggleston, Municipal Accounting. Floy, Valuation of Public Properties. Hayes, Public Utilities — Their Cost New and Depreciation. May, Street Railway Accounting. Auditing De Paula, The Principles of Auditing. Montgomery, Auditing Theory and Practice. Walton and Kimball, Auditing and Cost-Finding. INDEX Account {see also "Accounts"). balance, 153. balancing an, 157, 158, 159. form of, 25-27. Accounts (see also "Assets,"' "Liabilities,"' "Proprietorship"). classification of, 50-55, 117, 139. closing, 151-159. controlling, 63, 82-84, 97. construction of, 124-129. current asset, 35-39. current liability, 47, 147-150. current tangible asset, 120-126. expense and revenue, 39-43, 136-142. fixed equity, 132. fixed tangible asset, 110-117. mixed, 52. payable, 313-316. personal, 32, 45. receivable account, 126-127. closing of, 174-177. receivable, valuation of, 471-473. special equity, 42-47. with current rights, 126-131. Accounting, cost, 13, 609-619. definition, 3. fiduciary, 421-425. function of, 4, 7, 10. municipal, 620-628. partnership, 260-268. period, 155. railroad, 629-641. relation to the price system, 8. imit of organisation in, 3, 17. Accountancy (ie«"Accoimting,"" "Auditing""). Accruals, of interest, 188-189. of rent, 180-181. of taxes, 190, 200. of wages, 178-179. Accrued liabilities, 318-319. Accumulation (see also "Discount," "In- terest"). of an annuity, 360-365, Accumulation — contintied of bond discount, 381-383, 401-405. of principal, 340^353- Adams, H, C, 635. Adjusted trial balance, 219. Administrative expense, in income sheet, 560, 567. Advertising, illustrative entries, 130. preUminary, 535 (.see "Organization, costs"*). Allocation of costs, 166-167 (see also "Cost accounting'"). Allowance (see also "Valuation accounts""). for depreciation, 48, 107, 495. for uncollectible accounts, 127. Allowances (see also "Discounts"). purchase and sale, 165. American Society of Civil Engineers, report of its committee on public utihty valuation, 517. American Telephone and Telegraph Com- pany, balance sheets of, 597-598. Amortization (see also "Bonds'"). of bond premium, 381-383, 405-409. of goodwill, 535. of a lease, 540-541. Annuity, installments, determination of, 373-374. method of measuring depreciation, 525- 526. payments, apportionment of, 376-377. which a principal will purchase, 374- 376. Annuities, 327. accumulation of, 360-365. entries and transactions involving, 391- 395. present worth of, 365-372. Appraisal, 154, 156. Appreciation (see also "Valuation"). and depreciation, 238-243. an unwarranted estimate, 465. as a basis for dividends, 467. as unrealized profit, 464. objections to the recognition of, 463-469. 677 678 INDEX Appropriations {see also "Surplus"). of surplus, 201, 300-312. Asset, definition of, i8. -^ Assets (see also "Accounts," "Property"). accounting for fixed tangible, 103-110. accounting for current tangible, 120-126. as a class of accounting data, 18. current, 36. current rights as, 126-130, distinction between fixed and current, 111-112. fixed, 36. fixed intangible, no, 113-116. Audit, 642. purposes of, 642-645. Auditing, 642-649. essentials of, 646-649, Auditor, qualifications of an, 647-649. Authorized stock, 283. B Bad debts (see also "Accounts receivable"). treatment of, 175-176. Balance (see "Account, balance"). "Balance of balances," 202. Balance sheet, 10, 20, 572-586. capital account, 580, 581, 582. captions, 572-576. classification of current assets in, 574. classification of equities in, 575. classification of fixed assets in, 573-574. comparative, 207, 587-592. condensed, 205-206. consolidated, 592-598. current account, 580,- 581, 582. essential nature of, 201-207. general, 572-586. importance of, 201. in account form, 202, • in report form, 203-204. municipal, 621-623. railway, 637, 670, 674, Balance sheets, illustrative, 576-584, Bibliography, selected, 675, 676. Bond interest, 378, Bond interest account, closing of, 187. Bonds (see also "Interest," "Accumulation," " Amortization ") . accumulation of discount on, 381-383, 401-405. amortization of premium on, 381-383, 405-409. as assets, 113, 115, Bonds — continued collateral, 325, convertible, 325, coupon, 322, debenture, 324-325. discounts on, 379. equipment, 325. income, 3^4, interest on, 341-343. issued at a discount, 401-405, issued at a premiupi, 405-409. issued at par, 395-400, mortgage, 324. par of, 378, payable account, 135-136, premium on, 379, registered, 322. serial, 325. treasury, 327. valuation of, 378-380. Bondholder (see also "Bonds"), control of, 275, Bookkeeping (see also "Accounting," "Ac- count," "Credit," "Debit," "Tech- nique"), double-entry, basis of, 31, essential steps in, 59, single-entry, 3r, 255, Books (see also "Technique"), principal, 56-59, Budget (see also "Municipal accounting"), municipal, 626-628. Buildings (see also "Fixed assets"), account, closing the, 157-158. in municipal balance sheet, 622, valuation of, 477-478. Business, enterprise, 3, cycle, 9, Buying expense account, use of, 186, Capital (see also "Proprietorship"), fixed and circulating, 37, Capital deficit, 294-297. Capital stock (see also "Equities," "Pro- prietorship," "Stock"), account, 133. illustrative entries in, 134-135. authorized, 280, 283. common, 272. dividends, 303-305. donated, 285-288, fully paid, 286, individual accounts for, 292, issued for cash, 280-285, outstanding, 284, INDEX 679 Capital stock — continued par value, 283. preferred, 273. subscribed, 281. subscriptions, 281. treasury, 287-290. unissued, 283, 284. Capital surplus, 294-297. Cash, 123-126. account, 123. as an account receivable, 125. book, 61, 8s, 90. discounts, 653-656. as entered in cash book, 88-89. transactions involving, 71-72. sales, 91. statement, 224-228, 624. valuation of, 470-471. Certificate, book, 293. stock, 271. Charging (see also "Debit"). meaning of term, 60. Closing, 151-191. Cole, W. M., 47, 653. Comparative, balance sheet, 207, 587-592. income sheet, SSSSS^- Commercial interest (see also "Interest"). account, closing of, 188-189. Common stock, 272. Compound discount (see "Interest," "Dis- count"). Compound interest (see also "Interest"). method, of measuring depreciation, 517- 520 Consolidated, balance sheet, 592-598. income sheet, 567-570. Construction (see also "Organization"). period of, 446-448. valuation during, 433-450. Contingencies, treatment by auditor, 647. Contingent liabilities, 129, 320-321. Contingent reserves, 309, 310. Continuous inventory, 156. Copartnership (see "Partnership"). Copyrights, 116, 234, 529, 539. Controlling accounts, 63, 74, 97. advantages of, 82-84. Corporate entity, 6. Corporation, 4, 5-6 (see also "Capital stock," "Bonds," Proprietorship"). importance of, 269. limited liability of the, 270. membership of the, 270-272. opening entries for the, 279-280. Corporation — continued organization of a, 270. Cost (see also "Expense," "Valuation"). accounting, 13, 609-619. as a basis for valuation, 451. of goods sold account, 166. of production, relation to net revenue, 222-223. of replacement, 456. per job or order, 611. per product, 610. per process, 612. use of weighted average, 476. Current assets, 1 20-130. accounts with, 35-39. valuation of, 455-456. Current liabiUties, 147-150. accounts with, 47. Customers' accounts (see also "Accounts re- ceivable"). special methods for handling, 98-102. Customers' ledger, 64 (see also "Customers' accounts"). Credit, defined, 31. Creditors' ledger, 63. D Daybook, 57. Debenture bonds, 324-325. Debit, defined, 31. Debit and credit, rule for, 34. Defalcations, 648. Deferred, charges, 228-231, 577. credits, 231-232, 575. expense, 228-229. Uabilities, 320. Deficiency, account, 603, 604. statement, 603-605. Deficit (see also "Surplus"). account, 46. accumulated, 298. 1 Departmental, expense accounts, 139-141, 559-560. property accounts, 11 7-1 18. revenue accounts, 141-142, 561. Depreciation, 106, 238 (see also "Valuation"). account policy, 491-496. accounts, 482-505. allowance for, 48, 107, 495. annuity method of. measuring, 525-526. compound interest method of measuring, SI 7-5 20. during construction, 436-438. 68o INDEX Depredation — continued entries showing, 109. equal annual payment method of measur- ing, SiQ- expense accounts, 136. fixed percentage of declining value method of measuring, 526-527. fund, 496-500. fund reinvested, 503-505. funds returned, 500-503. I. C. C. rulings in connection with, 634. methods of measuring, 506-527. physical efficiency as a basis for measuring, 506-509. present opinion concerning, 454. present value of future revenue method of measuring, 520-524. problem of, 482-484. repair charges as a part of, 524-525. reserves for, 107. revenue as a basis for measuring, 509-510. sinldng fund method of measuring, 515- 517- straight Une method of measuring, 511- SiS- use of valuation accounts to show, 106-107. Deterioration, 106, 452. Developmental, period, 446. value, 535. Direct expense, 615. Directors {see also "Corporation"). importance of income sheet to, 548. Disbursements, journal, 85, 87. contrasted with expense, 225. Discount {see also "Interest"). account, r33, 282. compound, 357. on stock, 295-296. rate of, 355. simple, 356. Discounting, 355. Discounts, accounts, closing of, 173. casli, 71-72, 653-656. colimins for, 88-89. on securities, 448-450. purchase, 89. sales, 88. stock, 22. trade, 71. treatment in statements, 194-195. Dissolution {see "Partnership," "State- ments of insolvency"). Dividends, account, 144, 302. appropriations of, 300-305. Dividends — continued payable, 319. payment of, i89-r90. scrip, 303. stock, 303-305. Donated, stock, 285-288. surplus, 2S8, 312. Donations, significance of, 45. Double-entry bookkeeping, basis of, 31. advantage of, in a single-proprietorshin, 254-2SS- Drafts, 317 {see also "Notes payable," "Notes receivable"). Economic cost, 614 {see also "Net revenue"). Efficiency, 10 {see also "Cost accounting," " Management ") . Embezzlements, 648. Enterprise, business, 3. Endorsements, of notes receivable, 129. Entries {see also "Journal," "Journaliz- ing"). closing and adjusting, 56. balancing, 158, 168. Equity accounts, 43-47. classification of, 132-150. closing of, 1 87-191. Equation, the fundamental accounting, 20-24. Equities {see also "Accounts," "Liabilities," "Proprietorship ") . as a class of accounting data, 19. Examinations {see also "Auditing") . bank, 644. Expense, classification and distribution of, 6i5-6r9. definition of, 41. indirect and direct, 615. transactions, 42-43. Expense accounts, classes of, 136-142. functional classification of, 139-142. illustrative entries in, 136-137. in municipal accounting, 624-626. railway, 632-635. subdivision of, 42. Expense and revenue, account, 163, 171. closing of, r85. statement, 193-197, account form, 194. report form, 195. INDEX 68i Experimental, costs, 230-231. value, 535. Factory ledgers, 97. Fiduciary accounting, 421-425. Financial statements, I92-219. Finished goods, account, 121, 162. closing the, 160-167. valuation of, 474-477. Fixed assets, 103-120. closing accounts with, 157-159. controlling accounts for, 118-119. valuation of, 457-461, 477-481, 483-541. Fiscal period, 155. Franchise, 116, 529. Frequency of conversion, 350. Fuel account, closing of, 179. Functional classification (see "Balance sheet," "Cost accounting"). of fixed asset accounts, 11 7-1 20. of expense and revenue accounts, 139-142. Funds, depreciation, 496-500. sinking, 372-374. 425-429- Gain (see also "Dividends," "Profit"). definition of, 45. General expense, 179. Going value, 535-538. Goods in process, accotmt, 121, 161. closing the, 160-167. valuation of, 474-477. Goodwill, 116. nature of, 528-530. recognition of, 277. valuation of, 530-534. H Hatfield, H. R., 10, 335. Holding company, 567. Hepburn Act, 629. Improvement (see also "Maintenance"), meaning of an, 104. valuation of an, for municipal balance sheet, 622. Inadequacy, 452. Income (see "Dividends," "Interest," "Profit," "Proprietorship"). Income bonds, 324-325. Income accounts (see also "Income sheet," "Revenue, accounts"). railway, 635-636. Income sheet, 10, 545-57r (see also "State- ments"). comparative, 555-558. consolidated, 567-570. municipal, 623-626. operating accoimts classified in, 558-560, 563-567; purposes of, 546-549- railway, 668, 670. report supplementary to, 557-558. sales accounts classified in, 561. significance of, 193. summary, 549-555. Indirect expense, 615. methods of distributing, 617. Insolvency, statements of, 599-605. Insurance, account, closing of, 180. Installation costs, 479. Installment book, 291. Intangible assets, S28-54r. Interest, 188-189. account, 144. accruals, 189. and discount, 338, 355. on non-interest bearing note, 388-391. and notes payable, entries involving, 148-149. and notes receivable, transactions in volving, 70-71. calculations and formulae, 349-386. commercial, 334-339- compound, 350. computations, 338-339. determining the rate of, 383-386. during construction, 438-446. effective rate of, 354. expUcit, 331-334. implicit, 331-334- in cost accounting, 613-615. in fiduciary accounting, 421-425. in relation to a future sum, 355-356. in valuations, 344-348.J nominal rate of, 354. on bonds, 341-343. on capital owned, as an expense, 223. rate of, 350. simple, 350, tables, 657-667. transactions, 387-429. Interstate Commerce Commission, 119, 555 (see also "Railroad accounting"). classifications prescribed by, 119, 629-637, 682 INDEX Interstate Commerce Commission — cont. expense and revenue classifications of, 142. power of, to have public utility books examined, 645. rules in connection with discounts and premiums, 2961 rules in connection with maintenance charges, 236. rules relating to interest during con- struction, 444. Inventories, treatment in statements, 196. Inventory, bases of valuation for, 156. necessity for, 154-156. perpetual, 156. types of, 156. Investment, as a basis for valuation, 461-463. Joint stock company, 257. Journal, 58, 59-61. special-column, 77-84. stock, 293. Journalizing, 64-74. Journal of Accountancy, 461. Labor, account, closing the, 178-179. cost data concerning, 612. Land valuation, 108, 458-461, 480-481. for municipal balance sheet, 622. Leases, 234, 539-541. Ledger, 58, 62-84. contrasted with journal, 62. creditors', 63, 84. customers', 62, 83, 97. general, 63. stock, 291. subscription, 290. Length of life, of assets, in, 112, 120. Liabilities, 23, 313-327 {see also "Accounts," "Balance Sheet," "Bonds," "Eq- uities"). accrued, 150, 318-319. contingent, 129, 320-32r. current, 47, 147-150. deferred, 320. Liquid assets, in balance sheet, 203-204. Liquidity of assets, in, 112. Liquidation (.see "Insolvency"). Loss, definition of, 44. treatment of, 190. Loss and gain, account, 133, M Machinery, treatment of installation costs of, 479. valuation of, 478-479. Maintenance, 486 (,see also "Depreciation," "Repairs," "Replacement"). and improvement, contrasted, 234-238. Management {see also "Cost accoimting"). and valuation, 455-461. problems of, 609-615. statistics of, 12. Manufacturing, department, expense accounts for, 139- 140. expense, in income sheet, 559, 566. expense account, use of, 186. Materials, account, 121, 160. entries involving, 122-123. returned, 164. valuation of, 474-477. Merchandise, discounts, 653-656. valuation of, 474-477. Merchandise accounts, 167-174. cost, 167. mixed, 167-169. revenue, 167. trading, 172-173. Methods, of measuring depreciation, 506-52.7. Middleditch, Livingston, 461. Misappropriations, 648. MitcheU, W.'C, 8. Montgomery, R. H., 458, 459. Moody's Manual, 597. Mortgages, no (see also "Bonds"). types of, 322-323. payable account, 135, 136. Municipal, accounting, 620-628. balance sheet, 621-623. budget, 626-628. income sheet, 623-626. N Neglected discounts (see "Cash, discounts"). Net loss, 44. Net revenue, 44. accoimt, closing of, 190-191. accounts, 143-147. effect of accruals upon, 155. determination of, 220-243. division in income sheet, 555. division into economic shares, 223. INDEX 683 Net revenue — continued < figure, importance of, 200, [ relation to economic cost, 222-223. significance of, 220-224. variations of, 553. Net revenue and surplus statement, 197- 201. account form, 198. report form, ig8. "Net worth," 250. Notes, non-interest bearing, 387-391. Notes payable, 317-318. bank, 317. entries involving, 148-149. Notes receivable, discounted, 128. endorsements, 129. entries involving, 127-128. valuation of, 177, 473. Obsolescence, 106, 121, 432. Operating, and non-operating accounts, 241. division of income sheet, 555. ratio, 551. Operation, the accountant's conception of, 24. Organization («« also "Construction"). costs, 433-436- entries {see "Capital stock," "Partner- ship"). Original entry, book of, 61. Overburden, 230. Ownership, 19 (see aiso "Equities"). Partners, accounts of, 257-260, 260-268. kinds of, 256. * Partnership, 4, s, i33- agreements, 255. closing entries for, 276-278. dissolution of, 267-268. limited, 236. proprietary accounts, 257-260. purpose of a, 255. unlimited, 256. Par value, 448-449. Patents, 116, 234,- 529, 538-539- Payroll, 178. Period, importance of, 454. Perpetual inventory, 454. Perpetuities, 274, 327. Personal accounts, 32. Petty cash, account, 125. book, 125. Pioneering value, 535. Posting, 75-76 (see aiso "Technique"). Preferred stock, 272-273. Premium, on stock, 133, 282, 296-297. on bonds, 381-383, 405-509 {see also "Amortization, of bonds"). Present value, as a basis for valuations, 451. Principal {see also "Interest"). accumulation of, 349-355. Production, large scale, as related to accounting, 7. nature of, as viewed by the accountant, 241. Profit {see also "Dividends," "Net Revenue," "Proprietorship," "Surplus"). "unrealized," 242. distribution of partnership, 25&-260. Profit and loss, account, 253. accounts, railway, 636. accumulated, 297-300. statement, 193. Promissory notes, no (see also "Notes"). Promotion costs, 535 (see also "Organization, costs"). Property {see also "Assets"). accoimts, railway, 630. as a class of accounting data, 18. register, 585. types of, 7-8. Proprietorship, 19 (see also "Accounts," "Equities"). accounts with, 132-134. contrasted with habilities, 248-249. corporate, 269-312. general explanatiijn of, 248-249. in the balance sheet, 583, 589-590. in the partnership, 133, 255-260. in the single-proprietorship, 250-255. Purchase, book, 61, 92. discounts, 71-72, 88-89, 315-316 (see also "Discounts"). Public utility accounting, 629 (see also "Going value," "Railroad account- ing," "Regulation," "Valuation"). R Railroad accounting, 629-641 . Real estate, account, closing the, 159. Realization (see "Insolvency"). Rebates, 165. 684 INDEX Receipts, and disbursements, statement of, 224-228. contrasted with revenue, 225, journal, 85, 86. Receiver {see "Insolvency"). Refunding, of securities, 409-411. Register, property, s8S- Regulation, public, as related to accounting, g. rate, and accounting, 638-641. Renewals, 484, 487-491. Rent, account, closing of, i8o-i8r. accounting significance of, 143-146. payable, 181. Repairs, 483-487. Replacement, 104. policy of treating depreciation, 488-491 . Replacements, 235-236. Reserve (see also "Funds," "Surplus"). [ for contingencies, 309. for donated stock, 287, 288. for fire insurance, 308-309. for improvements, 133. for taxes, 190, 311. Reserves, in balance sheet, 580. secret, 236-237, 311. valuation, 106-107, 304-310. Revenue {see also "Net revenue"). accounts, 39-43, 136, 142. definition of, 39, 41. net, 40. transactions, 42-43. Rights, as assets, 110-116. Royalties, 533. Sacrifice, as a basis for valuation, 461-463. Salaries, of proprietors, as expense charges, 223- 224 Sales slips, use as customers' ledger, 97. Sales, account, closing the, 160-167. accounts, 162. book, 61, 90-92, 99, loi. classified in income sheet, 561. discounts, 71-72, 88-89 (■'«« also "Dis- counts"). returns, 165. Scrip dividends, 303. ' Secret reserves, 236-237, 311. Securities {see also "Capital stock," "Lia- biUties"). as assets, 11 2-1 16. corporate, 271-276. interest on, 339-348. investments in, 412-420. refunding of, 409-411. valuation of, 177. Selling department, expense accounts for, 140. Selling expense, account, use of, 186. in income sheet, 559-360, 566. Services, as assets, 115-116. Share, of stock, 271 {see also "Stock"). Sight drafts, 317. Single-proprietorship, 4, 133, 250-255. Single-entry bookkeeping, 31, 235. Sinking fund, appropriations, 305-308. assets, 306, 426-427. method of measuring depreciation, 315- 517- reserve, 133, 428. Sinking funds, 372-374, 425-429. Solvency, as determined in balance sheet com- parisons, 578-379- Specialized ledgers, 9&-102. Sprague, C. E., 20, 452. Statements {see also "Balance sheet," "Income sheet"). balance sheet, 201-207. construction and analysis of financial, 343-605. deficiency, 603-605. fimdamental, 10. importance of, 192. of affairs, 599-603. of expense and revenue, 193-197. of insolvency, 599-603. of net revenue and surplus, 197-201. of profit and loss, 193 . of receipts and disbursements, 224-228. preparation of, 192-219. Standards, of operation, 612. Stock {see also "Capital stock"). certificate, 271. certificate book, 293. common, 272. dividends, 303-305. donated, 285-288. discount, 22 {see also "Discount"). journal, 293. ledger, 291. INDEX 685 Stock — continued preferred, 272-273. subscriptions, 282. treasury, 287-290. Stockholders, 272. Stores accounting, relation to cost accounting, 619. Straight line method, of measuring depreciation, sii-SiS- Subscriptions, stock, 282. ledger, 290. Sundry, assets account, 182-183. columns, use of (see "Technique")- liabilities accoimt, 183-184. Supplies, valuation of, 474-477. Surplus, account, 133, 191. accoimts, 143-147, 294-312. accumulated, 247-300. appropriations, 201, 300-312. donated, 288. in balance sheet, 580, 621. purposes of accumulating, 299-300. sheet, 550, SS4- Suspense items, 579 (.see also "Deferred, charges," "Deferred, credits"). Tables, interest, 657-667. Tangibles, current, 120-126. fixed, 103-110. Taylor, F. M., 248. Taxes, accounting significance of, 145. accruals of, 190, 201. during construction, 445. location in income sheet, 552, 560. recent, effect upon accounting, 645. Technique, developments in bookkeeping, 77—102. Ten-column statement, 207-215. Terminal company, 321. Trade discount, 71. Trademarks, 529, 539. Trading, accounts, 162-164. enterprise, 196. [i9S' section of expense and revenue statement, Transactions, asset, 65-68. asset and equity, 68-73. classes of, 29-30, 33. effect upon asset and equity classes, 25-26. Transactions — continued equity, 73-74- essential nature of, 22. explanation of, 56. mixed, 74. Trial balance, adjusted, 219. arrangement of accounts in, 154. errors in, 153. illustration of, 152. methods of preparing, 153. Treasury, stock, 287-290. bonds, 327. Trustee (see "Fiduciary accounting"). Turnover, 551. U Uncollectible accounts, 175-176. Underwriting, of stock, 282-283. costs, 535. Undivided profits, 133, 298-299. Unissued stock, 283. Unit, for valuation purposes, 485. V Valuation, and management, 455-461. and price changes, 461. basis of, 156, 451-469. general significance of, 451-461. in organization, and construction period, 433-450. of accounts receivable, 127, 471-473. of assets, 433-454- of bonds, 378-380. of cash, 124, 470-471. of securities, 412-471. problem of, 11. relation to accounting, 8. Valuation accounts, 23, 47-50, 106-107 (see also "Reserves"). in balance sheet, 575, 579-580. in ten-column statement, 210. Vouchers, payable register, 93-96- use of, 94- Value (see also "Valuation"). significance of present value as a basis for valuation, 451. types of intangible, 535. W Wages payable, 178. Wasting assets, 232-234. Working assets, 204. Working sheet, 215-219. Printed in the United States of America.