THE LIBRARY OF THE UNIVERSITY OF CALIFORNIA GIFT OF Professor W» Leonard Crum I / accordingly extend the $30,000 into the gain column. If, on the other hand, the balance according to our books were a debit of $io,oco — meaning that we had paid $10,000 more for goods than we had received for goods sold — and our stock on hand were still $20,000, our gain would be $10,000 ; for we should have still on hand goods worth $20,000, which, taking everything into con- sideration, would really have cost us but $10,000. The $20,000 of stock on hand is usually written in red ink to show that it is taken not from the books but from an inventory that does not yet appear upon the books — though destined ultimately to appear upon them. A similar thing may be true of any other property account even when not connected with buying and selling. If the firm has certain real estate which is depreciating, it may carry the item through the statement somewhat after this fashion, assuming the depreciation to be 3%. Gain Dr. Cr. Resource Liability Loss Real Estate and Plant 54,200 52^574 1,626 42 ACCOUNTS Another account which may include inventories is interest. In- terest is paid not daily, of course, but at intervals. If a firm pays on December 30 a large amount of interest, and knows that on January 2 a much larger amount will be due to it, a statement which is made on December 31 neglecting the interest due on January 2 does not fairly represent the facts. That interest payable to the firm on January 2, though not yet due, has been earned, with the exception of the amount for two days, on December 31 ; and a statement of the business for the year closing December 31 should take note of it. Interest accrued but not yet due, both for and against a business, should be inventoried whenever a statement is desired. Then the entry on a six-column statement should be made in much the same fashion as that already worked out for Mer- chandise. Suppose here the balance both according to the books and according to the inventory is favorable. On the statement the item might show as follows: Dr. I Cr. 600 Interest I I 000 100 Resource I Liability Loss Gain 700 The balance of earnings of interest as shown by the books is S600, and the inventory shows that an additional balance of $100 has already been earned by this year's business, though that interest has not yet become due and hence is not yet on the books. The total gain therefore is $700. If now we add to our original items on the six-column statement, as given on page 40, those that we have since worked out, i. e., Merchandise, Real Estate and Plant, and Interest, we shall find our totals of each column as follows: Dr. I Cr. II Resource 116,800 I 116,800 II 118,274 Liability 105,000 Loss I Gain 18,626 I 31,900 The first two columns here are nothing but the trial balance, and indicate simply that for every debit a credit has been given. The next two show that the property of the business is greater than its liabilities by $13,274. In these liabilities, it is to be noticed, is in- cluded the liabiUty of the business to the proprietor; hence, if the property is so much in excess of the liabilities, that excess must represent the earnings of the year. If we wish to know where that property came from, we look at the nominal or explanation accounts TRIAL BALANCE, STATEMENT, AND BALANCE SHEET 43 and find some interesting figures. Merchandise earned $30,000, commission earned $1200, and interest earned $700, or a total of $31,900 ; and the cost of securing this profit was $17,000 for expense, and $1626 for wear and tear of real estate and plant, or a total of $18,626. The difference between the gains and losses, therefore, is $13,274 — just the difference between the resources and the habilities. Should the difference between resources and Habihties equal the difference between gains and losses? Inevitably. The nominal ac- counts are kept solely to show the causes of the changes in the real accounts, and hence they must explain just as many changes as occur : a change cannot occur in a real account, other than an ex- change of one thing for another, without a nominal account record- ing the cause of the change. Hence the proof, by correspondence of dift'erences, must follow. It is well to show the proof by subtract- ing the total of the columns at the bottom of the sheet, as follows : Resource 118,274 Liability 105,000 Net Gain 13,274 Gain 3i>9oo Loss 18,626 Net Gain 13,274 For practical purposes this is perhaps sufficient explanation of a six-column statement and its principle, but certain facts yet remain which are of interest to one who wishes something better than a rule of thumb. If the question arises, How does it happen that the balancing is not thrown out by putting into the six-column state- ment items not on the books, such as merchandise stock on hand, accrued interest, and valuation of real estate? the answer is that these outside figures are carried also through the loss and gain col- umns, for the figures in the loss and gain columns are taken from com.bining the book figures with the inventory figures: thus the change affects both sets of figures alike. Perhaps a more puzzling problem to solve is the reason for the apparently erratic manner in which book or trial balance figures and inventory figures are combined. Let us try all possible combi- nations of the books and the inventory with respect to interest. The following are conceivable cases: (Case i) (Case 2) (Case 3) (Case 4) Interest f Dr. Cr. Resource Liability Loss 600 100 500 600 600 600 100 100 100 700 Gain 700 500 44 ACCOUNTS The correctness of the loss and gain figures should be clear. In case I, the books show a loss, but $ioo will come in later : hence the net loss is less. In case 2, the books show a loss, and $100 loss is com- ing later : hence the total loss is greater. In case 3, the books show a gain, but $100 is coming in later : hence the total gain is greater. In case 4, the books show a gain, but $100 must go out later : hence the net gain is less. The curious thing to note is that seemingly unlike things are added and Hke things are subtracted. In case i, one debit, or left-hand, column of a pair is subtracted from the other debit column ; in case 4, one credit, or right-hand, column of a pair is subtracted from the other credit column ; in cases 2 and 3, debit and credit columns are added. This calls for explanation, since we usually add similar items and subtract dissimilar. The explanation is the rather abstract one that the inventory figures represent a differ- ent sort of thing from the book figures. This can best be illustrated by a question. What would you give for what is represented by the $6oc debit in case i ? Clearly nothing, for it represents sums con- sumed, paid out on account of that force in business which we call interest. What, on the other hand, would you give for what is represented by the $100 in the resource column ? It is clearly worth $100, for it represents $100 of claims that can be enforced. The book figures are from mere nominal accounts, and hence are mere explanations. Yet an explanation can never be a resource. The figure of one hundred dollars in the resource column, then, is not a nominal figure, but indicates the anticipation of a real account ; for if that one hundred dollars never comes in as a real thing, it will never come in at all. That expected real resource must be explained in the six-column statement now, for it belongs to this year's earn- ings; but, as it has not yet come in, it is not included in the trial balance. When it does come in, it will be a credit to Interest and a debit perhaps to Cash : it is now included as a credit to Interest in the gain column, and is simply placed artificially in the resource column to show that a real resource (probably expected cash) is explained by the credit to Interest, though that resource is just now so intan- gible that it can hardly be properly classified. From one point of view, then, the resource under Interest is not interest at all, but is some unknown real account temporarily called interest for want of a better name. The figure of gain opposite Interest, in case 3, for TRIAL BALANCE, STATEMENT, AND BALANCE SHEET 45 example, is not derived from adding the $100 in the resource column to the S6co in the credit trial-balance column, but from adding to the $6co an entirely different $100 which the bookkeeper knows will ultimately be credited to interest, next year; and the $ico in the resource column is simply the other half, representing a real account, of the expected credit to interest, and put here simply because there is no more intelligible place to put it. ^ The six-column statement as a whole has now served its chief purpose, — to show a summary of the business. Usually such state- ments are drawn up only annually. Then, since the condition of the business has been carefully figured out, preservation of those figures on the books, in more durable shape than a separate sheet, is Hkely to be desirable. This can be accomplished by embodying the con- clusions of the statement directly upon the ledger, that is, closing the ledger accounts and bringing down the balances. Indeed, this is necessary if the same books are to be continued into the coming year, for the affairs of the new year will attach themselves to the condition as it now stands on the six-column statement, and if the books are to tell the truth they must be brought into accord with the facts. The process of doing this is comparatively simple. In all bookkeeping the method of closing an account that is not naturally balanced is to produce an artificial equality of debit and credit by adding to the smaller side a sum equal to the excess of the other side, and then bringing down such excess as the first entry of the new account. If, for example, cash account shows a debit of * It is obvious that when it is desired to enter upon the books the details of allow- ances and inventories here recorded, the result may be accomplished by opening accounts in the ledger with the items concerned. For example, instead of entering the accrued interest in red ink under the head of Interest, an account may be opened with Accrued Interest, which may be debited, with a credit to Interest, and the amount may be carried through the six-column statement. On the statement, then, the Ac- crued Interest would show as a resource (a real account), and Interest would show as a gain (a nominal account). This plan avoids the theoretical complication ex- plained above ; but it has one disadvantage. Under this plan the balance of Accrued Interest continues on the books indefinitely until canceled by a new entry. So watch must be kept and an entry made whenever accrued interest becomes due. Under the other plan, described in the text, the payment of interest automatically wipes off the item of accrued interest, for« going to the same account, the debit and the credit offset each other. In some lines of business, as explained in Part II, it is necessary to distin- guish three sorts of interest, — Interest Accrued, Interest Earned, Interest Due; but the principle is the same throughout. 46 ACCOUNTS $17,000 and a credit of $15,400, the excess of debit is $1600. An artificial balance or equality is struck by adding to the credit side $1600, which should be considered not as a credit but as simply a means of recording the measure of debit excess. Then the two sides are added, the totals written in the book, the proper ruHngs made, and the debit excess brought down to the new account, thus : Jan. 13 26 Cash Balance 8000 00 Jan. 3 Sundries 28 2000 Bills Rec. 27 6000 00 14 Sundries 30 3000 Bills Pay. 29 3000 00 00 00 16 Bills Pay. J. Jones Balance 30 30 5000! 5400 1600 17,000 17,000 Balance 1600 Feb. The balance artificially inserted, as here $1600 on the credit side, should be written in red ink or have some other distinguishing feature, that the eye may note that it is not an entry but is placed in the account artificially to serve the purposes of balancing. Strictly speaking, the $1600 brought down to the debit of the new account is not the $i6co written in red ink on the credit side: the $1600 in red ink is merely a memorandum to determine the debit excess, for, since on the books subtraction can never be performed, the only method of showing excess is to show how much must be added to the smaller side in order to produce equality. Hence the $1600 brought down is simply the debit excess brought down where it naturally belongs, in a debit column. The figure of totals of the two sides, $17,000 in the case above, is not an essential, and is often omitted. Yet a case is known where the omission of those figures cost the loss of more time than the writing of such figures in all closed accounts would probably have cost in many years. The story is worth telling because it illustrates several important principles of careful bookkeeping. A bookkeeper had worked several days over his trial balance, following every clue that he could find and then checking his work over. Everything appeared correct, but a discrepancy of $8.40 persisted. A friend happened into the office, was told of the difficulty, and volunteered a few moments' assistance. He began, with the bookkeeper, to com- pare the trial-balance sheet with the ledger. The bookkeeper was TRIAL BALANCE, STATEMENT, AND BALANCE SHEET 47 about to turn over a certain ledger page, on the ground that it con- tained no open accounts, when the friend remonstrated. He no- ticed that the accounts were ruled as if closed, but that the figures of totals were not written. A moment's figuring showed that one of those accounts, though ruled, did not balance by $8.40 — just the amount of the discrepancy in the trial balance. The bookkeeper insisted that the account ought to balance, for the customer had paid all that he owed. The investigation that followed showed a curious state of things. In the settlement of the account had been included a discount of S8.40, which should have been credited to the customer ; but by some chance the entry was never made. When the bookkeeper, knowing that the account had been settled, had posted the cash payment that settled the account, he proceeded without further formality to rule the account as closed. Had he added the figures of the account as he should have done, he would have seen that the account was not balanced, and the omission of discount would have been discovered. The result was that the account of the customer was related to the trial balance as it should have been, though not as the books warranted ; but the discount account was wrong to the amount of $8.40, not only upon the trial balance but also on the books. Although there were two errors in the books, there was but one absolute error in the trial balance. It was only because the bookkeeper's friend was suspicious of such slip-shod closing of accounts that he was able to find the error. There is no knowing when the bookkeeper himself would have found it. Before an account is ruled the bookkeeper must be sure that it balances ; and he must be sure, not by figuring the items on another piece of paper, but by using the identical marks of the pen that he finds in his ledger, for the marks on his paper may not be the same as those in his ledger, — as is shown by the case above. One should never add a column of figures and then transfer the total as the footing of another column of figures, even when one thinks they are alike. Of course the actual writing in the ledger of the total of ledger footings is not essential, for correspondence is all that is needed ; but the appearance of them upon the page is a satisfaction to the eye and requires little labor. When accounts shall be closed is a matter solely of convenience-. Sometimes when a settlement is attempted and some matter is in dis- 48 ACCOUNTS pute, convenience suggests that the amount in dispute be preserved on the record by the closing of the account and the carrying down of the disputed balance as the first item of the new account. Often, even at the end of the year, it is not worth while to close an account, for the items on it may be so few or so simple that the account is sufficiently intelligible as it stands. It is usually desirable, however, to close at the end of the year all accounts showing loss or gain, and in the case of corporations which intend to pay dividends this is practically necessary. This is most simply done by transferring to the ledger in red ink all red-ink items of the six-column state- ment, and then transferring the balances of those accounts to Profit and Loss, and ultimately transferring the Profit and Loss balance to the Proprietor's account, to Dividend account, or to Undivided Profits account. This may be illustrated by using the figures that we already have in our six-column statement, and assuming, for simplicity, that the balances that we find on the trial-balance part of the statement happen to be the only entries under each account. These will be best understood if the reader, as soon as he finds that any entry has been carried to the Profit and Loss account, turns to that account and notes how the item is there treated. Expense I I II i7,ooo|cx3||| \Profit b' Lossl L25 l| i'/,ooo \oo [The index figures in these illustrations will be omitted, except for the new entries which the illustrations are designed to show. The page index number in italics is to show the ledger page to which the item goes, and, conversely, in the Profit and Loss account, below, it shows from what ledger page the item comes. The principle of carrying forward the balance is the same here as in the cash account (see page 46).] Commission \ Profit ^ Loss I L25 \\ r,20o|oo III I | || i,2oo|oo Jan. 6* Loss L25 Mei 30,000 00 ^NDISE 30,OC50 00 00 e 20,000 Inventory 10,000 00 20,ooo\no 30,000! 00 [Here we find a new type, though the principle is the same. The ledger does not ordinarily show the goods on hand, for Merchandise is a combined real and nominal account. Here the separation of the two elements must be made. When we close Merchandise account, to determine its responsibility to us or ours to it, we must clearly take into consideration the goods that it still TRIAL BALANCE, STATEMENT, AND BALANCE SHEET 49 has' on hand: we charged Merchandise with them originally, and we must now, in making a settlement, at least temporarily give credit for them. Their amount is accordingly written in red ink to show that the item comes from outside the books. When this has been done, we find that the excess of credit over debit is $30,000, and we know that Merchandise has yielded that amount of profit — has by that amount produced more than it has cost. This is transferred to Profit and Loss as in the other cases. The balance brought down for Merchandise itself is of course simply the $20,000 worth of stock on hand, with a debit of which Merchandise must begin the new year since the warehouse is still responsible for it. To summarize this treat- ment of Merchandise: the $20,000 brought down as a debit for the new year is simply that part of last year's debit to Merchandise which the account, as a property account, has not yet got rid of responsibihty for; and the $30,000 carried to Profit and Loss is the profit on last year's sales which the account, as an explanation account, last year recorded.] Jan. I Balance Real Estate and Plant 54,200 c 54,200 52»574,oo Inventory Profit &> Loss L25 52,574 00 1,626 00 54,200 00 [Here we have a loss, caused not by bad buying or bad selling, but by a natural depreciation. We simply reduce the valuation brought down to the new year — a process called "writing off." Interest Jan. I Profit &> Loss Balance L25 700 00 700 00 100 00 Accrued 6ooj 00 ioo\oo [In this case we have something of a new type, though again we have the old principle. It may look at first sight as if it were unfair to ask Interest to begin the new year with a handicap of $100.00 against it. When one realizes, however, that the interest has been earned this year, and will come in only next year, one sees that next year's Interest is responsible to collect that sum and is properly charged. When that interest is paid. Interest will be credited; and the diflfer- ence between that credit and the debit balance carried over to the new year will properly represent next year's earnings of interest on that score — and that is what next year's interest account should represent. Note that a sum in red ink when transferred or brought down always goes to the other side ; for its occurrence in red is an indication that it is inserted artificially either as a measure of the excess of the other side — as here with the profit and loss item, — or as an anticipation of an item on the same side — as here with the accrued item. When it measures excess, the amount must be brought down on the side that is in excess, i. e.y on the other side, as is done with the profit and loss item here when transferred to the profit and loss account. When it anticipates an item on the same side, that item, being anticipated, must be corrected or nuUified whenever it shall occur, and such nullification can be made only by an entry on the other side; so here the accrued item is brought down to nuHify the credit to interest when it shall occur on next year's account. If the accrument were against the firm, instead of in its favor as here, the item of accrument in red would be on the debit side, of course, and would be brought down as a credit balance to the new year. Since in that case next year would have to pay the sum for this year's business, it if right that a o-edit should be given it at the start to nullify that apparent burden.] so ACCOUNTS Profit and Loss Expense R. E. & PI. Proprietor L21 Lio U 17,000 1,626 13^274 31,900 00 00 00 00 Commission Mdse. Interest L22 Lii L20 1,200 30,000 700 31,900 [The L with the index page-figure is used here to show that the item comes not from another book but from the ledger itself. Transfers to this account, since the items now belong here, are in black. Transfers from it are in red.] Proprietor Balance 88,274 ,274 Profit & Loss Balance L2S 75,000 88,274 88,274 [Another method of closing the books, with the advantage of giving full explanations, though it is more laborious, is shown in Appendix B, II.] When all this has been accomplished, the books are said to be closed. It is to be noted that now, for the first time since the last closing of the books, do the accounts show the actual condition of the business. Profit and expense have been going on every moment, and a dozen bookkeepers probably could not write fast enough to keep up with the accruing of interest, the expiration of insurance, the wear and tear of plant, the depreciation and the profit in mer- chandise. Bookkeeping does not pretend to record all matters as they occur, but usually only as distinct elements reach their cul- mination. If the business has a sole proprietor, every loss or gain made on January 2 is his as much at that time as it is on December 31 when the books are closed. It should be remembered, therefore, that except when the books have been brought up to the moment by closing as indicated here, they do not quite faithfully report conditions. If the business is conducted by a corporation, a slightly different method of closing will be required. A corporation knows no stock- holders as individuals: it knows them only as holders of stock certificates ; and hence accounts are kept not with individuals but with capital stock, with dividends, with profits, and sometimes with surplus. When the end of the year has been reached and a state- ment has been made, the disposition of the net earnings will deter- mine the bookkeeping entries. Dividends are usually declared some weeks before they are to be paid. In that case the dividends owed to stockholders form a liability of the business, and the profit and loss account, instead of being closed out to the proprietor, as in TRIAL BALANCE, STATEMENT, AND BALANCE SHEET 51 the case above, is closed out, at least to the amount of the dividends, to the dividend account, which will show a credit. When dividends are paid. Dividends is debited, as responsible, and Cash is credited. If the dividends do not require the full amount of the profits, the balance may be carried to ''Surplus," to "Undivided Profits," or it may remain undisturbed in Profit and Loss. Some remnant usually remains after dividends are declared, unless they are de- clared in excess of earnings, for practically never can the profit be divided exactly by the number of shares, and most corporations desire to keep at least a small reserve. The balance undivided, under whatever account it appears, will show as a credit, for it in- dicates stockholders' profits intrusted to the business. In case the statement shows a loss, — or, in the case of a corpo- ration, if the dividends exceed the profits, — the bookkeeping is equally simple. The profit and loss account will show a debit, and that debit will mean that the investment of the proprietor or of the stockholders in the business is less valuable than at the time of the last closing of the books. In the case of the proprietor, that debit balance is transferred to his account, and the closing of that ac- count shows him to have a reduced present worth. In the case of a corporation, the balance is allowed to remain undisturbed, repre- senting the impairment of capital. Though not a resource in the ordinary sense, this figure of loss, this deficit, is a bookkeeping re- source, for it enables the business to satisfy its accountability: it furnishes an explanation of what has become of the capital of the corporation, just as a receipt for an authorized payment for charity is a resource for an agent intrusted with property. It is to be noted that a trial balance taken from the books as they now stand will be very different from the one taken for the six- column statement. Such a trial balance, moreover, if extended intc a six-column statement, will yield nothing for the last two columns, and for the other two will simply duplicate itself. All the nominal accounts save one — and that one. Profit and Loss in the case of a corporation, is in a sense no exception — have disappeared. There is no longer anything to explain, for the business has settled with its proprietors, transferring the title to its gains and rendering account for its losses. All that remains is simple liability to proprietors and outsiders on one hand, and simple property with which to meet 52 ACCOUNTS that liability on the other. Even the profit and loss account, in the case of a corporation, now represents liability of the business to the stockholders because of profits, just as Capital Stock represents its liability to them because of their investment. It is true, of course, that at all times the profit belonged to the stockholders, but not until now has it been known formally to be profit and ultimately assign- able to them. The new trial balance taken after the closing of the books, then, is simply a statement covering the solvency of the business — it com- pares resources and liabilities, showing them to be equal. How sound a business may be, however, is determined not so much by the equality of the footings as by the availability of the resources to meet the liabilities. A Profit and Loss credit, representing the undistributed earnings available for stockholders, is an element of strength from the point of view of outside creditors, for since those earnings have not yet been assigned to individual stockholders, they constitute resources to which outside creditors may look for the payment of their claims. The exact significance of this profit and loss balance is important, but easily lost sight of by one unfamiliar with accounts. Even in this new trial balance, taken after the books have been closed, it is a nominal account, not a real account. It simply serves as a measure, or register, to show how much of the property of the business is in excess of the already recognized claims. It is the margin of solvency. Trial balances taken after the books have been closed, and serving, as just indicated, to show solvency, are commonly called balance sheets, and hereafter will be so designated in this book. Such sheets are usually arranged not in parallel columns but with the items grouped, so that the figures derived from the books already illus- trated would look as follows : Balance Sheet Resources Liabilities Real Estate & Plant 52,574 Proprietor 88,274 Bills Receivable 36,000 Bills Payable 25,000 Cash 1,600 J. Smith 5,000 J. Jones 8,000 Interest 100 Merchandise 20,000 118,274 118,274 TRIAL BALANCE, STATEMENT, AND BALANCE SHEET 53 The nature of the trial balance, of the various parts of the six- column statement, and of the balance sheet, may well be summarized at this point so as to show the relationship between them. The pur- pose of the trial balance, as the name suggests, is to test the accuracy of the books — for equaHty of debits and credits. This trial balance, moreover, is used as the basis for the six-column statement, for it shows exactly how the books stand at the close of business, — and hence the first two columns of the statement are a dupHcate of the trial balance. The next two columns of the statement, showing re- sources and liabilities (not necessarily as on the books, but making allowance for matters not yet on the books), are intended to show the facts of solvency. The last two columns of the statement, show- ing losses and gains (not necessarily as on the books, but making al- lowance for matters not yet on the books), show the facts of revenue. The only way to make the books serviceable for use next year is to bring them up to the times by entering upon them the allowances indicated for the close of the year in the last four columns of the statement, and then disposing of the net profit or loss thus shown. This process closes the books. A trial balance taken after the books are closed is the balance sheet ; and except for the changes due to the disposition of profits it should agree exactly with the second pair of columns (resources and liabilities) of the six-column statement. One other set of illustrations, to comprise practically every type of allowance and a different disposition of profits from that pre- viously made, may be worth while, presenting the whole genealogy of the balance sheet in a comprehensive view. Trial Balance Dr. C Cash 5,500 Real estate 20,000 Merchandise 17,000 Expense 8,000 Commission 700 Interest 500 Rent 300 Capital stock 50,000 51,000 51,000 54 ACCOUNTS Six-Column Statement [By the books] [Solvency facts] [Revenue facts] Dr. Cr. Resource Liability Loss Gain Cash Real estate 5,500 20,000 *^ 5,500 19,500 1 500 Merchandise 17,000 35,000 18,000 Expense Commission Interest 8,000 500 700 1,200 250 700 6,800 600 950 Rent 300 2^ 200 2^ 100 Capital stock 51,000 50,000 51,000 -1 s 61,450 50,000 50,300 7,900 19,050 a 50,300 h^ 7,900 Net gain 11,150 Net gain 11,150 [Since in closing the books at this point the allowances are entered and the loss and gain items are closed out to dividends and surplus, the obsolete valua- tions and the old revenue facts are removed from active standing and only those that pertain to the new year remain as balances. For instance, $8000 was spent last year on account of expense, but $1200 of that is found now to be uncon- sumed (perhaps unexpired insurance, as no separate account is kept for in- surance), and so $1200 properly belonging to next year, though spent this year, is brought down as a balance for the new year to carry. Conversely, though $300 was collected for rent last year, only one third of that has expired, and $200 of it belongs to next year. That amount is brought down as a bal- ance to the credit of the new year. Since, moreover, the new year has been given that credit, it is responsible to supply the equivalent, and hence on the balance sheet this amount is a liability: to put this somewhat differently, since the old year turns over to the new all receipts (such as the balance of cash col- lected from that rent), the new year must be held accountable also for the equiv- alent — to supply the quarters or to refund the money. When a new trial bal- ance is taken of the books as they now stand closed, the result is as follows: J Balance Sheet Resources Liabilities Cash 5,500 Interest IOC Real estate 19,500 Rent 200 Merchandise 35,000 Capital stock 50,000 Expense 1,200 Dividends 5,000 Commission 250 Surplus 6,150 61,450 61,450 TRIAL BALANCE, STATEMENT, AND BALANCE SHEET 55 We have now seen the full meaning of two of the three principles of bookkeeping — the significance of debit and credit, and the difference between nominal and real accounts — and may well summarize them. Since debit records responsibility taken and credit records responsibility conferred, and since no transaction can take place without a responsibiHty both taken and conferred, though by different persons or properties or forces, the debits must equal the credits not only for each transaction but for all transac- tions. This gives us the trial balance — which records in classified order, from the ledger, the items getting into the books of original entry in chronological order. Hence nothing can get into the trial balance except, through the ledger, from the books of original en- try or from closing allowances that affect both debit and credit. Accounts are of three sorts, property or claim (representing prop- erty in the business or claims of it or against it) , force (represent- ing forces of business that cause it gain or loss), and proprietorship (representing what the proprietors have invested, plus any profits accumulated but not yet withdrawn). In a sense, the last two classes are identical in nature, though they are different in form; for a gain or loss, explained by a force or nominal account, shows an increase or decrease in proprietorship — for w^hose gain or loss is it but the proprietor's ? The difference in form between these two sorts of accounts, however, is wide, in that they bear titles having no apparent relation. At a certain stage in the bookkeep- ing processes this difference in form disappears and the fact of ownership is disclosed under some title that suggests it. This stage is that of closing the books. Then the two classes of transactions — those which involve exchanges of values but no changes in values, and those which involve changes in values but no exchanges — come to a final reporting and summary. The exchanges result in transfers of items from one property or claim'^account to another, as the exchange of cash for a note or of merchandise for cash, and hence do not affect the volume of net assets — or the excess of assets over outside liabilities, which is proprietorship — though they do affect the amount of particular assets and Habilities on the balance sheet. The change transactions, however, involve a prop- erty or claim account on one side and a force or nominal account on the other, and hence bring in property or claims without direct S6 ACCOUNTS outgo or cause them to go out without direct income — and so affect proprietorship or excess of assets over outside liabilities. Since the purpose of closing the books is to show final results, and the final fact about all force accounts is the effect on proprietor- ship, these accounts are closed to some proprietorship account. This is why the balance sheet is exactly like the resource and lia- bility columns of the six-colvunn statement except in one respect: this respect is the balance of profit or loss shown on the balance sheet in some proprietorship account; but this balance of profit and loss is the same as the last two columns of the six-column state- ment; and hence the whole six-colimm statement goes into the balance sheet — but with translated terms and with cancellations of losses against gains. The proprietorship accounts may be many in number, as Partners, Capital Stock, Undivided Profits, Surplus, Dividends Declared — or, as an offset to the capital which has been depleted but cannot be reduced on the books because the stock certificates are actually outstanding. Deficit. This proprietorship, though a liabiHty in the bookkeeping sense, is not a Hability that must be legally met. A business may be solvent and yet have noth- ing with which to pay back what it has received from its proprie- tors. Solvency is concerned with outside creditors only, or with proprietors in relations with the business independent of their in- vestment in it. Finally, every item once on the books is there to stay xmless removed by cancellation against other items or with- drawn through proprietorship; for (exchanges will shift the form of^assets or HabiHties, though they will not affect the net results, but change or proprietorship transactions will increase or decrease the net results. CHAPTER SIX LABOR-SAVING DEVICES The most obvious improvement that can be made over the primitive books described in Chapter III is a combination of the day-book and the journal in one book. No purpose is served by their separation. At least the turning of pages may be saved. When the combination has been made, the combined book is usually known as the journal. The simplest combination is made by v^riting the journal entry, or "journalization," as it is commonly called, directly beneath the day-book entry. This is also the most logical combination, for a bookkeeper would naturally wish to have the detailed history be- fore him when he is journalizing. One difficulty with this arrange- ment is that, in posting, the eye of the bookkeeper must be careful to detect exactly where the journal entry begins, or he may omit some item from the ledger. This extra care, in separating the day- book portion of the entry from the journal portion, means less rapidity in posting. A more common form of combination, there- fore, puts the journalization first, with the day-book entry immedi- ately beneath. The following may serve as an illustration : May 30 Sundries To Sundries Henry Esmond Interest Mdse. Delivery Equipment Bills Receivable Sold Henry Esmond the following: 100 M. Cedar shingles fi@s Second-hand wagon and harness, from stable I. Jay's note for $500 dated Apr. 30, on 3 mos. (less discount $5.00) taken over by him 495.00 63 20 II 12 13 300.00 217.00 300 217 500 58 ACCOUNTS Here no delay is suffered in posting, for the bookkeeper finds con- spicuous the items that he wishes to post. Still a third form of combination is in use. This consists of a parallel arrangement, and can be well illustrated by the transaction just given in the other form. May 30 63 Henry Esmond Sold him: II To Mdse. 100 M. Cedar shingles /i $3.00 13 To Bills Rec. I. Jay's note, 4/30, 3 mos., taken over by him, . 20 Interest less discount 12 ToDeliv. Equipment Wagon and harness from stable 1,012 00 00 300 500 217 [Interest is debited here because Interest was credited when the note was ori- ginally taken, on the ground of expected profit, and now that the chance of profit is lost by the taking up of the note Interest must be debited to offset the pre- vious credit.] This form is much more concise than the other, and shows more closely the connection between the journalization and the detailed record, but in such complicated entries as this it is not always easy to arrange intelligibly. Credit items are indicated not only by the position of the amount, in the right-hand figure column, but also by the word "to" prefixed to the name of the account. For simple transactions, such as the receipt of a note or the allowance of a dis- count, — and in practice most journal entries are of that sort, — this form is very convenient, and is coming to be widely used. The next step in the saving of labor is an important one, for it embodies a new principle which may be extended almost infinitely. In most mercantile business, at least two accounts. Merchandise and Cash, are of continual recurrence. Obviously, if the items of these sorts could be tucked away by themselves for a while and posted in lump sums, one posting for perhaps a hundred items, the advantage would be very great. This can be accomplished by the provision of special columns in the journal, — one for Merchan- dise, Dr., one for Merchandise, Cr., one for Cash, Dr., and one for Cash, Cr. All other items would appear in the usual columns, and would be posted in the usual way. Such a journal might look as follows : LABOR-SAVING DEVICES S9 r Si !^ .a 3 8 oo 2 OO I20 oo 247 00 97 ^ oo 12S 00 11 2 OO 1 2 00 9 9 ■ I ^IZL 00 July 21. Mdse. To Cash Cash To Mdse. Bo't 2 Cords Oak of DaTid Grieve, (u^ 4 22 Retail sales at yard Mdse. To J. March 20 C. Walnut, @ 6 Bills Pay. To H. Barr Our note of May 7 paid by him Mdse. Dr. Total Cash Dr. Mdse. Cr. Cash Cr. 1 ja i 2 u 8 00 2 00 12000 247 00 2 00 2 00 8 00 Joo_ 377 00 _ _ [This arrangement practically posts, though not in the ledger, Merchandise and Cash merely in the act of entering them, and the totals may be carried to the ledger at the end of the month or the page. Note that in the check column, before the names of the accounts, ledger-page numbers are not used for Merchandise or for Cash. It is desirable to have all items checked, but as these are posted only in total at the foot of the column, the post-mark should not appear except with the footing. The blank check mark is used to show that the bookkeeper has looked to see that the item has appeared in the proper special column. If a figure should be omitted entirely from a column, or should go upon the wrong side, the trial balance would go wrong, and so the footings of the merchandise and the cash columns are carried into the general columns, and added with the other items, merely to test the balance of total debit and credit.] To summarize this special-column journal, or columnar journal, as it is sometimes called, we find that it is like the ordinary journal, except that the postings for two accounts are, by a temporary setting aside of the items, posted in totals only, those totals being written at the foot of the journal page with appropriate explanations. It is to be noted, of course, that this temporary setting aside does not always apply to a complete entry, but only to that part of it which is Merchandise or Cash. If one half of an entry is Cash and the other half Bills Receivable or the account of a customer, the half not Cash is treated as usual. The principle here used may be applied to any account and any number of accounts. The only limit is convenience. It would be more work to provide and maintain a special column for an account having an average of two entries per page than it would be to post those entries individually. 6o ACCOUNTS It is worth while to go on and see in what ways this principle of the special column is commonly applied in business practice, for the saving that it has made possible is almost beyond the belief of the uninitiated. One application of this principle is nearly universal, consisting in the separation of the cash book from the journal. The cash book is simply a supplementary journal, containing nothing but entries of which one half is cash. In other words, the two special columns given to Cash in the special-column journal are taken entirely out of that journal and kept in a separate book, and with the cash por- tions of each entry are carried also the other half of such entries — that is, the items to be credited when Cash is debited, and vice versa^ as can be seen below. The idea of separation is carried so far, also, as to put all Cash, Dr. items on one page — the left, — and all Cash, Cr. items on the opposite page. Cash entries can now be made very simply, for no indication need be made of the fact that half of the entry is cash. The presence of the entry on the cash book shows that Cash is concerned, and the page, right or left, indicates whether Cash is to be debited or is to be credited. A cash book, accordingly, may look like this : Left-hand page] Receipts Aug. lo Balance Bills Receivable J. Jones Bills Payable H. Smith Cash, Dr. #327 paid His invoice, 8/2, paid Borrowed on ^27 His acct. to balance Total rec'ts [This space is left blank for reasons explained below.] 3»549 27 643 247 1,000 2,502 08 611 2,502 6,051 35 6,051 35 630 85 Balance [The balance brought down for the new month is taken from the credit or disbursements page, which see.] [Right-hand page Aug. 10 II 12 23 53 9 B. Robinson Disbursements Paid on acct. Bills Payable Paid #21 Expense Stationery, H. M. & Co. Expense Printing, Minerva Press Freight On invoice, L. K. £f Co. Expense Postage, stamped envel. Freight On invoice, J. L. M. K. Pickard & Co. Paid them in full Cash, Cr. Total disbursements Balance 1,000 00 1,500 00 62 00 24 00 73 00 85 00 53 00 2,623 50 5.420 50 6jo ^5 6,051 35 LABOR-SAVING DEVICES 6l The full principle of this form of book may be summarized in a very few words : this book is simply a part of the general journal ; it con- tains all entries involving cash, and contains not only the cash part of those entries but the other half as well, one writing of the figures serving both entries ; the receipts page contains all Cash debits, and hence all amounts appearing on that page except the total must be posted to the credit of the accounts named, for those accounts are to be credited for bringing in cash; of course the contrary is true on the credit page ; at the end of the month or the foot of the page the total of the receipts may be posted to the debit of cash, and the total of the expenditures to the credit of cash. It is desirable to show the balancing of the book by providing that the corresponding totals, 6051.35 in this case, shall be on cor- responding Hnes on the opposite pages. Yet it is undesirable to leave blank lines on either side, for in such case no assurance ap- pears that items were not or may not be inserted after the book was balanced. The old-fashioned way to escape the difficulty is to draw diagonal red ruling across all blank lines left on either page. This is effective, but the various slants of glaring red lines produce a page that is somewhat offensive to any one with an eye for form. A satisfactory substitute is the method employed here. The total of the short side, here the debit, is taken on the first blank line, and is then repeated, as if it were a new total, on the desired hne opposite the corresponding figure on the other page. Thus the only blank lines are left between two totals that must correspond ; and any insertion advertises itself as out of place. This device is equally serviceable for closing the ledger, though since the ledger is not a book of original entry, blank spaces are not necessarily to be avoided. Many business houses do not bother to post cash at all, but when drawing up a trial balance turn to the cash book to obtain the figure for Cash. The only objection to this is that the ledger, which is theoretically supposed to show a full summary of the business, fails to do that if Cash is omitted. Only two postings a month are involved in keeping Cash in the ledger, and merely for the sake of completeness it seems well worth while to post Cash. If Cash is to be posted, however, care must be taken that the balances are not posted, for those have already once been included in the receipts of the preceding page or period. On the receipts side a separate column 62 ACCOUNTS for the balance keeps it out of the total until after posting is done, and on the disbursements side the total may be taken before the balance is added. The principle of closing and balancing, which is the same for the cash book as for the ledger, has already been ex- plained on page 46. A comparison of the cash-book balance with the actual cash on hand is a valuable check on error. When a transaction involves several parts, of which some are cash and some are not, it is necessarily divided between the general journal and the cash book. If, for example, a customer pays his bill in part by cash and in part by a note, Cash is debited and he is credited in the cash book for the amount of cash, and Bills Re- ceivable is debited and he is credited on the general journal for the note. When both items are posted, the customer's account shows credit for the proper amount. We have seen that sometimes both halves of an entry may be included in totals, so that neither need be posted by itself, — as in the purchase for cash and sales for cash on the columnar journal, page 59. There fifty sales for cash would require but two postings, one total for Merchandise, Cr., and one for Cash, Dr. This same principle may be applied to the cash book. In the cash disburse- ments given on page 60 are three items of expense and two of freight. If such items are frequent, they may well be given special columns so that they will need to be posted but once each month. We have already by the device of a separate book or column for cash pro- vided that at least one side of all cash entries may be neglected in posting except for monthly totals; and now we find that so far as certain kinds of entries occur often enough to be worth special columns, we can provide that also the other half of those cash en- tries may be posted in monthly totals. Such a special-column cash book might look as follows, using the items already given on the disbursements side of the simple cash book: LABOR-SAVING DEVICES 63 '. 10 55 15 II i v i 12 V V 53 ^3 21 9 Disbursements Sundries Expense Freight B. Robinson Pd. him on acct. I, COO: 00 Bills Payable Paid ;f2I 1,500,00 Expense Stationery, H. M. & Co. 62 00 Expense Printing, Minerva Pr. H 00 Freight On invoice, L. K. & Co. 73 00 Expense Postage, stamped envel. 85 00 Freight On invoice, J. L. M. 53 00 K. Pickard ^ Co. Paid them in full 2,623 50 Freight Totals 126 00 126 00 Expense Totals Total disbursements 171 00 171 00 Cash, Cr. 5420 50 Balance 630 si_ 6,051 35 [The use of check marks here is the same as has already been explained in connection with the special-column journal. In this type of book, if cash is to be posted, the transference of the totals of special columns to the general column is a necessity, not a mere convenience as in the special- column journal, for here, unless these totals are included in the general column, the total credit to Cash will not be adequately stated. The same general principle of special columns is, of course, applicable to the receipts side of a cash book: a special column might there be useful for Bills Receivable, for example. It is desirable not only in this book but in others that the column for ledger-folio numbers shall be full when posting is finished, with blank checks if no others are required, for then the eye sees at a glance that the posting for that page is complete.] Similar to the cash book in principle are two books for merchan- dise, corresponding exactly to the Merchandise, Dr. and Merchan- dise, Cr. columns of the special-column journal. The book for Merchandise debits is, of course, the invoice or purchase book, and that for Merchandise credits is the sales book. These are very simple in form. In each book a record is made of the purchases or the salts, showing at the head of each item the name of the business house to be credited or debited, and showing in a column kept clear for the purpose the net amount of each invoice or sale. In posting, each account is debited or credited for the net amount of the bill, and at the end of the month the totals of all bills are posted to Merchandise, — to its debit or its credit as the case may require. A sales-book form might look as follows : Sundries To Merchandise January i 97 Silas Lapham 25 Tons Lehigh Egg 700 17'^ 00 Carried over 1 75 00 64 ACCOUNTS 84 Brought over Paul Pry 8 T. White ash stove 6 CO 175 48 69 2 Peter Stuyvesant lo Cords Walnut Less 5 ^0 Merchandise, Cr. 8 GO 8o 4 CO oo 76 II 299 00 [The only precaution required here is to see that nothing but net amounts gets into the last column. Subtraction, such as in the charge to Peter Stuyvesant, should never be done there, for the total of everything in the column is the credit to Merchandise, and the bookkeeper in posting the debit items will look in this column for the amount to be charged to the customers. The purchase book is identical in form, — though, of course, in posting, Merchandise is to be debited and the other accounts are to be credited. Many business houses paste their bills into their invoice books as an easy way of making entries: others file their bills and for the detailed entry in the invoice book simply refer to them by number.! Special columns may be applied to the purchase and the sales book as well as to the cash book, of course ; but usually little advantage would be derived from such a device, for unless most of a firm's purchases are made from a few sellers, or unless most of its sales are made to a few buyers, the frequency of transactions with any particular house would be too slight or the number of special col- umns required would be too great. It is obvious that the purchases and the sales cannot usually be combined to advantage in one book, as are cash receipts and cash disbursements, in such a way as to show the balance on hand; for, since purchases are at one set of prices and sales are at another, the difference between totals is not the inventory. As we have already seen, not even profit or loss can be determined until the inventory has been learned by taking account of stock. As soon as our cash book, purchase book, and sales book come into use, our journal shrinks in ordinary mercantile business to small dimensions. Only items which are neither cash nor merchandise can then go thither. There is much for it to do, however; for many things, such as payment of debts by notes, discounts not given in cash, and credit for services, can go nowhere else. Since the books already described are in almost universal use in mercantile establishments, and since the number of details about LABOR-SAVING DEVICES 65 them may seem to have made a jumble of incomprehensibility to the uninitiated mind, it may be well to summarize the situa- tion as it now appears. The ultimate destination of all items, either individually or in total, is the ledger; and items get into the ledger by posting from the cash book, the purchase book, the sales book, and the journal. A compHcated transaction may involve so many parts that it must be divided, — possibly even into four parts, one for each book ; but, in any case, each part must preserve a balance of debit and credit, for no item can go into any one of these books without pre- senting in that book a debit for every credit, and vice versa. By the mere fact of appearing on the debit side of the cash book an item is debited to Cash and is credited to some other account named; for when the bookkeeper posts his books, he posts the total of the page, less the balance, to the debit of Cash and posts all individual amounts to the credit of the accounts named. By the mere fact of appearing on the credit side of the cash book an item is credited to Cash and is debited to some other account named ; for, when post- ing is done, the total of the page, less the balance, is credited to Cash and the individual amounts are debited to accounts named. By the mere fact of appearing on the purchase book an item is debited to Merchandise and is credited to the account named, for the total of the purchases is posted to the debit of Merchandise and the individual items are credited to the accounts named. By the mere fact of appearing on the sales book an item is credited to Mer- chandise and is debited to the account named, for the total of the sales is posted to the credit of Merchandise and the individual items are posted to the debit of the accounts named. On the journal, too, a debit item must have its corresponding credit, and vice versa; but both accounts are specified, as our journal now stands, for we have removed all the special columns and carried them to special books. Absolute correspondence of debits and credits is assured; and the need for this is fundamental, for, if it fails, something is unexplained, and the purpose of accounting is not only to record changes in property but to explain those changes. So far as special columns have been introduced into special books — as an Expense column in the cash book — there is no serious compHcation, for the special column here means simply that instead of posting each (A ACCOUNTS individual item, as individual items on the cash book are usually posted, these particular individual items are lumped at the end of the month. A moment's consideration will now show why double entry does not involve double work. Thirty items of sales will require how many postings ? Not sixty, but thirty-one ; thirty for the customers and one for the Merchandise. So far as we use special columns, moreover, thirty items may not require even thirty postings; for if our thirty items are cash expenses, two postings will do all the work, — one to Cash and one to Expense. An interesting complication exists in the use of both a sales book and a cash book when a cash sale is made. It is always desired that all cash should go upon the cash book; it is often desired that all sales shall go upon the sales book, simply in order that the record may be complete in one place. To enter the item under the usual plan, however, is to cause it to be posted twice to each account: for on the cash book it will be included in the total receipts and hence posted to Cash, and at the same time will be posted, as all individual items are posted, to the credit of the account yielding the cash, which is here Merchandise; and on the sales book it will be included in the total sales and so be posted as a credit to Merchandise, and at the same time will be posted, as all individual accounts are posted, to the account causing the outgo of Merchandise, which is here Cash. Thus both halves of the entry are posted twice. This, however, can be easily avoided. Suppose we in each case head off one posting. We can hardly with ease provide that the item be omitted from totals, but we can provide that the individual part of each entry be passed without posting. If at the time of entry in the cash book we check the item with a blank check mark (y/) in the posting- check column, it will not be posted thence as a credit to Merchan- dise, and if in the sales book we check the item in the same way, it v/ill not be posted as a debit to Cash. The result is that from the cash book, the item, included in totals, is posted to Cash and not at all to Merchandise, and from the sales book, included in totals, it is posted as a credit to Merchandise, and not at all to Cash. Thus is the desired duplication avoided. This sort of use of the blank check (\/) is a great convenience in many ways. Sometimes two or three accounts are kept with merchandise, LABOR-SAVING DEVICES 67 even when different classes of goods are not kept separately. One, called Purchases, is to be debited for goods purchased and to be credited for purchased goods returned. Another, called Sales, is to be credited for goods sold and to be debited for goods returned by customers. Care should be taken that goods received from cus- tomers be not debited to Purchases rather than to Sales; for then both Purchases and Sales would be overstated (Purchases finally, and at the wrong price, and Sales originally, since the goods were never sold). This division of Merchandise is an illustration of the difference between bookkeeping and accounting, for by it, though profits and property are no more accurately determined and hence the bookkeeping is no better, the ratios and percentages of sales and purchases are accurately preserved whereas by the simpler method they are confused. The third of these accounts serves no purpose but convenience. It is called Merchandise Inventory, and takes as a debit the balance brought down from the year before. Otherwise this balance would naturally go to Purchases. The ad- vantage of carrying it separately is statistical, for the preservation of the figure permanently on the ledger in a separate account makes easy the comparison of yearly stocks over a long period. The dis- advantage is that the figure must remain unchanged until the books are next closed, and the trial balance is likely to be mislead- ing with an account showing as Inventory a figure many months out of date. To avoid this possibility of confusion, the title should always bear a date, as Merchandise Inventory, January i, 191 5. So far none of our devices for labor-saving has applied to the ledger. Only one of much importance is available. A business house having a long list of customers is Hkely, from the extreme volume of its ledger, to suffer delays in taking trial balances. It is common under those circumstances to put the names of all customers into a special ledger (or as many ledgers as are convenient) and to represent the whole body of customers by one account in the general ledger, commonly called "Accounts Receivable." Such a special ledger is usually called a ''sales ledger." A similar device provides a "purchase ledger," and an "Accounts Payable" to represent it in the general ledger. The treatment of these books and these accounts in the general scheme is simple. In the first place, the total of the sales book at the end of the month, besides going to the ledger as a 68 ACCOUNTS credit to Merchandise, is posted as a debit to Accounts Receivable. By this means, with no more labor than that of making one posting, the whole body of customers is represented in the general ledger. The amount to be debited to each individual customer is posted to that individual's account in the sales ledger just as previously it was posted to the general ledger. In the cash book, too, a special column is provided for Accounts Receivable, and whereas the credits to individuals on the payment of their bills is made in the sales ledger just as previously it was made in the general ledger, the total of the Accounts Receivable column is posted at the end of the month to the general ledger, representing the whole body of customers. It may be also desirable to provide a column in the journal for Accounts Receivable, so that when bills are paid by notes or in any other way than cash, the two postings, one to the individual in the sales ledger, and one to Accounts Receivable in the general ledger, may be made without the confusion of requiring two postings from the same figure. The account called Accounts Receivable is not an absolute essential of the division of the ledger into parts, for without it the ledger would simply consist of two or more volumes. With such an account, however, the general ledger shows always, when posted to the time in question, just what sums are due the firm from customers — information which could not be obtained otherwise without fig- uring all the accounts in the sales ledger. This account, too, serves as a check or test for the correctness of the sales ledger, for the balance of the Accounts Receivable should always be the same as the balance of all the accounts on the sales ledger. Accounts of this sort are commonly called "controlling accounts." To summarize: the accounts of all customers of the firm are kept in the general ledger in a bunch, as Accounts Receivable, and the amount of each customer's share in the bunch debt is kept in the sales ledger only; similarly kept are Accounts Payable and the purchase ledger ; post- ing the bunches as totals of columns prevents extra labor from the double posting. This device of controlling accounts and subordinate ledgers is available for many groups of accounts. When expenses are much subdivided, for example, it may be worth while to have General Expense in the general ledger, and a special expense ledger for the subdivisions. Then the tendency of General Expense can be LABOR-SAVING DEVICES 69 watched daily, and reference can be made to subdivisions when necessary, without the labor of combining numerous small accounts. It is to be noted that posting to the controlling account in the general ledger is made not from the subordinate ledger, but from the same sources as the postings to the subordinate ledger: the post- ing to the general ledger is from the total of a column or group of columns in the books of original entry, and the posting to the sub- ordinate ledger is from the details of which the total is made up. So the two are parallel but made independently. This is shown in the following figures from a cash-book page : Jan. I 13 47 64 17 9 Receipts Balance Bills Rec'ble #67 Paid B. Sykes Paid invoice, 12/1 B. Patterson To bal. acct. Accts. Rec. Total Cash, Dr. Accts. Rec. 2,354 27 600 00 2,700 00 400 00 1,000 1,000 00 00 32_7oo 6,054 00 27 3,700 00 [The credits to B. Sykes and B. Patterson are posted to the sales ledger, and the total, or credit for Accounts Receivable, to the general ledger.! Since the general ledger only is included in the trial balance, the correspondence of debits and credits is not thrown out by the double posting. One comment on the whole system remains to be made. The modern passion for short-cuts must not be carried so far that the definiteness of the detailed portion of an entry, the day-book por- tion, shall be sacrificed. One illustration will suffice. Suppose a man buys, in settlement of an account, his debtor's half-interest in a piece of real estate, say worth $5000, and takes cash for the balance of the debt, say $2500. Suppose now the man buys from some one else the title to the remainder of that piece of real estate for $5000, using in part the cash received from his debtor, which pays for one half what he buys, or one quarter of the whole property. He would be very foolish to record that he had received three fourths of that property from his debtor (though he did receive one half and cash enough to buy another quarter) and had bought the 70 ACCOUNTS other one fourth from the other owner. Such abbreviation would save one entry, but it would falsify the record. If the deeds should be lost before they were recorded, and it were shown that the debtor never owned more than one half of the property in question, the buyer's books would militate against him in his claim to the whole property. They would indicate that he had bought from the last seller but one quarter of the property and had taken from his debtor what the debtor did not own. Transactions which are for any reason distinct must not be combined in a way that will destroy their identity. Often, on the other hand, good bookkeepers make entries that are known to be false in detail, though not in essential facts, if they can make the detailed explanation sufficiently clear and can save labor in the process. A good illustration of this is in connection with Accounts Receivable. Often customers are allowed discounts if bills are paid within a certain number of days. The entry of a payment of this sort would naturally involve two transactions, recorded in two books, — on the cash book a credit for the cus- tomer and a debit to Cash for the net cash paid, and on the journal a credit for the customer and a debit to Merchandise Discount. These two entries in two books mean unnecessary labor. Several devices are in use for reducing it, and the principle is worthy of notice. The simplest will serve for illustration here. Credit is given the customer for cash in the usual way, but the amount is given as the full amount of the bill before discount was subtracted, — as if the bill were paid without discount ; and then on the other side of the cash book, Merchandise Discount is debited, — usually in a special column to save frequent postings. The net result of these two entries is to make it appear that the customer paid the full amount of the bill and the cashier returned to him the discount; and this is for practical purposes true enough, especially when the customary entries explain it, as they do. An overstatement of facts when the necessary subtraction is at hand does no harm : danger lies in the understatement for which deficiencies cannot be supplied. Other methods of accomplishing the same result are given in Ap- pendix A, I. All books of original entry should be so arranged that no items can be inserted after the books are written in natural order. Thus LABOR-SAVING DEVICES 7l each cash-book entry should occupy but one line ; for if some should occupy one line and others more, figures could be inserted on the lines where no figures originally appeared. For the same reason, no blank lines should be left between cash-book entries. On the journal, the sales book, and the purchase book, however, blank lines are not only safe but desirable ; for in those each entry neces- sarily occupies more than one Hne, and a blank line, or a line used for the date only, shows separation between entries so that the eye can easily distinguish them, and yet does not allow space for a fraud- ulent insertion. For the purpose of giving a comprehensive view of the various books just described, with their rulings and footings, and of the postings from them, the pages following show the working out of a series of transactions that involve virtually all common types of entry. These are shown in a journal, a cash book, a purchase book, and a sales book, with the ledgers and the trial balance. Use is made of special columns, and of controlling accounts with special ledgers. Any one who has followed the discussions and the forms so far should have no trouble in translating the entries into trans- actions. The explanation portion of each entry in the books of original entry should make clear enough just what happened. The reader is recommended to follow the transactions chronologically from book to book, rather than to read one book as a whole. The relation between the columns for controlling accounts and the items for subordinate-ledger accounts should be observed, with the postings to both general ledger and subordinate ledger for such items. The posting of all totals — like those for special columns and for books as a whole — is worthy of attention. Though the transactions number forty-six, the postings number only fifty ; and yet double-entry is preserved, the amounts for both customers and creditors are carried to both general ledger and subordinate ledger, and the number of transactions is too small to illustrate the full effect of the labor saving. It should not be supposed that the forms here shown are typical of the best forms in common use, for such forms are complicated not only in arrangement but in content. These forms are given simply to illustrate the fundamental principles of the special col- umn and the special book. If attempts were made to show virtu- 72 ACCOUNTS ally every type of development of these principles, as found in mod- ern bookkeeping practice, the task would require many volimies. In Appendix A, Part I, will be found a considerable number of such developed types, suggesting the application of the most common and the most serviceable devices. p_ >"* lo Co <> V c* r>. bO •c . M 00 n 73 1- ii =0 CO ^ LABOR-SAVING DEVICES 8 73 88 §1 8-2 < ^ Oh 8 88a 8 10 d d »^ d t^ 00 00 c> fo 00 q^ 0.0^ 0^ f Id 3. ^ s 1 88S, as to Si 88" cl d cl 51 c 4J ^ »o H 2 On cT i^ t 2 • Pt« ^~ ^ ^ 0.. '5. 1* § >% 4> .. « rt M r^ PO .2 h« •^ S S3 b^ ^ .U ^11 U- S 2 a-2 d It 04f 3 To Interest U. S. Grant Business begun to-d besides cash, the and the following n #1 1 due Sept. i, f 2 '* Aug. I, 3 " July 16. >> i g To Bills Payable Accepted his draft, his invoice credit Bills Receivable To P. H. Sherida Our draft on him, i N \0 C*5 H fO CI s2 •^ M vO NO ;g§8 1 74 ACCOUNTS 88 I a 888 8 CO l§8 1 8 8 a Ui ^ 8 88 8 8 s| § §§ 8 8 P^ fO rt M M On ^3 ^1 8 d O.OO o.oo 8 O i^-s o >o • "'3 cPh ^33 IS « 2 2 y^ £3 . 3 ^ Q Ph P^ .^ Pij Pi i: Ph ^. is ^^P^ ^P^ !=j S S ^5 S § ^ m ;S d Ji t-^m ►-^S < u h\ vO \ "VX, -^ ^cc \ O \ O V M M H M C* 3 'III LABOR-SAVING DEVICES 88 8 8 8 88 8S88 w 4-» S 8 ;s 00 S 4) o PO M lO C3 lO M o 1— I 88 8 8 8 8 8 O O CO »0 O ^ g 8 8. M Ci tn 4) 8 3 8 ^1 8 8 ^^ N •* o M M 8« n ^ 1-1 OJ •« •s S s Si §"- t! c tfl 2 i1 - ^"^^ "TS >>< O c*=5 o « 9* w o B '-J Oc/20 4> o *-■ -Z^ o cj a, b£ o p^ -4-) >^ - o £J 2 ^ 3 S2^ ^^ y % = «^ c '^dfj^ g-Q c ol^ggssi i Q^+j rt a'g c 2 o 5 W PL. c^ U c^ C O U H H ^ % C3^ s s *3 '3 r2 WW g (U >% >. D ^ S <^ "" C 0) 6 -WQQW<^^:^h5«h^W^Wp:!::)^^^W< U CQ a»»^s>^^»> >>2 \ M vo O O ^ rOO CO x/^oo O M c* 76 ACCOUNTS 1 60 164 166 160 80 so PURCHASE BOOK July 2 W. S. Rosecrans 10 days 100 doz. #124 28.00 2800.00 100 doz. #114 52.00 5200.00 2 Cash (J. Hooker) » [Details should be shown as above or by invoice number] S (Cash) 2 A. E. Burnside [Details] J. Longstreet [Details] Cash [Details] 9 10 days II (G. G. Meade) W. S. Rosecrans [Details] Accounts Payable, Cr Merchandise, Dr. 30 10 days Accounts Payable [page i] Sundries 8,000.00 12,000.00 14,000.00 2,000.00 6,000.00 12,000.00 36,000.00 36,000.00 54,000.00 * The name is given here for memorandum purposes only. Compare this entry with the next. • Here, though the purchase was for cash, credit is given to the seller so that the item can be indexed ander bis name. He is debited on the cash book. The preceding purchase does not get indexed. LABOR-SAVING DEVICES 77 SALES BOOK 162 168 170 16 V 168 170 88 50 Julys p. H. Sheridan 30 days 50 doz. #103 13 G. B. McClellan 10 days [Details would be shown] 15 J. E. Johnston 10 days [Details] 28.00 Bills Receivable [Details] Cash [Details] Cash [Details] G. B. McClellan [Derails] 16 (W. S. Hancock) 17 (T. J. Jackson) 24 (G. H. Thomas) 30 30 days J. E. Johnston [Details] Accounts Receivable, Dr Merchandise, Cr. 30 Cash and 30 days ^ Accounts Receivable [page i] Sundries 1,400.00 1,150.00 400.00 1,000.00 1,000.00 1,200.00 600.00 2,400.00 4,950-00 4,950.00 9,150.00 * See Dote on this item in the cash book. 78 ACCOUNTS LEDGER July 25 Cash 29 " U. S. Grant 2* 15000 July I [ Sundries 2 300 00 Cash [page 2] I 39,987 50 I 30,000 00 July 31 1 Sundries Cash I I II 62,634150 III July 31 I Sundries [page 10] I 2 II 56,395(20 Bills Receivable July I I U. S. Grant 16 Merchandise 26 P. H. Sheridan July 31 I Cash July I I U. S. Grant 22 Cash July 31 I Cash I 10,000 00 July 31 I 1,200 00 I 1,400 00 July 3 I Cash Bills Payable 8,000 July 9 10 18 Cash W. S. Rosecrans Cash Cash Real Estate 30,ooo|oo |l| 6oo|oo III Interest 65I20 III July I July 31 I Sundries | i Sundries 10 I Cash Rent I III July 22 I Cash Merchandise 54,ooo|oo III July 31 1 Sundries July 31 I Cash July I I Cash July 31 I Sundries 31 I Cash July 31 I Merchandise j i Expense 790I00 III Furniture & Fixtures 2 II i,ooo|oo III I Accounts Payable 1 II 8,ooo|oo III July 31 I Merchandise 2 II 26yOOoloO III I Accounts Receivable 4,95o|oo III July 31 I Sundries I III 31 I Cash Delivery Equipment 2 II i,ooo|oo 2 II I30I0O I 8,000 I 10,000 I 8,000 [page 16] 9,400 [page 24] 00 00 00 [page 32] [page 36] I2|50 34150 [page 44] 200I00 [page 50] 9,i5o|oo [page 60I I [page 70I I [page So] 36,ooo[oo [page 88] i,40o|oo 2,000)00 [page 96I » It is not usually necessary cash items must come from the to designate the book, for the explanation makes that obvious ; e.g, cash book, and debits by merchandise from the sales book. July 8 I Cash July 24 [ Cash LABOR-SAVING DEVICES Wages I 2 II 160I00 111 I |2 Profit & Loss 200|00 III I 79 [page 104I I I [page 120] July 5 I Merchandise | i July 13 I Merchandise 30 I July IS I Merchandise 30 July 5 1 Cash July 19 ! Cash July 9 I Bills Payable | i SALES LEDGER P. H. Sheridan [page 162] II i,4oo|oo III July 26 I Bills Rec. | i || i,4oo|oo G. B. McClellan [page 168] 11 i,i5o|oo III July 23 I Cash I i || 1,150100 11 i,ooo|oo III I I II I J. E. Johnston [page 170] II 4oo|oo III July 25 I Cash | i || 400J00 II i,ooo|oo 111 30 I " I I II 450I00 PURCHASE LEDGER W. S. Rosecrans [page 160] II 8,ooo|oo III July 2 I Merchandise I i || 8,ooo|oo II I III 30 I " 1 I II 2,ooo|oo A. E. BuRNSiDE [page 164] II i2,ooo|oo III July 5 I Merchandise 1 i || i2,oooioo J. LONGSTREET [page 166] I 2 II i4,ooo|oo III July 9 I Merchandise | i || 14,000:00 The general ledger gives the trial balance as shown below. It will be noted that no figures from the sales ledger and the pur- chase ledger appear in that trial balance. The controlling ac- counts, Accounts Receivable and Accounts Payable, cover the same ground as these items. For assurance that proper debits and credits have been made to the accounts in the special ledgers, how- ever, an abstract of each ledger is taken and the total is compared with the corresponding controlling account which enters into the general-ledger trial balance. If the amounts correspond, obviously the subordinate ledger accounts are as well proved to be correct as if they themselves entered into the trial balance. So ACCOUNTS Trial Balance Dr. Cr. U. S. Grant $69,537-50 Cash $ 6,239.30 Bills Receivable 3,200.00 Bills Payable 18,000.00 Real Estate 30,600.00 Interest 18.20 Rent 200.00 Merchandise 44,850.00 Expense 790.00 Furniture & Fixtures 1,000.00 Accounts Receivable 1,550-00 Accounts Payable 2,000.00 Delivery Equipment 1,130.00 Wages 160.00 Profit and Loss 200.00 $89,737-50 • $89,737.50 Abstract of the Sales Ledger Dr. G. B. McClellan $1,000.00 J. E. Johnston 550.00 Trial Balance (Accts. Rec.) $1,550.00 Abstract of the Purchase Ledger W. S. Rosecrans Trial Balance (Accts. Payable) Cr. $2,000.00 $2,000.00 PART TWO THE PRINCIPLES OF ACCOUNTING CHAPTER SEVEN THE DISTINCTION BETWEEN CAPITAL AND REVENUE Perhaps the easiest way of stating the difference between book- keeping and accounting is to say that the purpose of bookkeeping is to show debts, both those due by the owner of a business and those due to him, and the purpose of accounting is to show profits, losses, and valuations. Nobody is likely to think that he now has what he never had, but a business man is constantly likely to confound what his business once had, but no longer has, with what it still has. The fundamental purpose of all accounting processes is to provide against such confusion; and just here, more than anywhere else, does the average business man fail to get from his books what he thinks he is getting. As a part of the same confusion, though the connection is not always obvious, is the ignorance of costs and returns. Good accounting will show as nearly as possible the cost and the return from every appHcation of force and from every change of methods — in service, as in mercantile affairs, and in transportation, or in pro- duction, as in a factory. In Chapter IV of Part I, two sorts of internal accounts were de- scribed, the real and the nominal, or, as they are sometimes called, property accounts and explanation accounts; and in Chapter V emphasis was laid on the fact that in determining profit for the year it is of vital importance to distinguish between these two sorts. This was shown by carrying out the six-column statement so that figures of the one sort were extended into the columns devoted to resource and liability, and those of the other into the columns devoted to loss and gain. These are mere bookkeeping expressions with which the average business man has Uttle occasion to deal, but every man en- gaged in business affairs must, at some time or other, deal with these things whether he calls them by any name or not. For example, most corporations report their business under the head of two state- ments, the first of which is commonly called the "balance sheet," 84 ACCOUNTS and the other the "income sheet," though each is sometimes called by other names. The balance sheet is simply a statement of re- sources and liabilities/ or property and claims (both favorable and unfavorable) ; and, consequently, it shows the solvency of the busi- ness. The income sheet, on the other hand, shows earnings and expenses for the year just passed, that is, the sources of gain and the kinds of cost or loss. The balance sheet accordingly represents the real accounts as they stand at the end of the year ; and the income sheet shows the explanation of the changes in solvency, so far as profit and loss have produced them, during the year. The balance sheet gives a summary view of the situation at a definite moment of time : the income sheet gives a summary story of the last year that produced that situation. These two statements correspond exactly with the two sets of columns on the six-column statement into which the trial balance is extended. If, then, one desires to determine the solvency of a business, one must turn to the balance sheet ; but there one gets no information as to earnings or expenses. If, on the other hand, one wishes to determine profits, one should turn to the income sheet ; but there one can get no information as to ultimate solvency. There is, nevertheless, one common element between these two sheets ; this is the figure of profit or loss still remaining in the business as an element of solvency. If, for example, the business has been accumu- lating a surplus of io% a year for five years as shown by the last five income sheets, the last installment of it will appear on the income sheet accompanying this year's balance sheet, and will also be in- ^ Some accountants favor making a distinction between a balance sheet and a statement of resources and liabilities. In their practice, a balance sheet would repre- sent figures taken directly from the books without allowance for possible or theoretical shrinkage in values, whereas a statement of resources and liabilities would show re- sults after such allowances had been made. No exception can be taken to such distinc- tion, and it is indeed desirable that it shall be not only made but published in the form of the two tables. When but one of these two tables is published, however, it is desirable that the balance sheet, rather than the statement of resources and liabilities, shall be chosen. The advantage of this is suflBciently illustrated by the case of Bills Receivable, which must appear on a true balance sheet at the face value of all the notes, but must usually appear on a true statement of resources at a lower figure. The objection to a publication of the latter rather than of the former is that, since the valuation is determined by judgment, and since no two men may judge quite alike, the arbitrary valuation may not be so satisfactory as a piece of information for the intelligent reader as would be the face value of the notes themselves. This is further discussed in the next chapter. DISTINCTION BETWEEN CAPITAL AND REVENUE 85 eluded in the surplus, which appears upon the balance sheet as one of the liabilities of the corporation to its stockholders. We have this common element because the year's transactions as shown by the income sheet have resulted in the situation shown for one mo- ment of time on the balance sheet. Thus it is obvious that no confusion can be permitted between items which are to appear upon the balance sheet and those which are to appear upon the income sheet ; for if such confusion is allowed, what was once had is confused with what is now had. Only the bal- ance sheet represents the present condition, whereas the income sheet represents the transactions which produced that condition but ceased to have independence as soon as they were completed ; for all tangible results can be measured in the tangible items of the balance sheet. In accounting parlance, entering transactions so that they shall appear upon the balance sheet is called "charging to capital," and entering them so that they shall appear upon the income sheet is called "charging to revenue." Perhaps this can best be illustrated by a few examples. Suppose we are the owners of a building. It has been in use as a bowling alley, a skating rink, or a riding school, and the movement of business and population requires that in order to serve good tenants it shall be cut up into various stores. The building is re- modeled, and the question arises as to what account shall bear the charge for remodeling. The exact title of the account is not here of importance, but whether it should be charged to revenue or to capital is a matter of the greatest importance. Let us assume, for the purpose of making our illustration clear, that the alternative is simply charging to Rent or to Real Estate.^ The real estate account, representing property, should represent on the books the value of the building. The rent account, on the other hand, since it is nominal, should show the earnings from rental less any deductions that may be necessary to secure that rent. It is fairly obvious that under the conditions named the cost of these alterations should be charged to ^ It is intended to use initial capitals for the names of ledger accounts, without using the word "account." The expression "real estate," therefore, means in the following pages the actual property; but the expression "Real Estate" means the ledger account of that name. When, for any reason, it happens to be desirable to use the word "account" in connection with a ledger account, capitals will not be used. 86 ACCOUNTS Real Estate and not to Rent, for the improvement is intended to be permanent. Now let us suppose that after one of these stores has been let for a year the tenant moves. Another man offers to hire the store if we will take out the windows and substitute others adapted to his particular business, and he refuses to hire unless we make the change. Suppose again we charge to Real Estate, on the ground that the property is improved. In the course of time this tenant moves ; and, in order to let the building again, we are forced to replace the old windows. Here, clearly, the question might arise as to which account the alteration should be charged to ; but let us suppose that on the principle that the alteration makes the building worth more for present purposes than before, the charge is made to Real Estate. Now, in course of time, business has left that section of the city. Small shops succeed large stores. We cut the old store into several small shops and charge to Real Estate. At the end of this year the tenants move out, and we can let the property again by removing the partitions. We make the change and, as before, debit Real Estate. So the thing, let us suppose, is repeated indefinitely. Each year we make some change and the next we undo what we had done. Each year we charge Real Estate for improvement in the property, making it each time rentable. What is the result ? Our books show a stead- ily increasing charge to Real Estate, and yet the property is pre- sumably even less valuable at the end of the time than at the begin- ning. Clearly this is bad accounting, and the fault lies in the fact that some of these alterations were not permanent improvements, but were mere costs of getting rent. They were expenses or loss, in- curred in the process of earning rental. They should have been set against that rental and not considered as additions to our property. Though ordinarily it would be desirable to distinguish between de- ductions from rent and alterations to secure rent, for our purposes here we may disregard such distinction, since both are charges against revenue, and say that the charges for alterations, in most of these cases, should have been made to Rent. They were proper charges to revenue, and not to capital account. In other words, at the end of the year, they should have been extended on the six- column statement not into the resource column, but into the loss column. They should go not upon the balance sheet as resource, but upon the income sheet as expense. They should not be counted DISTINCTION BETWEEN CAPITAL AND REVENUE 87 as investment, or capital, but should be taken out of earnings, or revenue. The last problem was concerned with determining to which of two accounts an item should be carried. Let us take another sort of case. Suppose you are engaged in the ice business and have on your ledger an account with a certain ice house, charging that ice house with the cost of ice put in. At the end of the year that ice, con- sidered on hand ready for the next season's business, is a resource, and is naturally carried into the balance sheet under the title, we will say, of "Silver Pond Ice." Now suppose that in the spring, before the season has opened, a fire destroys the house, and, in con- sequence of the heat and the exposure, the ice is destroyed.^ What entry need be made upon the books? Clearly no entry becomes necessary if, in closing the books at the end of the year, you realize that that Silver Pond Ice account is no longer a real account, but has become, by force of circumstances, nominal. It will then be carried on the six-column statement into the loss column, and, what is the same thing, will be carried into the income sheet as one of the losses rather than into the balance sheet as one of the re- sources. In other words, the same account may represent an item upon either sheet, and its ultimate destination will be determined by the particular thing it represents at the time the sheets are made out. On the books there is no difference in appearance between a revenue account and a capital account. It is only in interpreting the figures at the end of the period that any distinction need be made, and then the interpreter must know exactly what the account at that moment represents. Let us take a third sort of case. You are the owner of a quarry, and preparatory to getting out rock it is necessary to remove ''top," that is to say, get off the loose earth which covers the valuable stone. Suppose, for purposes of our illustration, that it is convenient to re- move, before any excavation is begun, all the top from the bed of rock to be quarried. Suppose it is known that this particular bed of rock will last for four years. At the end of the first year how shall the cost of removing top appear upon the books? Clearly the removal of top is an expense and must go ultimately into the income sheet. It is a cost of obtaining revenue and therefore chargeable to revenue account. Yet three fourths of the cost is as yet unutilized and is con- * This illustration is repeated from Part I, page 12. 88 ACCOUNTS sequently a resource for the future. At the end of the first year, therefore, thiee fourths of this cost may be counted as a resource, and may appear upon the balance sheet ; whereas the remaining fourth, chargeable to the revenue of that year, must appear upon the income sheet. Suppose, now, to make our illustration a little more service- able, the bed of rock is of a peculiar formation, so that in three of the four sections into which the bed may be divided there are known to be three hundred thousand tons of rock each, whereas in the other section there are known to be but one hundred thou- sand tons, and the section containing the one hundred thousand tons is that removed in the first year. 100,000 Tons 300,000 Tons 300,000 Tons 300,000 Tons At the end of the year how shall Top-removal stand on the books ? Clearly, one fourth of it has been consumed in getting out but one tenth of the total amount of rock. Is it chargeable against one quar- ter of the rock or against one tenth? That is to say, shall we take for our basis of depreciation the total utilization of top-removal, or shall we take the amount of rock quarried by means of that utiliza- tion ? Shall Top-removal be included in the balance sheet as if the fraction still serviceable were three fourths or as if it were nine tenths ? Still further information is necessary to enable us to deter- mine this fraction. If in order to reach the rock in the three larger sections it were necessary to remove the top covering all four sections, the top-removal now utiKzed (that over the small section) would be a direct cost chargeable against the full one million tons ; that is to say, only one tenth of its serviceability would have been consumed and nine tenths would remain. If, on the other hand, the top over the small section has nothing to do with quarrying in any other section, as is of course probable, one fourth of the top-removal has been utilized and only three fourths of the total cost can be con- sidered an asset. So in one case the balance sheet will include nine tenths of cost of top-removal among the assets and the income sheet one tenth among the expenses, and in the other case the assets will include but three fourths and the expense will be one fourth. This difference is of more importance than may at first appear. One can- DISTINCTION BETWEEN CAPITAL AND REVENUE 89 not be sure, just because it will pay to remove the top over one of the larger sections, containing three hundred thousand tons of rock, that it also will pay to remove the top over the smaller section. It might indeed happen that the proceeds from the smaller section prove not enough to pay for the removal of top over that section. If that is the fact, the books should show it. Otherwise, the books are failing in one of the first purposes of all accounting, namely, to show not only what is the absolute profit or loss, but also the source from which each portion comes. Any failure to charge cost against the particular revenue for which it is incurred sacrifices information that may prove of great value. It is obvious, from the three illustrations that have been given, that it is not always possible in making entries of cost or loss to treat them so that at the end of the year they shall be known at a glance to be exactly either revenue or capital. Allowance must usually be made. Nothing can be valued with permanent certainty. Even those things in business which seem most unchanging are subject to fluctuations, especially to depreciation. Even a stone building is worth less as the years go by ; and, therefore, allowance must be made each year for some depreciation. It may seem that, if in the end so many allow- ances must be made, it is hardly worth while to attempt in the origi- nal entries to distinguish very exactly between revenue and capital. Some one may say if the allowances have got to be made at the end of the time, the original labor of distinguishing day by day may as well be saved. The answer is that the more carefully distinction is made day by day as original entries are made, the more largely is the labor of making allowances at the end of the year reduced to a mini- mum. The accounts should be so kept that they throw the greatest: light possible upon the probable depreciation of each kind of pro- perty. It is obvious, however, that even with the most complete set of books at one's disposal, if one does not know what each ledger account represents one can tell nothing of how the business stands at any particular time. A cost account means a certain thing with one corporation, but may mean a different thing with another. One must know the business significance in each particular case. The presumption always is, however, that, unless something is known to the contrary, certain common accounts stand for certain definite things : that is to say, Rent, Interest, Wages, Commission, Insurance, 90 ACCOUNTS etc., are revenue accounts; and Real Estate, Bills Receivable, Accounts Receivable, and Merchandise are capital accounts. Roughly, we may say that whatever is expected to exist as an asset at the end of the current earning period should be charged to cap- ital, and whatever is expected to be consumed during the earning period should be charged to revenue. This means, of course, that expenditures which contribute to assets, even though the direct result of the expenditure seems to disappear immediately, should be charged to capital. The wages of a night watchman engaged in protecting a building under construction, for example, are charge- able to capital, though apparently no atom of value is added by his attention; for his task is to protect from theft the value already pro- duced, and since society is so constituted that this is an essential of production, its cost is a capital charge. So far, expense and loss have been mentioned only in connection with some particular year's business, — that is, as if they could go only into the loss column of the six-column statement and into the income sheet. It is possible, however, to take the loss out of the earnings of no particular year. If the loss has been inevitable and general, touching the business as a permanent institution and not simply as a momentary thing, the charge may well be made to some account representing accumulated profits of the past. That is, the charge would be made not to some account that is closed out at the end of the year to Loss and Gain, and thus extended into the income sheet, but directly to the general profit and loss account or other undivided profits account that never appears on the income sheet; thus it would not appear anywhere in the expenses of the particular year in which it occurs. Illustrations of proper cases for such treatment would be the cost of repairs after an earthquake, and rebuilding after an ex- tensive conflagration such that insurance companies were not able to meet their Uabilities. A word of explanation of such charges should be given in the annual report, preferably in the form of a statement of changes in Profit and Loss, or in Surplus. A similar principle applies to gains. If property other than mer- chandise (which is goods bought for sale) is sold at a gain, the gain is not usually either a gain of the period in which the sale was made or properly a revenue gain of any period. If, for example, a fac- tory outgrows its quarters and sells its real estate at a gain over DISTINCTION BETWEEN CAPITAL AND REVENUE 9I cost, because of changes in demand for real estate, the gain does not arise from doing business, and hence is not a gain of revenue : the capital of the business has increased independently of operations connected with the function of the business; so the gain should not appear on the income sheet but among the changes in Profit and Loss or in Surplus. Gain on owned stock and bonds sold, when dealing in stocks and bonds is not a part of the business, is of the same nature. Premium on bonds and stocks issued, however, is not properly a gain at all, and hence is not so treated: it will be dis- cussed later. Capital gains are not usually distributable as divi- dends. Unless they are so distributable — both as a matter of law and as a matter of policy — they should be credited not to general Surplus, but to a special Capital Surplus account. Otherwise divi- dends may be inadvertently declared from them. Below will be found figures from a report of the United States Steel Corporation. Balance Sheet Assets Liabilities Property (Real estate, Capital stock $868,607,000.00 plant, etc.) $i ,353.907,945-68 Funded and mortgage debt 566,388,375.96 Mining royalties, etc., paid Current liabilities 43,672,009.34 in advance 1,772,621.94 Special funds 104,921,669.74 Investments (outside real Surplus 97,720,714.35 estate, etc.) 1,617,351.29 Special funds 27443,944.60 Current assets (inventories, cash, claims, etc.) 266,567,905.88 ,681,309,769.39 I 1,681,309,769.39 Income Sheet Gross receipts from production I $696,756,926.01 Producing costs, including maintenance 517,083,955.02 Administrative and selling costs 18,551,552.75 535,635,507.77 Net receipts from operations 161,121418.24 Other income 9,159,863.74 Gross income 170,281,281.98 Taxes 4,356,126.36 Interest 29401,328.68 33,757455-04 Net income from operations 136,523,826.94 Less profits between departments, not yet realized by the combined business 2,739403.74 133,784423.20 Appropriations for sinking fu nds, extraordinary de- preciation allowance, etc., 35,655,836.26 Available for dividends 98,128,586.94 Dividends 35,385,727.00 Surplus for the year 62,742,859.94 92 ACCOUNTS It is to be noted that all items appearing on the balance sheet are either property (or claims) of the corporation or liabilities incurred by it in acquiring that property. The items on the income sheet, on the other hand, represent no property : they all once involved pro- perty, but that property has now ceased to be identified with income or costs, and is registered among the assets or the liabilities; the income sheet shows whence property came or whither it went. In very few cases, of course, do items on the income sheet represent accounts of the same name ; for usually so many cost accounts are kept, for purposes of detailed study, that combinations must be used to show general conditions. Even condensed balance sheets, like that presented above, are usually made up of detailed accounts combined to show things in the large. It is often convenient, in order to show the exact relative condi- tion of all matters pertaining to income, to give separately five condensed statements — supplements to the general income sheet. The first two show the elements of principal income; the third shows the make-up of total income; the next shows the disposi- tion of income; and the last shows the condition of the surplus. They are illustrated below. INCOME STATEMENT Merchandise Account Inventory, Jan. i, 1915 $ 40,000 Sales $187,000 Purchases 150,000 Inventory, Dec. 31, 191 5 30,000 Gross profit, to Trading Account 27,000 $217,000 $217,000 Trading Account Rent $ 3,000 Merchandise, gross profit $27,000 Wages 10,000 Conamissions earned 3,000 Insurance 300 Depreciation 1,000 Advertising 2,000 Losses from bad debts 1,500 General expenses 2,700 Net trading profit to In- come Account 9,500 $30,000 $30,000 DISTINCTION BETWEEN CAPITAL AND REVENUE 93 Income Account Taxes on investments $ 100 Trading profits $ 9,500 Net income, to Disposition Miscellaneous profits 500 of Income Account 11,900 Interest on investments 2,000 $12,000 $12,000 Disposition of Income Profit-sharing distribution $1,900 Net income $11,900 Dividends 8,000 Balance, to Surplus 2,000 $11,900 $11,900 Surplus Account Loss by fire, not chargeable Balance, Jan. i, 191 5 to the year $ 3,000 Surplus for year Balance 17,000 Gain on bonds sold $17,000 2,000 1,000 $20,000 $20,000 Balance $17,000 It is convenient actually to have on the books a Trading Ac- count, an Income Account, and a Disposition-of-Income Account, and to close to them, rather than to general Profit and Loss, the other accounts related to them as above shown, and finally to close these accounts themselves. Then the statements are preserved on the books, and comparisons between years are easy. Many persons not familiar with ledger accounts are puzzled by the debit and credit arrangement and prefer an ordinary addition- and-sub traction form. That form is shown below for the items given above. 94 ACCOUNTS Income Sheet Sales $187,000 Inventory, Jan. i, 191 5 $ 40,000 Purchases 150,000 Cost of goods handled $190,000 Inventory, Dec. 31, 191 5 30,000 Cost of goods sold 160,000 Gross merchandise profit $27,000 Commission 3,000 Gross trading profit $30,000 Rent 3,000 Wages 10,000 Insurance 300 Depreciation 1,000 Advertising 2,000 Losses from bad debts 1,500 General expenses 2,700 Expenses 20,500 Net trading profit $9,500 Miscellaneous profits 500 Interest on investment 2,000 Taxes on investment 100 1,900 Net income $11,900 Profit sharing distribution 1,900 Dividends 8,000 9,900 Surplus for the year $2,000 Surplus Jan. i, 191 5 17,000 $19,000 Loss by fire, not chargeable to the year 3,000 Gain on bonds sold 1,000 2,000 Surplus Jan. i, 19 16 $17,000 CHAPTER EIGHT THE GENERAL PRINCIPLES OF DEPRECIATION The last illustration in the preceding chapter showed that in treat- ing depreciation one is concerned not chiefly with a choice between different accounts when an entry is originally made, but with the length of time the value shall remain charged to capital account. Allowing for depreciation is usually called, in technical terms, "writing off." The expression means simply that the valuation formerly on the books is displaced by a new and smaller valuation. This expression is used whether the change is made by simply re- valuing the original account by the method shown in Chapter V, page 49, or through a depreciation account, as shown in Appendix B, II. The converse of "writing off" is "writing up." This expression means simply that the valuation set upon the property has been in- creased and is carried forward as a new valuation. It is hardly likely to be done through the medium of another account, unless one wishes to open an account called "Appreciation," and it is, therefore, man- aged simply by bringing down a new valuation, as shown in Chap- ter V. We have already considered the principle of depreciation as shown in its simplest type, and we must now see some of the particular forms in which it may appear. The method of handling it will de- pend upon the circumstances under which it occurs. There are three main policies of treating depreciation, and one or more of these three is adapted to every conceivable case. The three policies are these : first, allowing the property to wear out or go to decay without re- placement, on the theory that no use will ever again be had for its like; second, keeping the property up to the original standard by frequent repairs and replacements but without special provision for future replacements; third, allowing depreciation to continue to a certain point and accumulating, in the mean time, special funds to be available for replaceijient at whatever time it shall become 96 ACCOUNTS necessary. Let us see how these three forms will appear in account- ing. The first, allowing the property to wear out without provision for replacement, can be good business poUcy under only one condition, namely, if the business, or that department of it, is to be abandoned. In such a case poUcy requires full benefit to be got from the plant without large cost for renewal and repairs. The property must be exhausted as thoroughly as possible. An easy method of treating depreciation under such a condition would be to distribute to stock- holders all net receipts. If that is done, stockholders get all they are entitled to, and when the business is exhausted the profits stop and the capital is gone. If the capital was originally wisely invested and has been properly employed, the stockholders will ultimately receive back their original investment in the final winding-up of affairs ; for if the business could have replaced the worn-out plant — as it could if prosperous — it can pay the stockholders as much as re- placement would have cost, which is, of course, practically the origi- nal capital.^ The thing works automatically; but since, as a matter of fact, the stockholders are getting their capital handed back to them piecemeal, they must be informed that the dividend is not all profit, or they may be sadly deceived and led to consequent extrava- gance and ultimate loss. Careful accounting should show that a part of each dividend of this sort is not earnings, but is simply capi- tal returned because the business has no further use for it. The common type of this sort of thing is found in mining and quarry- ing. Properties like ore beds, which are exhausted in the process of earning profits and cannot be replaced by maintenance, are com- monly called ''wasting assets." It will pay to examine at this point, for the principle is funda- mental, the origin of the property paid to stockholders as return of their capital. The original assets are converted, by the processes of business, into other types of assets, and either these later assets may be reconverted into the original type, providing repairs and ^ Of course fluctuations may occur in costs between the time of original investment and the time of exhaustion, and in any particular case the capital may not be restored; but the price of commodities cannot ordinarily and permanently fall so low as to fail to supply replacement funds for goods manufactured under proper conditions; or else manufacturing would not pay. THE GENERAL PRINCIPLES OF DEPRECIATION 97 replacement, or, as in the case of wasting assets, the particular business activity must cease. We may go so far as to say that the original assets, machinery or ore-beds, for example, have become, through the processes of wearing out or excavation, textiles or metal, perhaps, then debts of customers, then cash. At this stage of the process, the Hst of assets will show less machinery or ore, and more cash. The books of account, if they are to tell the truth, must register this change. The thing to note here is that the pre- servation of the original investment, if to be provided at all, must come out of the product of the business. There are no profits at all if the product is not sufficient to pay all running expenses and still leave free assets equal in value to the original capital that has been consumed. If, then, on our income sheet, we treat the destruction of original capital as a cost of business, and on our balance sheet deduct that destruction from the previous value of our machinery or ore-beds, we shall have what is desired on our statements. The obvious entry is to debit Profit and Loss (or Depreciation, a sub- division) and credit Machinery, or Ore-beds. The property that now takes the place of the machinery, or ore-beds, is not recog- nizable on the balance sheet, of course, as a substitute for the ex- hausted original property, — at least from any entry which we have yet made: it looks just like any other assets. The cash that came as return from the labor of workmen is just like the cash that came from the exhaustion of property. Only our nominal, or ex- planation, accounts can tell us how much of our assets owes its origin to labor and how much to exhaustion of property. In other words, if we wish to know where is the property that takes the place of the exhausted original property, our answer is that it is scattered through our general assets — into which the original property has been in part converted. Of course, then, so much of the general assets are available, if we care to use them, for returning to stock- holders that part of their original capital for which there is no further use. This may be done by (Plan I) reducing stock, by (Plan II) buy- ing stock in the market (if allowable by law), or by (Plan III) ac- cumulating a fund for ultimate redemption. Under the first of these plans, no new account will appear on the balance sheet; ulti- mately assets and liabilities will go down together. If we assume 98 ACCOUNTS that we started with Plant at $90,000 and Capital Stock at $100,- 000, we should have during the process of business a shrinkage of Plant to possibly $80,000, with an increase of other assets by $10,- 000, and then a loss of the $10,000 of other assets and a shrinkage of Capital Stock to $90,000 — giving finally the figures shown in the table below. The second plan would be similar except that Treas- ury Stock as an asset would be substituted for a reduction of Capi- tal Stock as a liability, — which is the same as saying that the only change from the original condition is a substitution of Treasury Stock for $10,000 of Plant. Under the third plan, the $10,000 would be placed in a separate cash fund, and hence would be created out of the general assets into which the original investment had been converted. These are shown in tabular form below. Balance Sheets Assets Liabilities First year — All plans Plant 90,000 Capital Stock 100,000 Second year — Plan I Plant 80,000 Capital Stock 90,000 Second year — Plan II Plant 80,000 Capital Stock 100,000 Treasury Stock 10,000 Second year — Plan III Plant 80,000 Capital Stock 100,000 Retirement Fund 10,000 Income Sheet All plans Depreciation (included in operating expenses, or, better, given sepa- rately as an element in such expenses) 10,000 Now we are ready for our second sort of policy in the treatment of depreciation. In this, replacements and repairs are made as they may become necessary to maintain the original standard, and no effort is made to provide funds for future replacements or repairs. This used to be the policy of railroads. Railroad property comprises so many parts — depreciating at so many varying rates, and most of the parts, such as cars, rails, ties, bridges, etc., lending themselves readily to exact repairs or complete replacement — that the neces- THE GENERAL PRINCIPLES OF DEPRECIATION 99 sary repairs or replacements in any one year are likely to measure fairly well the average rate for all years. It is obvious that under such circumstances, with intelligent and careful daily bookkeeping, depreciation to great extent takes care of itself. The property ought to be in as good condition at the end of the year as at the beginning; and, if it is so, a debit to revenue of the cost of repairs and replace- ments is all that is necessary to make the books tell the truth. Obvi- ously this treatment of depreciation cannot appear on the balance sheet. The balance sheet does not represent the transactions of the year except as those transactions produce results that last into the new year and affect resources and liabilities. Repairs and replacements, since they have simply maintained the old status, cannot show on the balance sheet. On the income sheet, however, they must be included among the costs or expenses of conducting the business. Under the third policy of treating depreciation, repairs are pre- sumed to be unable to maintain the property at its original standard. For example, many buildings used for manufacturing purposes depreciate rapidly under the influence of steam, jar, and chemicals, and cannot be maintained by economical repairs. A manufacturing corporation having such buildings, since it cannot keep them re- newed by ordinary or even extraordinary repairs, must naturally replace them. It may chance that two buildings may need to be replaced in one year and that for five following years no other may need attention. Clearly, that one year should not sufifer a charge to revenue of the cost of the two new buildings and leave five years to escape without any such loss. Bookkeeping of that sort would be almost as deceptive as would charging the new buildings to Real Estate. There was as much depreciation in each of the six years as in the one. The proper method is to charge depreciation each year with a fair proportion of the wear and tear that is not offset by repairs, and to lay aside or retain in the business from each year's income an equivalent sum as a depreciation fund. This fund must be available whenever replacement becomes necessary. This policy will show, or have effect, upon both the income sheet and the balance sheet. The depreciation would appear on the in- come sheet as among the losses or expenses. On the balance sheet, it may appear in either of two ways, or not at all. If (Plan I) the fund lOO ACCOUNTS is set aside in property, Real Estate and Plant would have been written off, and among the other resources would appear an item of Depreciation Fund for the amount of money set aside. In prin- ciple, this case is similar to that discussed above, on page 97; the difference hes in the fact that this stops a little short of that. The assets derived, by natural process, from wearing out the fixed prop- erty — machinery, for example — are not returned to the stock- holders as unnecessary for business purposes, but are held await- ing the time when they shall be reconverted into machinery. Lest they may not be sufficiently available for immediate use when needed — sufficiently liquid — they are put into a special fund, perhaps invested in readily saleable bonds, and carried on the books under a special name. (See the table, page 102.) If, on the other hand, the assets realized from the conversion of machinery, by wear and tear, into finished goods are not set apart or invested in a distinct fund, but are utilized (Plan II) in the busi- ness (sometimes the most profitable use to make of such assets), they are not recognizable on the books or on the balance sheet as having such origin or constituting a depreciation fund. Sometimes doubt arises in the minds of the uninitiated as to the reality of a depreciation fund that does not appear on the books under that title. The matter is plain only when one sees the origin of such a fund. As a matter of fact, the case is exactly similar to those al- ready discussed. Instead of real estate and plant, the business has cash or claims arising from the sale of goods produced by the wear and tear of real estate and plant. If on the books and on the income sheet the actual depreciation is treated as a cost, and is also de- ducted from the value of the property on the books and on the balance sheet, a part of the assets must be those into which the depreciating property has converted itself. We may see this by observing what are the sources of assets. An increase in the total amount of assets can come from only three sources — new investment by proprietors or stockholders, loans (or credit transactions) by outsiders, and profits; but an in- crease in any particular asset may come from the exchange of any other asset. When any one of the three sources just mentioned as available for an increase in the total amount of assets is resorted to, double entry requires an explanation that will appear on the THE GENERAL PRE^CIPLES OF DEPRECIATION lOI credit side of the balance sheet; for new investment will appear as capital, loans as bonds or notes or accounts payable, and profits as surplus. If, then, the total assets equal the total liabilities — in other words, if the balance sheet balances — any new assets de- rived from new investment, loans, or profits have been accounted for, and the remaining assets must be enough to cover all the old liabilities (investment, borrowings, profits), for the old Habilities are still on the balance sheet (which balances) ; so assets to offset depreciation are on hand somewhere, but undesignated, among the other assets; for depreciation has not been allowed to reduce the lia- bility of the business to any one. To summarize, if the depreciation is counted as a cost, so that profits are not overstated, and if the property is correspondingly written down on the balance sheet (and no property is overvalued), a balance sheet that shows no deficit must have among its assets enough to replenish the depreciated property; for, since assets equal liabilities, all original capital and loans, plus all later capital and loans, plus all accumulated profits, are matched by assets, and so any exhaustion of original capital locked up in plant must be offset by other assets — obtained in the processes of business in exchange for the original plant. If there are not enough available assets to provide for replacement of the prop- erty, depreciation was not the cause: the fact must be that the manager has allowed too many assets to attain an unliquid state, — either the assets which should have been kept liquid have been tied up, or else the business needs more capital and has been borrowing, so to speak, from its replacement assets to provide assets needed in less liquid form. Sometimes the same situation is represented in the accounts far otherwise. Some business houses object to writing down their assets, because they think those unacquainted with accounts will assume that they are running down hill. Instead of crediting asset accounts, therefore, with a debit to Profit and Loss for depreciation, they debit Profit and Loss and credit Depreciation, or Reserve for Depreciation (Plan III). Then the assets stand at their original fig- ures, as if worth as much as ever. In other words, these houses re- port an exaggerated valuation of assets, but offset this by an exag- geration of liabilities — the new liabiUty being no liability at all, but merely a necessary deduction from assets. This is the extreme I02 ACCOUNTS application of the principle that in bookkeeping deductions are made not by subtractions but by additions on the contrary side. Though the principle may apply to books, it should not apply to statements published for the use of the uninitiated pubHc. If the practice were not common and of long standing, one could call it reprehensible. It is at best unfortunate. In view of the other uses for the word " Reserve," to be discussed later, the title used should indicate clearly that the credit item is a mere deduction from as- sets, as ^'Allowance for Depreciation." Usually the preferable plan is to reduce the assets. Balance Sheets Assets Liabilities First year — All plans Plant 90,000 Second year — Plan I Plant 80,000 Depreciation Fund 10,000 Second year — Plan II Plant 80,000 [Miscellaneous assets in- creased] 10,000 Second year — Plan III Plant 90,000 Allowance for Depreciation 10,000 [Miscellaneous assets in- creased] 10,000 Income Sheet All plans Depreciation (included in operating expenses, or, better, given sepa- rately as an element in such expenses) 10,000 So far we have noted only pure conditions — exhausting the property or keeping it up. The common condition is mixed — keeping up part and allowing part to run down. We must note first that keeping up property does not mean keeping up each bit of property. An absolutely new bit of property cannot be kept up; but after a certain age most kinds of property may be kept up to that aged standard by replacement of some parts new each year, improving upon the standard, while other parts are suffered to de- THE GENERAL PRINCIPLES OF DEPRECIATION IO3 cline — thus maintaining the standard ' as a whole. So a single new building cannot be absolutely maintained in value, though a single old building virtually may be; but a sufficiently large group even of new buildings may be maintained in value, for each year enough new buildings may be added to keep up the value of the group, even though those previously new have suffered deprecia- tion. Technically, expenditure to keep property up to standard is called ''maintenance," and suffering it to decline involves "depre- ciation." In practical accounting, the standard is the standard of the last earning period, whatever that period may be; for if the property is as good as it was the last time the books were closed, no allowance for depreciation as cost becomes necessary for the new period. Obviously, if the property is partly maintained and partly de- preciated, the books and statements should show a combination of two at least of the policies just discussed. Let us suppose the busi- ness is to continue, and that it would take $7,000 a year to main- tain the plant in condition, but that for three years the actual ex- penditures are as follows: $3,000, $4,000, $5,000; and that in the first year a depreciation fund was set aside, but not increased later, and in the third year Plant was not written down. Then the in- come sheets should show as costs the following: First year Second year Third year Maintenance $3,000 $4,000 $5-000 Depreciation 4,000 3,000 2,000 Let us suppose we have the condensed balance sheet at the begin- ning of the first year, as indicated below. Balance Sheet at Beginning Plant $100,000 Capital Stock $150,000 Other assets 100,000 Outside liabilities 50,000 $200,000 $200,000 If all profits are distributed as dividends, we shall have subsequent balance sheets as shown. One year later Plant $96,000 Capital Stock $150.0^0 Depreciation Fund 4,000 Outside liabilities 50,000 Other assets 100,000 $200,000 $200,C^0 104 ACCOUNTS Two years later Plant Depreciation Other assets Fund $ 93,000 Capital Stock ^ 4,000 Outside liabilities 103,000 $150,000 50,000 $200,000 $200,000 Three years later Plant Depreciation Fund Other assets $ 93,000 Capital Stock 4,000 Outside liabilities 105,000 Allowance for Depreciation $150,000 50,000 2,000 $202,000 $202,000 If we assume that the property is now to be carried to its original standard, we find that $9000 must be spent — the sum of the three depreciations of the income sheets, and also the Allowance for De- preciation plus the difference between the last figure for Plant and the first; but we also find property for the purpose. The Deprecia- tion Fund amounts to $4000 (waiving for the moment interest pre- sumably earned by it), and the other assets have a free excess, over the original other assets, of $5000. Debiting Plant for the improve- ments gives Plant $102,000; but the Allowance for Depreciation must be set off against this, or transferred to this account, leaving our original $100,000. We should note that expenditure to restore property once written down is charged to the property, to restore it on the books; but expenditure to maintain property not written down is charged to maintenance, as a cost on the income sheet, — otherwise the prop- erty would be overvalued. We have so far discussed depreciation and maintenance as if property were never given better treatment than maintenance. Sometimes a repair or replacement not only restores value as it was at the beginning of the period, but actually extends the Hfe of the property; and sometimes this occurs not only for one piece of prop- erty, offsetting loss of value on other pieces of property, but for so many pieces that the value as a whole is increased. Obviously in such a case a part of the expenditure, that which is in excess of the amount needed for maintenance, should be charged to the property account, increasing it on the balance sheet. The difficulty is to know from time to time, as entries are made, when maintenance ends and improvement begins. Not until one sees things in the THE GENERAL PRINCIPLES OF DEPRECIATION 105 large can one distinguish, and one cannot usually see them in the large as they occur. It is desirable, moreover, to charge deprecia- tion and maintenance month by month and not wait until the end of the quarter, half-year, or year. So far as costs are concerned, there is no difference between maintenance and depreciation. Both are costs of doing business. The only difference between them is that in the case of maintenance cash is exhausted in the process of making repairs and replacements which are necessitated by the destruction of property used in producing or selling goods, but in the case of depreciation machinery or other property is exhausted directly in producing or selling goods. The cost lies in the exhaus- tion of property, whether exhaustion of cash to replace other prop- erty or exhaustion of other property directly. When, then, the cost of complete maintenance is estimated from watchful experience, it is possible to charge as an expense this amount monthly, or one- twelfth the annual estimate, whether the expenditure is actually made for maintenance or not. Then at the end of the year the actual expenditure for maintenance is compared with the estimate and the difference, if any, accounted for. If the actual maintenance is less than the estimate used, and if the experience of the year sup- ports the estimate of what would have been required to keep the property up to standard. Depreciation will be charged for the difference and the property will be credited for the shrinkage. If the amount spent is in excess of the estimate, and the experience supports the estimate, obviously the charge made as an expense should be corrected by a debit to the property account and a credit to the account originally charged. The bookkeeping entries are interesting. The account for origi- nal estimated monthly charges may well be called Temporary De- preciation, and when it is debited Allowance for Depreciation may be credited. The actual expenditures for maintenance may be charged to Maintenance, as usual. Let us suppose that the esti- mate for wear and tear is $6,000 a year. Then at the end of each month the entry will read Temporary Depreciation $5CX) To Allowance for Depreciation $500 If the actual expenditure is $400 each month, the entry will be Maintenance $400 To Cash $400 I06 ACCOUNTS The monthly statements of profit and loss, of course, will treat Temporary Depreciation as a cost. Maintenance, on the other hand, since it is a payment of the liability recorded under the head of Allowance for Depreciation, is an asset: as the exhaustion of property still stands as a Hability, the replenishment must stand as an asset. At the end of the year the accounts will look as follows (using totals and omitting Cash) : Temporary Depreciation $6,000 Allowance for Depreciation $6,000 Maintenance $4,800 If now we debit Depreciation (the usual nominal account — see entry below) for the $1200 deficient maintenance, and credit Temporary Depreciation, the facts regarding both maintenance and depreciation will show on our books; for Maintenance will show at $4800 and Depreciation at $1200. We shall now have a balance of $4800 on Temporary Depreciation and of $6000 on Allowance for Depreciation; of the latter, $1200 represents actual deduction to be made from the property account. We might now cancel the Maintenance against the Allowance for Depreciation (the replen- ishment account against the exhaustion account), and report the Temporary Depreciation as a cost on the income sheet. This would make a misleading statement, however; so we correct the $4800 Temporary Depreciation and the $4800 of the Allowance for De- preciation (since our Maintenance shows that to that extent the depreciation was made good) and report the Maintenance (having a balance of the same amount) on the income sheet as a cost. De- preciation (not Temporary Depreciation) also appears here. The correcting entry is to debit Allowance for Depreciation $4800 and credit Temporary Depreciation $4800. The entries, with the re- sulting ledger, follow. Depreciation 1 200 To Temporary Depreciation 1200 Allowance for Depreciation 4800 To Temporary Depreciation 4800 THE GENERAL PRINCIPLES OF DEPRECIATION 10/ Temporary DEPREaATiON 6oco 6000 Allowance for Depreciation 1200 4800 6000 4800 6000 Maintenance 4800 Depreciation 1200 If, on the other hand, our actual expenditure for repairs and replacements were more than $6000, instead of an entry to De- preciation w^e should need an entry to the property account. Our debit to Maintenance would show that Temporary Depreciation and Allowance for Depreciation had no longer any validity, and the excess of this debit to Maintenance over the Allowance for Depreciation would indicate how much more care than mere main- tenance the property had been given. Such excess should be closed to the property, by an entry debiting the property account and crediting Maintenance. Then the balance of Maintenance would be closed to Profit and Loss as an expense of the period and reported on the income sheet. Finally, as Temporary Depre- ciation and Allowance for Depreciation are wholly met by the amount of Maintenance just closed to Profit and Loss, they should be canceled, one against the other, by debiting the latter $6000 and crediting the former the same amount. Then we have a clean score. The Interstate Commerce Commission requirements for the treatment of depreciation by railroads (succeeding the former pol- icy of most roads, which assumed that maintenance kept up their property) are similar to the treatment described above; but the titles used for the accounts are so technical as to require more ex- planation than is fitting for illustrations here. Depreciation of merchandise is in a somewhat different category from depreciation of fixed property. Since merchandise is sup- posedly constantly flowing, a progressive depreciation may or may not be necessary. When a stock of goods has once attained an age Io8 ACCOUNTS normal for its line of business and has been depreciated to a value recognizing that age, further depreciation is not necessary if the stock is not depleted of newer goods or held stagnant enough to increase its average age. The replenishment of stock is then exact- ly equivalent to maintaining its value, and depreciation no more occurs with it than with any large property that is kept up by re- placing old parts and repairing new ones fast enough to keep the average constant. If, on the other hand, some parts of the stock get older and older (assuming the usual type of merchandise with which age means shrinkage of value) and there is no ojffset else- where, progressive depreciation must be applied. One caution has been found often necessary in this connection. Managers have reported that they have depreciated stock 5% every six months, or 10% a year, for many years. They have con- sidered this liberal. On analysis the fact has been disclosed that their stock was depreciated 5% once and once only. Inventories were taken always at purchase price and then depreciated. Writ- ing off 5% depreciation from purchase prices under this plan may be done as often as is imaginable and still never amount to more than 5%; for at each period of figuring profits the 5% taken off at the last period was put back (in the purchase-price inventory) before the new 5% was taken. The only way to get a progressive depreciation, of course, is to take each percentage of depreciation off the last depreciated value — not off the original value. CHAPTER NINE THE GENERAL CHARACTERISTICS AND THE INTERPRETA- TION OF BALANCE SHEETS Perhaps the best way to apply the truths discussed in the last two chapters is to take an imaginary balance sheet and see what criticism can be apphed to it. As a prehminary to this, however, it is desirable to examine in detail some general facts about the most common items appearing on balance sheets. We will use, for a basis, a comparison of imaginary balance sheets for three years. (See page no.) It was suggested in Chapter VII that the name by which an ac- count is called is of far less importance than its disposition in closing the books for the year, — that is, determining whether its amount shall go into the income sheet or into the balance sheet, shall be charged to capital or to revenue. This suggests the necessity of getting behind the returns in any corporation statement. The first items on a manufacturing balance sheet are usually Real Estate and Plant. Though ordinarily they should be separated, they may here be considered together. The obvious questions in connection with them are, first, what is the basis of the valuation, and, secondly, what is the allowance for depreciation. Of the valuation usually no judgment can be formed unless one can examine the property itself. On the second question, however, means can often be found for forming some judgment. The figures of the balance sheets given below indicate that in the year 1907 $20,000 was allowed for de- preciation and was set aside as a special fund for repairs or replace- ment ; for, on comparing the sheets for the two years, we see that the Real Estate and Plant items have been written off to the amount of $20,000, and that a depreciation fund is among the assets. This de- preciation fund must be a real thing, for it could not appear among the assets under the name of a fund under any other conditions — unless, indeed, the books lie. 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