BUSINESS A CCO UNTING
H AR O LD DUDLEY G R EE L E Y E ditor ,
Vo lu me I —Th e o ry A ccou nt s
of
B y H a ro l d D u dl e y G re e ley
I I —C on s t ru ctiv e A ou n ting
cc
By G e orge E Be n n e tt .
I I I—C o s t A cc ou n tin g
B y D e Witt C a r l Eggl e s ton
IV—A d v d A n aly tical
a n ce d an Accounting
B y H enry C C ox .
V —I llu t r tiv A o
s a e cc un t in g o l ems
Pr b
By C h a r l e s F R itte n ho u s e an d
.
H a r ol d D u dl e y G r e e l e y
Bu sine ss A cc o u nt ing
2M
V O L U M E IV
ADVA NC ED A ND A NA LYT ICA L
A C C O UNT ING
By
H ENR Y C C O X .
fi d P ub l i A unt t ; C omp t roll r C olum b i
C e rt i e c cco an e , a
G r p h oph o
a neM f i t i g Co mp y ; M mb r Am ri
a n u a c ur n an e e e
can I t it u t
ns of A ou t t ; Fo m rly I t ru t or of
e cc n an s r e ns c
A unting N w Yor k U ni v r it y S h ol f C mm r
,
cco , e e s , c o o o e ce
Third P ri nti ng
NEW YO R "
T H E RO NAL D P R ESS C O M PA NY
1 92 1
40 0 6 9
Gl fb
E D I T O RI A L PRE F A CE u 4
T e n y e ars ago alm ost any contribution to the lite r
ature of accountancy would have been welcomed .
T oday h owever with the increasing number of excel
, ,
lent publications it is incum bent upon one who put s
,
forth a new accoun ting work to j usti fy h is action .
Muc h more is it necessary to expla in the p ub l ication
of a set o f ac counting books H ence it is desirable to .
state at t h e outset the purpose of B usiness A ccount “
ing and to outline its sco p e and general meth ods of
”
presentation .
W hile many books h ave been published on accoun t
ing topics in a lmost eve ry case th e y are unrelated v ol
,
u mes .I n some few instances a volum e on accounting ,
has logically followed another by the same author but ,
with these few exceptions every one published h as been
written without connection with or adj ustment to an y , ,
of those already existing U nder these conditions the
.
,
student of accounting to get any connected and logical
,
k nowledge of his subj ect must find one of his books ,
h ere another there a third somewhere else and bridge
, , ,
over the gaps between them as best he ma y T h e proc .
ess is difficult and the accounting knowledge he obtains
,
is not always well co ordinated and logically developed
-
.
The volumes of B usiness A ccounting are intended
“ ”
to meet t h is situation T hey cannot it is tru e p rovide
.
, ,
a course of st udy in the sense that prescribed readings
are recomm ended written answers to questions req uired
, ,
and p ersonal instru ction given N either do t h e y con .
iv EDITORIAL PREFAC E
s titu t e an ency clopaedia of unconnected and isolated
articles R ather are they an attempt to present in
.
simple non technical language the basic principles o f
,
-
account keeping and their application to various lines
-
o f business together with general directions for prepar
,
ing analyzing and interpreting accounting statements
, , .
O ne who starts at the beginning of V olume I and
works faithfully t hrough to the end of V ol u me I V and ,
then solves the problems and examines the solutions o f
V olume V should acquire some real understanding of
,
—
the theory and practice of accounts a knowledge that ,
supplemented b y experience should enable him success
,
fully to stand the test of practical work in any ordinary
business o ffice and furnish a foundation for going as
much further into the study of accountancy as he may
desire .
I t may be noted in passing that the vol u mes o f
”
Business A ccounting have been indexed in such a
way as to provide many of the features of an e ncyclo
pae dia so that the person desiring the practice on a
,
particular point or accounting ideas of suggestive value
in particular lines of industry will be able to use the set
to advantage .
T aking up the volumes of the set in order— V ol u me
I presents the fundamental principles of account keep -
ing and statement preparation U pon these basic prin .
c iple s all systems o f account are built V olume I I ex .
p lains the principles governing the development o f t h e
simple accounting procedu res described in V olume I
t o meet the needs o f more complicated and more ext e n
s ive systems of fi nancial a ccountin g V olume I I I ex
.
plains in much the same way how the basic princi p le s
EDITORIAL PREFA CE
h ave been applied to factory or cost a ccounting H av .
ing thus traced the fundam ental principles into more
elabo rate financial and cost accounting procedures V ol ,
um e I V treats accounting principles and practices
which are more advanced th an the basic ones described
in V ol u me I T hese a dvanced principle s are in most
.
ca ses subj ec t to differences o f opinion as to their nat u re
,
or applicatio n among persons qualified to deal with
,
them and it is for this reason that their di scussion is
,
confined to V ol u me IV Supplementing the illustra
.
tions of a ccounting principles and statement prepara
tion there follows in V olume IV a practic al di scussion
,
of the meth od s of verifyin g acco u nts and statements and
of their interpretation and analysis .
T h e se t closes with V olum e V which gives a num
,
be r of problems of a pract ical nature together with ,
their solutions T he working of these problems will
.
not onl y clari fy the reader s ideas but in many cases
’
will provide models upon which he can b as e accounting
procedures and bu ild statements to meet concr ete s itua
tions arising in his own work .
Th e readers to whom thi s set will appeal most
st rongly may be divided roughl y into two classes T here .
will be on the one hand business and professional men
, , ,
bankers office managers and other executives who feel
, ,
the nee d of understanding in a general wa y the methods
o f modern acco unt keeping and statement preparation
-
.
T here ca n hardly be excuse nowadays for them to con
sider b ookkeeping methods and accountin g st atements
as too complicated to underst and or o f such slight im
p ortance as to merit no at tention T h ey need a grasp
.
o f t h e subj ect so th at the y may j ud g e fo r themselve s
‘
i EDITOR IAL PREFA CE
whether bookkeepers and other persons who keep ao
counts for them and render statements to them are
gi ving information which is accurate adequate and , ,
presented in the most intelligible form T he entire .
tendency o f modern business and civic life is toward
more exact accounting of which the accounting re
,
q u ir e m e n t s of the present income tax legislation are but
one indication A ny person having substantial inter
.
ests at stake should be able to appraise intelligently
the stewardship of those to whom his interests are in
”
trusted and the volu mes of Business A ccounting will
“
give him the technical information this demands .
T he other class of p ersons to whom Business A c
“
counting will appeal is composed o f those whose dut y
”
it is to keep accounts and to prepare statements T hey .
should find in this set an inspiration and an aid to more
intensive study which in turn wi ll result in improved
,
accounting ability and an enhanced wage T he careful .
and intelligent use of these b ooks will lead beyond ques
tion to increased p ower of service to em p loyer and com
munit y .
H AROLD D U DLEY G REELE Y ,
E dito r Bu sin es s A cco unting Set
, .
New Y ork C ity ,
A p ril 1 1 9 2 0
,
P R E FA C E
'
The prc ffl mt
‘
volume is the fourt h of a series of five
v olumes on 2 c ounting I t therefore necessarily di ffers
.
from an in d ependent volume on advanced accounting ,
inasmuc h as it is not a complete treatise in itself I t .
does however give the reader who has covered the de
, ,
v e lopm e nt of the sub j ect of accounting in the three pre
ceding volumes or in other equivalent volumes a sys
te m at ic and connect ed presentation of the subj ect to a
p oint well be y ond the elementary and up to and through
an advanced stage of accountanc y .
Foll owing the presentation of accounting theor y
and bookkee p ing tech ni que which is given in the three
p receding volumes it is hoped that this boo k will find
,
some favor in its attempt to develop these subj ects to
the more advanced p hases I n addition it takes up .
,
some matters which are not touched upon in the preced
ing vol u mes Am ong these latter will be found a some
.
what detailed consideration o f the highly technical sub
j cet of consolidated balance sheets to which three chap ,
ters are devoted A number of chapters contain illus
.
t rat iv e bookkeeping entries covering the transact ions
peculiar to corporation accounting such as those inv o lv ,
ing capital stock sur p lus dividends and sinking funds
, , , .
T h e author t ru sts that the book will find its place in
accounting literatur e and th at it will prove help ful
,
.
H EN RY C Cox .
B ridge p ort C onn
, .
,
April 1 1 9 2 0
, .
C ON T E N T S
—A d j
I u s t in g an d C los in g Pr o b le m s
SC O P E
A D VAN E D A C O U N I N G
or C C T
El m t ry
e en ad A dv d A ou ting
an a nce cc n
P ro b l m of A dv
e s d A ou ti g an c e cc n n
A dj u ti g E t ri
s n n es
C lo i g E t r i
s n n es
T h V lu tio
e aof A t d V ri fi tion of
a n s se s a n e ca
bil iti es
Bo d n d O th r S ur it i
s an ec
A u iti d S inkin g Fu d O p r tion
e es
nn es an n e a s
S i k i g Fu d I nv tm t
n n n es en s
P r p r t io of F i n i l S t t m nt
e a a n na c a a e e s
D EFERRE D DE B I TS
C lo ro l m
'
s ing P b
A ru d I r I r A ru d
r e s
s
s cc e nte e s t v s . nt e e st cc e
e d of r p d xp
" in P ai E e n se s
A ou g for r p d xp
s s e
e
z cc nt in P e ai E e nse s
n
Or z o xpga ni a ti n E e nse s
A dv r g
s
a e t is in
s
R oy l a tie s
A ru d I om
r
b
cc e nc e
od of H dl A ou
s
o C M as h e th s an ing cc nt s
A ou g for A ru d I om
s
nt in
d
t p - cc cc e nc e
i
h r Di i vd d R en s e ce i v bla e
D EFERRE D C RE D I TS
L A ru d
ia b ilit ie s cc e
xp A ru d
E e n se
A o g for xp A
cc e
cc u n t in E e nse cc ru de
x A ru Ta ed
I om
es cc
D f rr e e ed nc e
A ou g for D f rr d I
cc n tin e e e nc om e
P R F I D E ER I NA I N
O T T M T O
? o of P ro fit
De fi n i t i n
s C p it l P ro fit
a a
a G r o or M ss uf tur i g P rofit
an ac n
r P ro fit W or k i P ro
on n c e ss
a P ro fit F i i h d G ood
on n s e s
p I t rd p rtm t l P rofi t
n e e a en a s
ix
X C ON T EN T S
CH AP TE R
Ne t P rofit
P rob l m of P rofi t D t rmin tion
s a
A ppr i l of A t V lu
e e e
a sa s se a es
A p t of V lu
s ec s
B i of V lu t io
a e
as s a a n
S our of D t for V lu tio n
ce s a a a a
C p it l
a R v u E xp d itur
a vs e en e en es
—R p ir R w l
.
M i t a n e n an ce nd e a s, e ne a s, a
m t en s
E ff t of D pr i t io
ec P ro fit e ec a n on
E ff t of A ppr i t io
ec P ro fit ec a n on
M th od of D t rm i i g P ro fit or L o
e s e e n n ss
Summ ry of P r i ipl a of P rofi t D t rmin tion nc es e e a
CO R RA E PO T D I VI D E ND S
De finit i o n
S our of Divid d en
ro fit A v il b l for Divid d
ce s s
P s a a e en s
R v u E xp d itur
e en e d C p it l E xp nd it ur
en e s an a a e es
D l r tio of D iv id d
ec a a n en s
For i g D l r t io of D ivid nd
c n ec a a n e s
P rt i ip t io i D iv id
a c d a n n en s
S t t u of D l r d Div id d en s
T W h om P id
a s ec a e
o a
No ti of Divid d
ce en s
P yma t of D iv id
end en s
Form of P ym t en
S t o k D iv id
a
c d en s
B o d D ivid d
n en s
S r ip D iv id d
c en s
P rop r ty D ivid d
e en s
A CCO UN T IN G FOR D IV I D E ND S
P ro dur for P ym t of Divid d
ce e a en en
Divid d Sh t or B oo k
s
en ee
E tri
n for C h Divid nd
es as e s
E tri
n for Divid d P id with Borrow d M o y
es en s a e ne
E tri
n for S r ip Divid d
es c en
for Sp i l d I t rim D ivid d
s
E tri
n es ec a an n e en
for Divid d A ppl i d t Sto k S b c ip
s
E tr i
n es en s e o c u s r
t io ns
E nt r i for C umul tiv Divid nd
es
for S to k Div id d
a e e s
E tri
n es c en s
E tr i
n for Bo d Divid d
es n en s
E tri
n for P rop r ty Divid d
es e en
I ll g l Divid d
s
e a en s
VI I S UR LU —NA URE
P S T A ND SO UR E C S
1 . De finit i o n a nd Na t ur e of Surplus
9 . S our ce s of Surplus
C ON T EN T S xi
C HA
PT ER
S urplu d U d i id d P rofit A ount
s an n v e s
t S urplu A ou t
cc
E nt r i o n
f A
es s cc
S urplu from S l s t a e O ss e s
Surplu d t h R v lu t io of A et
s an n
A ou ti g for Surplu d R rv
e e a a ss s
cc n n s an e se es
Efi t n B l n
'
ec Sh t
o a a ce ee
VII I RE S ER V E S AND F UND S
D e finit i N tur of R rv
o n an d
r
a e e se e
B l a ance Sh t T r t m t f R rv
ee ea en O e se es
R rve se Fu d es vs . n s
e R l tio B tw n R rv d Fu d
e a n e ee e se e an n
s S r t R
ec e rv e se es
a Fur th r C l ifi t ion of R rv
rv A ou t
e ass ca e se es
e O p r t io
e af T ru R n O e e se e cc n s
O p r t io of V lu t io n R rv A ount
0
s e a n a a e se e cc s
II —B o nds, C a p it a l Sto c k, an d De p r e c ia t io n
BO ND S A ND ND I N V E ST M E N T S
BO
"
2 N tur of Bo d I u
a e n ss e
3
9 " i d of B o nd
n
d V lu
s s
9
9 Bo d P ri
n ce s an a es
9 C ompu t i g B o nd V lun es
N omi l I t r t Itr t
2 a
’
9 na E fl ti
n e es vs ec ve n e es
A mor tiz tio d A —
.
9 umul tion
n an cc
A mortiz tion P rob l m n A l t r tiv Solution
a a
“ a e a e na e
A C C O U N T I N G FO BO ND S R
I nv tm t V lu M th od
es en
A ou t for Bo d I nv tm nt
a e e
cc n s n es e s
A ru d I t r t n I nv tm nt
cc e n e es o es e
P r mium e Bo d on n s
J our n l E tr i a n es
D i ou t Bo d
—
sc n on n s
P ro fit d L S l
anf B o nd o ss o n s
A ou ti g for B o d I u
a e O
cc n n n ss e
I t r t B on d I u
n e es on
P r mi um nd D i ou t n B o d I u
ss e
l
l e a sc n o n ss e
SI N I N K G FU ND A NN U I T I E S
S A ND
" D fini t io n d P urpo an se
S i king Fun d
E e
Q M t h od of C r ti g
e s ea n a n
C ompou d I t r t
S
W n n e es
P C ompu t tio f C ompou d I t r t
a n O n n e es
'
An uiti d A mou t of i A nnuity
n es an n an
t W or t h of A u ty
P
P Pr e se n an nn
S A n ui ty P ym t d Si ki g Fund
n e n s an n n
A mortiz tion nd Sinking F nd
a
P a a u
x ii C ON T EN T S
C H AP T ER
A ccou ti g for Si k i g F nd
n n n n u
S i k i g Fu d R
n n rv n e se e
R ord of P ym t i t o th Si en s n n ki ng
S i k i g Fu d I v t m t
ec s a e
n n n n es en s
T r tm t f I
ea om d E xp n
en O nc e an e ses
R d mp tio of D b t n e
A dju ti g E t ri
e e
n n
D i po itio of S i k i g Fu nd
s es
s s n n n
I llu tr tiv P rob l m
s a e e
D E RE IA I N P R B LE
P C T O O MS
r pl P inciol a nd P ic ie s
A ppr l of D pr
es
a is a e e ci a t i n o
De pr i tio R pl d b y R p ir
ec a n e a ce e a s and R e ne w als
L h old
e a se s
E t im t io of V lu
s a n a es
M t h od of R t D t rm i t io
e s a e e e na n
F ix d P ropor tio M th od n
C t of Dim i i h i g V lu M
e e s
P er en n s n a e e th od
D S i k ing Fu d M th od
n n e
u C ompo it D pr i t io n R t
s e e ec a a e
D E RE IA
P C T O I N ON THE BO O K S
C l ifi tio f P l t I t m n O an s
R rv A ou t
a ss ca e
e se e cc n s
Pl t L dg r
an
t A
e e
C o t roll i g P l
n ou t
n an cc n
C o t roll i g D pr i t io R
n n rv n A ount
I llu t r tiv J our l E tri
e ec a e se e cc s
s a e na n es
1
7 L d g r A oun t nd Ent r i
e e cc s a es
X IV C A I AL
P T ST O C K I SS UE S
Purpo of C orpor t St o k A ou nt
se a e c cc s
R ord i g A tu l I u
ec n c a ss es
R ord i g T ot l A u th riz d I u
ec n a o e ss
P ym t b y I t lm t
e
a en ns a en
A ounting for Diff r nt " ind of Sto
cc e e s c k
P RE I U M M S AND D I SC O UN T ; T REA URY S A ND OT H E R
S K
TO C
D is cou t d P r mium n St o k
n an
S t o k W ith ou t P
e o c
c V lu
ury Sto k
ar a e
Tr e as
A ou ti g for T r ury St k
c
cc n n e as
ury S to k P ur h
oc
5
"
Tr e as c c a se s
9 Tr ury Sto k P ur h B low
eas c c as e e P ar
C ON T EN T S x iii
CH A P T ER
Tr ury Sto k P ur h
e as c c a se A b ov e P ar
Tr ury Sto k n B l a a nce Sh ee t
o u S to k
e as c o
B n s c
1 Forf it d Sto k
e e c
Pa r t Il l —V a l u a t io n of A s se t s —Li a b ilitie s
C URRE N
A SSE T T S
r N t ur f C urr
a t A t e O en sse s
s R rv for B d D b t s
m V lu tio f A ou t R iv b l
ese e a e
a n O cc n s e ce a e
A ou ti g for B d D b t
a
e n n
a I
cc a e s
om T R q u ir m t
nc e ax e e en s
a A ig m t of A ou t R
ss n iv b len cc n s
d i I v ntory
e ce a e
q M r h e c an se n e
m D pr i t io St o k i T r d n on c n
d i I v tory
e ec a - -
a e
s P r i i g of M r h c n e c an se n en
O v r h d A ppl i b l t S t o k i T r d
t
p ca c n
H I ur d i I v tory
- e ea e o - -
a e
u
I
- f M r h
ns a nc e O e c an se n en
X VI I FIX ED A ND I N G A SE TS
W A ST S
F IX A ED SSETS
N t ur of F ix d A
a e t e ss e s
Flu tu tion in L nd V lu
c s
L nd I v t m n t
a a a e
a n es e s
A ou nting for L nd
cc a
B u ild ing s
R p ir nd I mprov m nt t B i u lding
hi ry nd E qu ipm nt
e a s a e e s o s
M ac ne a e
W IN A A ST G SSETS
°
D finit io n nd T r tm nt
e a ea e
A ounting for W ting A s
9
°
S cc as s e ts
X VI II L IAB I L I T I E S
"
1 D e fin it i N tur o n a nd a e
3
0 C urr t L i b ili ti
en a es
3
0 R l E t t M or tg g
ea s a e a es
9 C ol l t r l L o
a e a a ns
9 C o nt i g t L i b il it i
n en a es
9 A ommod tio I dor m nt
cc a n n se e
O t h r C o ti g t L i b iliti
1
7 e n n en a es
I N TAN GI B LE A S E S TS
N t ur of I nt gib l A t
a e an e sse s
G ood W ill
f G ood W ill
-
M t h od of D t rm i t io na n O
B i of V lu t io of G o d W ill
e e e -
as s a a n o
G ood W ill V lu f A dv r ti in g
-
a e O e s
D pr i tio n of G od W il l
-
e ec a o -
xiv C ON T EN T S
CH A PT ER
A unting for G ood Will
c co -
P t t
a en s
D pr i tion n P t nt
ec a a e s
A ounting for P t nts
e o
cc a e
T r d M rk
a e -
a s
T r d S c r ts
a e e e
C opyr i h t s
g
R oy l t a ies
Fr n hi
a c se s
FI RE L ADJ U ST M E N TS
O SS
N tur f P rob l m
a e O e
F ir I n ur n P ol i y
e s a ce c
S tt l m t f L o
e e en O s se s
C o in ur Cl u
s a nce a se
O b j t of C o i ur
ec Cl u ns a n ce a se
A pportio m t of Li bility n en a a nd a o
C insu r ance
Cl u a se
I v tory V lu tio
n en n
A ou ti g for F ir L o
a a
cc n n e ss
D pr i t io F t or
e ec a n ac
Pa rt IV —Fi n a n c ia l St a te m e n t s — Fo rm
A rr a n g e m e n t
XX I TH E B ALAN E C SH EE T
De finit i on
I mpor of B l Sh t
t a nce a a nc e ee
Form f B l n Sh t
t—
O a a ce
A rr g m A t
ee
n ant of C o t e e n en sse s
A rr g m
n ant of L i b il iti
e e a es
C p it l
a a
Sh owing of D fi it e c
Sh ow i g of R nrv e se es
Co d n t io f It m
e ns a n O s
I llu tr tiv Form of B l n Sh t
e
s a e a a ce ee
C omp r t iv B l n a a Sh t e a a ce ee s
Sp i l P oi t
ec a n s
T i U p B tw n B l n
e -
Sh t nd
e ee a a ce ee a I om
nc e St ate
m nt e
XX I I P R FI
O T A ND LO SS ST AE T M E NT
“0 De finiti on d P urpo an se
N P ro fit or L o R ul ting from O p r tions ss es e a
Q E xp of O p r tion
e nse s e a
P C p it l E xp n
a a e se s
P Form of P r nt tio e se n
I llu tr tiv Form of St t m nt
a
Q s a e a e e
fl F d r l R rv Bo rd Form
e e a e se e a
P Support ing Sch d l s e u e
C ON T E N T S xv
ST A E EN T M TS OF A M AN UFA UR I N G BU I N E CT S SS
1 Co u t P rt of R portns t it en
A rr
. a s e
g m t of R port
3Form of R port
9 . an e en e
. e
XX IV ST A E EN T M TS O F A M ER C A N T L E B U I NE
S SS
1 u t P r t of R port
Co ns t it en a s
A rr g m t of R port
. e
3Form of R port
9 . an e en e
. e
XX V ST A E EN T M T OF A FFAI R S A ND D EF I E N Y CI C ST AE T
MEN T
1 . m t C ov r i g L iq uid tion
S t a te en e n a a nd B an k rup tc y
Pro d i g cee n s
A ppo it tm t d Duti f T ru
n en s an es O s tee s in B an k
ru
p y c
R f r i B k rup t y
e e ee s n an
I v tig tio of B k rup t A fi i
c
’ '
n es a n an s
A u t d R por t
a rs
T ru t
’
s ee s c co n s an e s
P r ior it y of D b t e s
S t t m t of A ff ir
a e en a s
D fi ie y St t m t
c e nc a e en
Form f S t t m t of A ff ir
O a e en a s
Form of D fi i y S t t m nt e c e nc a e e
XX VI M E H T O D F C M B I NAT I N
S O O O S
G ro wt h d D v lopm tan en
A gr m nt
e e
P ool d G tl m
“ ’
s an en e en s ee e s
D v lopm t of T ru t
e e en s s
C om b i t io by L
na d b y P ur h
ns e a se an c ase
Form tio f H old i g C omp y n O n an
Fo m of St o k O w r hip
a
r s c ne s
P urp of H old i g C omp y
o se n an
C om b i t io b y P ur h
na f P rop rt y
n c a se O e
C om b i t io by L
na of P rop r ty
n e a se e
C omb i t io b y C o n o lid t i
A
-
p na n s a on
XX VI I H L D I N G C M AN Y BALAN C E S HEE T
O O P
H oldi g C omp y C o ol id t d B l Sh t
’
n an s vs . ns a e a a n ce ee
B l S h t f H old i g C omp
a a n ce y ee O n an
A dv t S u b i d i ry C omp
a nc e s i o s a an e s
M t h od f B l Sh t P r s O t ti o a a nc e ee e se n a n
I llu t r t io f H old i g C omp y B l Sh t
e
’
s a n O n an s a a n ce ee
P ro fit d Lo S t t m t of H old i g C omp
an y ss a e en n an
O b j t io H old i g C omp y B l
’
t ec ns Sh t o n an s a a nc e ee
xv i C ON T EN T S
CO NS L I DA E D
O T B ALAN E C S HEE T A ND I N C OM E
ST A E EN
T M T
urpo I om
P R ul o
s e , a nd nc e T ax e
g ati n
od of o ol d o
M e th C ns i a ti n
urplu of u d rS s r m umS b s i ia ie s a s P e i
ro of d r
P fitsr or o ol d o
S u b s i ia ie s P i t o C n s i ati n
r m um ood
P e i s a n d G V V
ill -
r m urplu of u d ry
T e a t e nt O f S s S b s i ia
urplu of u d ry W
S s o k ly r ly
S b s i ia h e n St c On Pa t
A qu r d i e
o ol d d I om
c
m
C ns i a t e nc e St at e e nt
r m of I r omp y ro
T e a t e nt n te c an P fit s
H I llu r v o ol d o ro l m
s t a t i e C ns i a ti n P b e
H
i
yp l o ol d o o
- S e c ia C ns i a t i n P in t s
Hm p l rov d d u d r
\Vo r k ing C a it a P i e b y S b si ia ie s
Hp
5 urplu v d d of u d ry
S s a nd D i i e n s S b s i ia
H5
: A dv u d r a nc e s to S b s i ia ie s
H9 r m of or y I r
T e a t e nt M in it nt e e s t s
H9 r m of u d ry L l
T e a t e nt a S b s i ia
’
s iab i it ie s a nd De ficit
Pa r t V —V e r ific a t io n and Te s t in g of t h e A c co u n t s
E RR O R S T HE I R C LA I F I A
A ND SS C I N
T O
I rodu o
nt c ti n
P rv o e rror
e n ti n O f E s
I r l Ch k
n te n a ec s
C l ifi tio of E rror
as s ca n s
E x mpl of E rror
a es s
N ity for C orr tio n
e ce ss ec
E rror in S ol P ropr i t or hip
s a e e s
E rror i P r t r h ip
s n a a ne s
E rror in C orpor t io n
s a a
H S umm ry a
XXX D E E T CT O I E RR R S B Y BU SI N E SS E X E C U T I VE S
N OF O
Fu tio of Ex u tiv
nc ns ec es
L imit of E x u t iv Sup rv i ion
s ec e e s
P r d t rm i d P r
e e e t g ne e ce n a es
P r e t g of G ro
ce n a P ro fit e ss
B i of P r
as s t g of G ro P rofi t
e ce n a e ss
A d d itio l U of G ro P rofit P r nt g
na se s ss
E x mpl of I v tory T t
e ce a e
a e n en es
P r e t g of T ur ov r
ce n a e n e
O th r P r nt g
e e ce a es
G r p h i St t m nt
l
i
- a c a e e s
H C u l
‘
as t iny
a cru
C ON T EN T S x v ii
C HA ER
PT P AGE
XXX I DE E T CT IO N OF E RR O R S B Y BO O KK E E P IN G D E AR
P T
EN
M T
I nt rod u t ion c
" i d of M i t k
n s t b E xp t d s a es o e ec e
Tri l B l
a D iff r a ance e e n ce s
G e ne r l R ul for L o t i g D iff r n
a es ca n e e ce s
S p ifi R ul for L o ti g Diff r n n
A ly i of th L d g r
ec c es ca e e ce s
na s s e e e
M t h od of A ly i na
A r ti ul tio St t m t
e s s
c a n a e en
C urr t T t en es s
XXX I I V ER I F I A I O N F A SE TS N D L IAB I L I T I E S
C T O S A
1 F t O p i io
ac s vs n ns
Fu d m t l St p i V r ifi t io
.
2
3 e
n
V rifi tio of th A ou t
a
ca
en a
n
e
e
s n
cc
e
n
ca n
V r ifi tio of E x i t of A t or Li b ility
5 V r ifi t io of C h i H d
4 . e ca n s e nce sse a
e ca n as n an
V r ifi tio of C h R ip t
.
6 ca n e ce s
7 V r ifi t io of C h P ym t
e as
e ca n as a en s
8 V r ifi tio of B l D po it n a a nce on s
V r ifi tio of A ou t R iv bl
e ca e
9 e ca n cc n s e ce a e
V rifi tio of Not R iv b l
.
10 ca n es e ce a e
V r ifi tio of I v tori
. e
II e ca n n en es
I Q V r ifi t io
.
of S ur it i
1 3V r ifi t io
n ec es
of F ix d A t
. e ca
. e ca n e sse s
14 V r ifi tio of L i b iliti
. e ca n a es
XXX I I I CO RRE I N
CT O E RR O R OF S
‘
? O r g n iz t io
a d Effi i n y R ords
a n an c e c ec
P Fu d m t l P r i ipl
n a en a nc e
W R ul f P ro dur
es O ce e
P Thr S t p i M k ing C orr tio n n ec s
Ch k M r k i g C orr t io n
ee e s a
Sy t m of C h k —
P ec a n ec s
M rk
-
P
I llu t r t ion of R ul I
s e ec a s
S s e
I llu t r t ion of R ul II
a
W e
I llu tr tion of R ul III
s a
P s a e
10 I llu tr t ion of R ul IV
I llu t r t io n f R ul V
. s a e
s a O e
12 . C on lu io n
c s
FO R
v d d L i t—
M
1 Di i P ym t b y M il
v d d B oo k—P r o l P ym
. en s a en a
3 Di i
9 . en e s na a ent
Pl. t L d g r C rd
an e e a
4 G r p h i C omp r i o n of
. a c a s
Advance d an d Analyt ical
Accou nting
Part I
Adju st in g an d Clo sin g Prob le m s
C HA P T ER I
TH E S C O P E O F AD VA N C E D A C C O U N T I N G
1 . Ele m e n t a r y and A d v a n c e d A c c o u n t in g
T hough there is no cle ar line of demarcation b e
tween elementary and advanced accounting it may be ,
broadly stated that the di fference b e tween the two lies
in the complexity of the transactions to be recorded A s .
explained in V olume I the elementary phase of ac
,
counting work comprised under the term bookkeep “
”
ing deals with the recording on the books of entries
”
relating to money values ; advanced accounting is con
“
cerned with the sum marizing and presenting of these
”
entries in condensed form ; and auditing is the term “
applied to the work of v e r ifv in g the accuracy of the
records .
I n a small mercant ile business in which the records
are comparatively simple few of the problems of a d
,
v a n c e d accounting would be met A ll that would be
.
required in such a case is that the work of the book
keeper be checked from time to time by a qualified audi
tor so as to insure the accuracy O f the final s tatements .
A s a business grows many accounting problems arise
, ,
the solution of which requires a knowledge of pr in ciple s
and procedure not ordinarily possessed by the book
keeper who is wholly occupied with the recording of
routine transactions T hese problems and the princi
.
ples and procedure upon which their correct solution is
3
4 AD JU S T I NG A ND C LO SI N G P RO BL E M S
based are taken up in Parts I to IV of this volume .
Part V is devoted to a discussion of methods of verify
ing the correctness of the entries so far as it is pr ac
t ica b le for the bookkeeper or the proprietor of a business
to carry out the work of investigation W ithout calling
'
upon the resources of the trained auditor .
2 . Pr o b le m s of A d v a n c e d A c c o u n t in g
The
accounting work to which the term advanced
might be p roperly applied would cover such phases of ,
accounting as :
1 . T he han dl ing of adj usting and closing entries .
2 . T h e valuation of assets and the verification of
liabilities
3
.
. T h e treatment of profits and dividends and the ,
nature of surplus and reserves .
T h e recording of transactions in bonds and
shares of stock in such a way as to show their
correct value at all times
5
.
. T h e computing of annuities and the operation
of sinking funds .
6 . T h e preparation of financial statements .
Brief consideration will here be given to the nature
of the above problems reserving detailed discussion for
,
the chapters devoted to these di fferent phases of ac
counting work .
3 . Ad j u s t in g En t r ie s
customary practice O f the small business is to
The
treat all items O f expense and inco m e as applicable to
the a ccounting period in which the expense is paid or
SC O PE OF A DVAN C E D A C C OUN T ING 5
recorded or the income received T his method of treat
.
ment has the advantage of simplicity in that it eliminates
the adj usting entries required for the purpo se of mak
ing the account reflect the true expense and income of
the period I f the business transactions are much the
.
same in character and amount from o n e year to another ,
and if the accounting terms under review cover a year s ’
operations the neglect to take up on the books an y
,
accru e d items of expense and income or to defer to
later periods when necessary a proper proportion of the
prepaid expenses and income w ill not as a rule seri
, , ,
o u sly affect the accuracy of the final statements .
I n a small business the items of income and expense
other than those connected with the purchase and sale
of merchandise are not usually of su fficient importance
to make necessary thei r adj ustment on the s core of ac
curacy when the books are closed But where items of
.
expense and income are numerous and where they tend ,
in consequence to fluctuate in their amount and inci
,
dence from one period to an o ther ; and where further ,
more the volume o f transactions varies in di fferent
,
months or with the sea sons of the year sound account
,
ing then requires that a fair apportionment of such pre
paid items be made over the periods to which they ap
ply ; and the same remarks are applicable to the treat
ment of accrued items T his is espec iallv true when
.
accurate figures of profit and loss are requ i red covering
brief periods of time .
I t may be noted that the handling of deferred and
accrued items is usually a matter o f routine bookkeep
ing and properl y should not be included among the
advanced accounting problems I n these volumes the
.
6 A D JU S T I N G A ND C LO SI NG P RO BL E M S
matter has been held over for later discussion because ,
to the student of accounting the subj ect is one of some
perplexity the difficulties of which may be more read
,
ily understood after the simpler but more fundamental
principles of bookkeeping have become firmly fixed in
mind .
4 . Clo s in g En t r ie s
T he method of closing the income and expense a c
counts into Profit and L oss account for the purpose of
determining the r e su lt of operations during the period
under review has been discussed in an elementary way ,
so far as concerns the bookkeeping alone in V olume I , ,
C hapter VI I I T h e more advanced treatment of the
.
subj ect is taken up in this volume .
T his treatment covers the accounting theory on
which the correct determination of profits is based ; the
method of their apportionment among dividends sur ,
plu s and reserves ; and the distinction between a reserve
,
which may properly be created out of profits and a r e
serve which must be treated as a charge to operations
before the correct profit figure can be determined .
While the apportionment of the profits of a business
is to a great extent a question of financial policy the ,
method of their disposal especially if the business be a
,
corporate organization is circumscribed by both legal
,
rulings and correct accounting procedure T h e d iffi .
cu l t ie s of the subj ect are further increased by the fact
that the legal ruling or opinion does not always coincide
with the accounting point of view T herefore the cor
.
rect treatment of these items requires a clear under
standing o f ( 1 ) the meaning of the terms used ; ( 2 ) the
SC O P E O F A DVAN C E D A C C OUN T IN G 7
sources from which dividends surplus and reserves may
3
, ,
be derived and to which they revert ; and ( ) the a c
ce pt e d legal rulings under the c ompulsion of which the
management of a corporation must render a true state
ment o f its profits and of the method of their disposal .
A ny discussion of the above phases of accounting is
so closely related to financial policy that a c o m pr e h e n
sive treatment of the subj ect necessarily involves many
matters relating exclusively to the financing of corpora
tions and which have little or no bearing upon the
,
work of the accountant I n this volume the discus
.
sion is confined within accounting limits ; thus only ,
those aspec ts of the subj ect are taken up which bear
directly upon the entries to be made upon the b oo k s
and records .
5. Th e V a lu a t io n o f A ss e t s and Ve r ifi c a t io n o f Lia b ilit ie s
A ll closing problems are c lo se lv related to the prob
lem of valuing the assets of an enterprise at their proper
worth to it viewed as a going concern I n the case of .
a manufacturing bus iness with a large investment in ma
chinery and equipment the correct valuation of the
,
fixed assets requires close co operation between the engi
-
neer ( or other person qualified by experience to appraise
the value of physical property ) and the accountant .
T h e expert knowledge of the appraiser is not a n e ce s
sary part of the accountant s equipment ; but a knowl
’
edge o f ( 1 ) the principles upon which all valuations
should be based ( 2 ) the method of determining depr e
3
,
c iat io n rates and (
, ) the accounting required to record
all fluctuations in asset values upon the books is a ver y ,
necessary part of the acco u ntan t s e q uipment With ’
.
~
8 A D JU ST I NG A ND C LO S I NG O BLE M S
PR
out an understanding of the principles of depr e ciation ,
he is compelled to accept as correct whatever valuation
the engineer or the ma n agement of a business may place
upon its fixed assets T h e profit ( or loss ) figure espe
.
,
c ia lly when the books are closed at freque n tly recurring
intervals may turn upon the accuracy of the appraisal
,
of asset values U nless the valuation is based upon cer
.
tain r e cognized principles and the entries on the books
conform with correct accounting procedure the info r ,
mation they contain may be biased and misleading .
T h e bias may as readily lead to the concealment of a
loss and a deficit as to the exaggeration of the prosp e rity
of the enterprise .
T h e verification of the liabilities presents none of
t h e difficulties encount e red in the valuation of assets and
reduces itself to a correct statement of their full a mount .
T h e amounts owed to creditors can be verified by refer
ence to the records T h e only concern of the account
.
ant is to ascertain their total amount including any ,
contingent liabilities if such have been incurred and to ,
inform the creditors and proprietors of the business of
the existence of these contingencies on the balance sheet
prepared for their scrutiny .
6 . Bo n d s an d O t h e r Se c u r it ie s
T heaccounting work in connection with the r e cord
ing of transactions in bonds shares of stock and stock
, ,
issues requires a small amount of legal knowledge and
a complete knowledge of the fo rms and procedure pe
c u lia r to corporate bookkeeping T h e special books to
.
be opened and forms to be used are matters which have
been taken up in V olume I I I n this volume there re
.
SC OPE OF A DVAN C E D A C C OUN T I NG 9
main to be expla ined ( 1 ) the procedure of recording
dealings in bonds s to ck issu es and di fferent kinds of
, ,
stock and ( 2 ) the meth o d of treating premiums or dis
,
c ounts paid o r r e ceived Pr emium s or di scount s on
.
bo nds should not be merged in the price received or paid ,
but sh oul d be shown as additions to or deducti ons from , ,
the price of t h e s ec urities T h e di scussion in this vol
.
ume is limited to an elementary explanation of the prin
c ipl es o n which the accountancy of inv e s tment is based .
7. A nn u it ie s an d Sin k in g Fu n d O p e r a t io n s
A study of the accountancy of investment includes
the method of computing an annui ty and of recording
sinking fund invest ments T h e co mputing of an annu
.
ity is a purely mathem atical problem by the solution of
which are determined th e series of equal pay ments plus
the co mpound interest thereon whi ch are required to
p roduce a given su m at a given ra te within a certain
period of time Suc h mathematics are pa rt O f actuarial
.
sci e nce and the calculations if they are to be readily
, ,
made require a knowledge of algebra For example
, .
,
the amortization O f bo n d premi u ms the accumulation ,
of bond discoun t and the figuring of sinking fund pay
,
ments are actuarial problems which are solved by the
use of algebraic formul ae T ables compiled from the
.
solutions enable the necessary calculations to be read ily
made Such algebraic formulae are a bran ch of mathe
.
maties with which neither the business man nor the
accountant need concern himself O rdin a r y require .
ments are met by the use of bond and compound interest
tabl e s or by simple arithm etical calcu lation s For this .
reas on the mathematics in t his vo lume are limi ted to the
10 A DJU ST IN G A ND C LO SI NG P RO BL EM S
arit hmetical solutions of the problems For a more de .
tailed treatment o f the sub j ect the reader is referred to
some o ther work l
.
ae
8 . Sin k in g Fu n d In v e s t m e n t s
Following the problem of annuity computa tions
comes that of accounting for sinking fund investments
a c om p a r a t iv e lv simple matter I f the distinction b e .
tween funds and reserv e s is clearly grasped the entries ,
on the books whic h are required to c omply with the pur
poses for which the sinking fund is created present little
difficulty .
9 . Pr e p a r a t io n of Fin a n c ia l St a t e m e n t s
’
final g oal of accou ntancy as of the accountant s
T he ,
training is the preparation of financial statements
, .
Such compilations may vary fro m a simple statement
of cash receipts and disbursements to the complicated
balance sheet of a holding and operating company
whereon is shown the consolidat ion of the assets liabili ,
ties and net worth of th e parent company with those
,
of its subsidiar y corporations A ny intelligent book .
k ee per could readily draw u p the former but the draw ,
ing up of a consolidated balance sheet requires a knowl
edge O f the method of s olving many of the problems
already referred to allied with wide accounting e x pe r i
,
ence and with anal yt ical power of no mean order .
Part IV of this volume covers the theory and practice o f
statement pre paration and the discussion is adequate
,
enough to me et all ordinary ac counting requirements
and to enable the business man to read and dissect in
Th A t y f I v tm t by Spr g d P rr i
“
e ccou n anc o n es en , a ue an e ne .
SC O P E O F A DVAN C E D A C C OUN T IN G 11
te llige n tly the content of any accountin g st atement .
T h e th eo r e ti c al side of statement compilation is also
supported by practical examples of the complete finan
c ia l reports that would ordin arily be drawn up for the
information of the m anagement of a mercantile and a
manufac turing bu s iness .
I n conclusion it should be poin ted out that a de
,
scription of many forms and certain pr o cedures which
p rope rly belong to the subj ect of advanced accounting
are taken up in V olum e I I ; also that no fu rther ref
erence is here made to cost accounting the treatment
,
of thi s phase of accounting in V olume I I I bein g con
sid e r e d adequate .
C H AP T ER II
D E F ERRE D D E B I T S
1 . C lo s in g Pr o b le m s
O ne of the main problems o f a ccounting is the ad
j ustment of the general ledger to bring it into accord
with the actual financial conditio n at the end of the
financial term and t h e diffic ulties which arise in this
,
connection relate largely to the closing entries T o sim .
p l ify the discussion of these entries they ma y be divid ed
into two main groups as follows
1 . T hose concerned with
E xpenses charged during the present
period which in part apply to a sub
sequent period
.
(b) I ncome received and credited during
present period for services to be ren
dered in subsequent periods .
( )
C E xpenses accrued during the present
period which have to be t aken up on
,
the books at its close .
d
( ) I ncome earned during the present pe
r io d which has to be taken up on the
books at its close .
2 . T hose concerned with
a
( ) E nding inventory .
b
( ) Depreciation and obsolescence of assets .
12
DE FE RRE D DE B I T S 1 3
( c ) E xpected losses on acc ounts receivable
and notes receivable .
( d ) C losin g of nominal accounts into Profit
and L oss .
di scussion o f the items in grou p 2 is reserved
T he
for detailed treatment in later chapters I n this chap .
ter the method of a ccounting for prepaid expenses
( group 1 it em
[ ])
a , and accrued inc ome ( item d
[ ]) is
taken up to be follo wed in the next chapter by the dis
,
cu ss io n of accrued expenses ( item [ c ] and income r e
c eiv e d for services still to be re n dered ( item [ b ] T he
prepaid expense items are sum marized on th e balance
”
sheet under the separate heading of Deferred Debits
,
“
( ass ets ) a cc r ued income items are included among the
c urrent assets I n the same way exp enses accrued ap
.
pear among the current liabilit y items and deferred in
come is shown und er the separate heading of Deferred
-
“
”
C redits or Deferred L iabilities
“
.
2 . A c c r u e d In t e r e s t v s. In t e r e s t A c c r u e d
A distinction is observed by some accountants in the
”
use of the word a ccrued so as to indicate clearly the
“
sense in which it is used i e whether the accrual is an , . .
,
asset or a liability A ccru e d interest for example if
.
, ,
the term is loosely use d may mean either interest due to
,
a concern or interest o wed by the same conc ern T h e .
distinction between th e asset an d the liability elements
may be express e d by the position of the word When .
the word accrued appears before the item to which it
“
relat es this item is an asset ; when it is placed after the
,
word this indicates that the item is a liability T hus
, .
,
“ ”
accrued interest means an acc rued as set recorded but
1 4. A DJU ST I N G A ND C LO S IN G PR O BL E M S
not collected because not as yet collectible ; in terest ac
”
er ned means a liability accrued whic h is recorded but
not paid because not a s yet payable
, .
3. " in d s of Pr e p a id Ex p e n se s
Prepaid expenses also ter med deferr ed expenses
,
and deferred c harges to operation constitute e x pe n d i
“
tures in excess of the portion applicable to the present
period by reason of which a smaller expenditure will be
,
re quired in subsequent perio d s T hey thus represent .
ass e t values to be charged to expenses in proportion to
their consumption d uring future periods .
T h e prepaid expenses of the av er age business usually
comprise such items as
I nsurance premiums p aid in advance
R ent and royalties paid in advance
I nterest and discount paid in advance
O rganization expenses
5 . A dvertising contracts
I f the policy b e adopted of charging against current
income all expenditures on t h e abo ve items as and when
made the pr o fits of c ertain periods might and probably
,
would su ffe r a detriment for the benefit of other periods .
Mor e over the value of c omparisons between the opera
,
tions of one perio d and those of another would be u t
t e r ly destroyed For t his reason conservative account
.
ing recommends that at the end of every fiscal per iod a
sharp distinction be drawn b e tween t h e expenses ap
plicable to the period which has j ust expired and the ex
penses applicable to subsequent ones and that each be ,
charged only with its proper porti on .
DE FE RR E D D E BI T S I 5
4 . A c co u n t in g fo r Pr e p a id Ex p e n se s
make the adj ustm ent entries requir ed before
To
closing the books the accounts should be examined with
,
a view of dete r mining what portion if any of the r e , ,
corded exp enses is to be deferred as expense chargeable
to future periods A ssum ing for example that the
3
.
, ,
year s in surance $ 60 is paid in advance on N ovember
’
3
, ,
0 and that the b o oks are closed a month later o n De
3
,
c emb er 1 the following j ournal entry woul d e ff ect the
,
requir ed adj ustment .
I n s ur an c e ( Ne w A ou nt )
cc
I n s ur anc e ( O ld A ou n t)
cc
I n the work of posting t h e credit part is entered ,
first the posting of the debit being postpo ned until a
,
new insu rance account is opened T h e debit balance of .
the old accoun t represents the amount chargeable to the
present period to be closed out to Profit and L oss W hile ,
the debit entry in the new account re p resents the de
ferred asset T h e procedure can be readily followed
.
from this example :
.
IN S URAN E
C EX P EN E S
Nov . 3
0 C as h De c . 3U
1 ne xp ir d
e
P ro fit a nd Lo ss . .
J an . 1 U n xp ir d
e e
A nother method of recording deferred expense
items is to make the necessary adj ustment by tak ing
out O f the account the expense element charging it to ,
Profit and L oss and leaving a balance whic h r e pre
,
sents the defer red ass et element T h e only j ournal .
6 A DJU ST I NG A ND C LO S IN G P RO BLE M S
entry required under the second method is the same as
the second entry under the first method which is to close ,
the expense into Profit and L oss viz ,
P rofi t an d Lo s s
I n s ur n ce E x p
a e n se
A fter posting and balancing the accoun t would , ap
p ear as follows
I N SURAN C E E X E N P SE
Nov . 3 0 C a sh De c . 3 ro1 P fit and Lo ss
Ba l a nc e
J an . 1 Ba l ance
A third method which involves the opening of new
,
accounts is to carry the prepaid expense in an asset ac
,
count ( for instance I nsurance Premiums Paid in A d
,
vance ) and to credit this a ccount at the end of the
period with the portion charged to operations debit ,
being to the expense account T h e latter account in .
its t urn is closed out to Profit and L oss I n this case .
the adj usting entry to the asset account woul d be :
I n s ur a n ce E x pen s e .
I n s ur n e P r e m ium
a c P a id in Ad v a n ce
and the closing entry to the expense account
P ro fi t an d L o ss
I n s ur nc E x pens
a e e
U nder this method the asset and expense elements are
recorded in separate ac count s th ereb v c learly indicating ,
the amount de ferr e d and the ch arge to op eration s .
D E FE R R E D D E BI T S 17
B efore
taking up the matter O f accrued income the ,
nature and origin of some of the pre p aid items need
explanation .
5O
. z
r g a n i a t io n Ex p e n se s
When a business is first launched especially if it be ,
a corporate organization numer ous preliminary ex,
penses are incurred such as incorporation fees fees for
, ,
filing and acknowledging papers legal expenses the , ,
cost of prospectuses the fees of promoters and organ
iz
,
er s
, cost of printing certificates of st ock and so on , .
T hese expenses which are a necessary outlay before
,
business can begin may be compared to the expenses of
,
installing machi nery in position and ready for use .
J ust as it is proper to add the cost of installation to the
as set value of the machinery and by means of deprecia,
tion to charge the total asset value to the cost of opera
tions so it is proper to capitalize the expenses of
,
organization and charge them o ff to future profits .
T heoretically O f course it would be j ustifiable to spread
, ,
the organization expense over the life of a corporation ,
but many accounting authorities ho ld that it should be
written O ff as rapidly as po ssible I n support of this .
contention it should be noted that organization expense ,
un like other prepaid expenses does not represent any ,
tangible a s set value in that it is an expense of the past
,
and not a saving in expense for the near future .
T herefore the general practice is to write o ff the item
,
within from three to five years though c onservative ac ,
co unting would recommend charging it against the in
’
c ome O f the first and perhap s the second year s O pera
tions.
18 A DJ U ST IN G A ND C LO SING P RO BLE M S
6 . A d v e r t is in g
A n adve rtising campaign of unusual magnitude is
sometimes capitalized among the intangible asset items
as good will T his is done when the purpose of the ex
-
.
p e n d it u r e s is to create a wide demand and thus establish
a good will that is expected to reac t favo ra bly upon the
-
s a le of the product during future years T h e method .
of treatment in this case is similar to t hat of a deferred
debit I t should be noted however that the practice
.
, ,
of carrying advertising on the books as a deferred asset
does not meet with the approval of conservat ive a c
c o u n t a n ts owing to the di fficulty o f estimating the value
,
of the good will created For this reason it is to be
-
.
discouraged unless special circum stances would war
rant its treatment in this way .
Th e basis of capitalizing the advertising e x pe n d i
ture as good will is discussed in C hapter X I X where
-
accounting for intangible assets is taken up .
7. Ro y a l tie s
I n mining lumbering and similar enterprises ro y
, , ,
alty is usually paid for the right to exploit the n atural
resources O f a tract of lan d Paym ents in such a case.
are customarily based on tonnage of production or cubic ,
yards or acreage worked and the lease usually provides
, ,
for a minimum royalty payment per year Where this .
minimum expense during the period of development
constitutes an excessive charge to a small volume
O f production it would be proper to carry all or part
,
of the royalty paid during the development period as a
deferred asset T h e expense would then be charged to
.
the operations of the years during which the output
D E FE R RE D D E B I T S 19
reached its max imum volume thus reducing the asset,
and spreading the expense of roy alties more equitably
over the period of pr oduction .
8 . A c c r u e d In c o m e
A ccrued income consists of rent interest or divi , ,
d e n d s earned which have accrued but which have not yet
be en received on
? I nvestments in real estate
”
S B onds of other companies
F L oans on collateral securities
F Bonds and mo rt gages
U
P S tocks of other companies
Since the date at which rent or interest matures and
becomes payable does not always coincide with the end
of the financial term it follows that a certain amount
,
of income from investments may have been earned of
which there is no record on the books beca use the actual
cash therefor has not yet been received Such income .
represents an asset c laim which at the time of adj usting
,
and be fore closing should be set up in what is virtually
,
a suspense account receivable T his like any other ac
.
,
count receivable is closed bu t by cash when p ayment is
,
r e ceived I f this point be borne in mind it will help to
.
make clear the distinction between accrued income and
deferr e d income to be discussed in the next chapter .
9 . Ca s h M e t h o d s of Ha n d lin g A c co u n ts
I n every business the customary practice is to set up
on the books all accounts for the sale of merchandise but ,
in the case O f the accrued items O f income frequentl y no
2 0 A DJU S T I N G A ND C L O S I NG PR O BLE M S
record is made until the income is actually received I t .
may be the poli cy of the concern to keep its books on a
”
“
cash basis which implies that only income actually r e
,
c e iv e d in cash is to be entered on the accounts and that
only expenses actually paid constitute charges against
operations I f such be the practice it is apparent that
.
,
the true income cannot be shown in the p eriod in which
it is accrued and that the period in which the cash i s
,
received obtains cred it for an amount to which it is not
entitled Moreover this policy has the disadvantage of
.
,
not being consistent for if it is sound accounting to ig
,
nore the income until it is received it is equally sound ,
accounting to ignore the profits on sales until customers
have paid the accounts receivable which contain these
profits Y et no business concern which claims to keep
.
its books on a cash basis is consistent enough to appl y
that basis to merchandise transactions .
A n argument in defense of the cash basis is that in
actual practice it works out correctly on the theory of
averages ; i e these accrued earnings of a preceding
. .
,
period when taken up on the receipt of cash in the
current period will approximatel y e q ual the accrued
amount of the present period which is not taken care
of While this may be true it does not fulfil the essen
.
,
tial requirement of accounting accuracy I f reliable r e .
su lt s are to be shown all accrued earnings must be
,
brought onto the books at the close of the period to
which they belong .
10 . A c c o u n t in g fo r A c c r u e d In co m e
manner of handling accrued income items is the
T he
same in principle as is the treatment of prepaid ex
D E FE R RE D D E B I T S 2 1
penses T h e o ff sett ing debit when the accru ed income
.
,
is credited to income account is to an asset account to ,
represent the accrued amount receivable When the .
accrued amount receivable has been collected cash is ,
debited and the asset account credi ted .
A s with prepaid expenses there are different meth ,
o d s of recordin g accrued income T o take the first
3
.
method described and assuming that on December 1
,
rent owed to a business but not yet collectible amounts
3
to $ 0 0 the j ournal entry to adj ust the income acco u nt
,
would be :
R n t I n om ( N w A ou n t )
e c e e cc
R e n t I n om ( O ld A ou n t)
c e cc
T he credit part of the entry is posted first after which ,
the debit posting is entered a few lines below the last
entry so as to permit th e account to be totaled and the
tot a l income closed out to Profit and L oss T h e debit .
part of the entry entered in the new account constitutes
the accrued asset element .
T o illustrate the procedure it is assumed that the in
come received during 1 9 1 9 amounts to and that
at the closing of the bo oks $ 0 0 have accrued 3 .
RE N I N M E T CO
3 ro
1 9 19
Lo
3A
Dec . 1 P fit a nd ss . C as h
De c . 1 cc ru de
192 0
J an . r d
1 A cc u e
When the a ccrued income is received the entry of the ,
amount thereof to the credit of the above account merely
cancels the accrual included in the earnings of the pre
2 2 A DJ U ST I NG A ND C LO SI NG PR B O LE M S
v iou s period ; in other words the cash when received ,
must not be included in the income of the present period,
as would be the case were it not o ff set by the accrua l .
T h e second method of handling accrued income ite ms
is to carry them in an asset account T his is separate .
and distinct from the income account and is set up at ,
the time of adj usting and before closing the books T o .
illustrate the pr ocedure A ccrued R ent R eceivable or ,
other suitable account is debited at the close of the fin an
c ial term with the items accrued but not collectible ; at
the same time the credit entry i s made to R ent I ncome
account T he A ccrued R ent R eceivable account is
.
opened as a temporary expedi ent to show the accrued
asset element when the books are closed T h e first e n .
tries for the new period consist in transferring all such
accrued asset balances to their respective income ac
counts where they serve the purpose o f subtracting
,
from the income actually received during the current
p eriod the accrued amount carried to Profit and L oss
at the close of the preceding period T h e followin g a c .
counts and entries make clear the method
RE N I NC
T OM E
3 ro
1 9 19
De c Lo
3
. 1 P fit a nd ss . . C a sh
De c . 1 A cc ru de
192 0
J an . 1 A cc ru d e
A CC RUE D R E N T R E E I VAB L E
C
DE FE R RE D D E BI T S 2 3
U nder a third method all r ec eipts of income are ,
credited to the asset account to which all income is ,
charged as due ; the balance showing the accrued income
not as yet collected or collectible Th e e ffect o f debit .
ing all income accrued or received to the asset account ,
with the offsetting credit to the earnings account is that ,
the debit side o f the a sset account is at all times e q ual to
the credit side of the income account .
T o illustrate assume that a bond and mo rtgage in
,
vestment of is made on J anuary 1 ; that interest
at 6 % is to be received semiannually ; that the books of
the investor are closed monthly ; that the mortgage is
redeemed with accrued interest of $ 72 0 on J une 0 3 .
T h e account and entries below cover the transaction
MO R GAGE I N V E
T ST M EN T
J an
. 1 . C ash J u ne 3 0 C a sh
A C RUE D I N
C T ERE ST ON MO R GAGE T
on M or t g g a e . Jun e 3 0 C ash
I N T ERE ST ON MO R GAGE
T ( I N COM ) E
P rofit an d Lo ss . J an 3A . 0 cc ru de I r
nte e s t .
3
(6 ‘S
Fe b . 2 8
A pr 3
M ar . 1
3
. 0
Ju 3
12 0 0 0 M ay 1
ne 0
2 4, A DJU ST I NG A ND C LO SIN G P RO BLE M S
should be noted that on the redemption of the
It
3
loan on J une 0 the usual monthly entry of
,
A cc ru ed I nte r e s t o n M o tg g r a e
I n t r e s t on M or tg ge
e a .
is first made in order to sho w the income in the earnings
account after which the transaction is closed by the
,
simple entry of
C ash
M or tg ge I n v e s tm e nt
a
A c ru d I n te r s t n M or tg
c e e o a e
g
T hus the debit side of the asset account at all times
equals the credit side of the income account the balance ,
of the asset account representing the outstanding
amount receivable .
11 . Div id e n d s Re c e iv a b le
A full discussion of dividends and the manner of
accounting for them on the books of a corporation which
has declared them will be found in C hapters V and VI .
H ere it is necessary to consider the method of recording
the m on the books O f the concern to which they are pay
able .
D ividends receivable differ from interest on invest
ments and from rentals in that they cannot be taken up ,
as an asset or income u ntil they have been declared I t .
may have been the custom of a conservative corporation
with ample reserves from which to draw to declare a ,
regular dividend at the close of each fiscal period but ,
because it has pursued this policy in the past the cor
p o r a t io n is in no way bound
'
to continue it in the future .
H e nc e as there is no certainty that the directors of any
,
DE FE R R E D D E BI T S 2 5
corporation wil l deem it advisable to make a distr ib u
tion of profits at any future date dividends which may ,
be expected but have not yet been declared should not
be taken up O n the other hand when once a dividend
.
,
is declared its amount may be included among the cur
rent accrued items o f income even though it ma y not
be receivable for some tim e to come .
RE VI EW QUE ST ION S
W h at ar e f our l d j u ting e n t r i s w h i h mu s t b m d
c ass es of a s e c e a e
t t he nd
a e f fi l pe r iod in or de r t h v th e b ook s h ow
o a s ca o a e S
th e tu l fi n n i l
ac a an d it io n ?
c a co
W h t is th e d i t in cti on in t rm in olo gy u d b y
a s e m ou nt se so e acc
nts t
a d iff e r e n ti t b t w e n in te r st ow d b y
o a e e e n d in t r e s t
e e ,
a e
ow ing t om p n y ?
o, a c a
Wh t a t h e pr p id e x pe n s
ar e e a f n v r g b u in s ?
se o a a e a e s es
Wh t a th
are ru d in om it m f n v r ge b u s in e ss ?
e a cc e c e e s o a a e a
W h e n m y in om e from d iv id e n d s b e
a c ru e d ? a cc
C HA P T E R I I I
D E F E RRE D C RE D I T S
1 . Lia b ilit ie s A c c r u e d
A s with the deferred asset items the contention is ,
frequently raised that the amount of liabilities accrued
not entered on the books at the close of one period
would approxim ately e qual those at the end of another
period and therefore the financial statement in which
the accrued items are not shown ma y yet reflect the true
financial conditions .
Th e answer to this argument is that i f it is n e c e s
sary to show all the assets of a business including the
‘
deferred items at the close of a fiscal period it is equally
, , ,
if not more important to give a full and accurate ac
,
counting O f all liabilities— not only those already e n
t e r e d on the books but any accrued items which have
not yet been taken up T herefore j ust as the principle
.
,
of showing full truth as to assets and income involves
carrying over any prepaid expense and accrued income
items fro m one period to a nother so does the same ,
principle applied to the liabili ties involve carrying over
—
any expenses accrued and prep aid income items which
appear on the balance sheet under the captions D e “
”
ferred C redits and L iabilities A ccrued“
T hese .
terms it should be no ted are used in connection with
, ,
the balance sheet as captions covering respectively items
of deferred income and of expenses accrued .
2 6
D E FE R RE D C R E DI T S 2 7
2 . Ex p e n se A c c r u e d
E xpense accrued consists of those claims again st the
bus iness for goods or services rendered which at the
time of closing the books have not yet been entered ,
usually because there is no documentary evidence of the
liab ility Practically every expense of a business may
.
at one time or another accrue in this way T h e items .
,
however which in general are encountered are rent
, ,
taxes interest water sales commissions traveling ex
, , , ,
penses advertising and s imilar services for the amount
, ,
of which an invoice or a memo has not yet come to hand
at the time of closing the books and the amo u nt of which
in consequence cannot always be accurately determined
and must sometimes be estimated A service received .
during one period which for some reason or other has
not y et been entered on the b o oks represents a current
expense which must be paid for later A s such it is a .
proper charge to a suitable expense account and a proper
credit to some liabi lity account T his liability account
.
represents a suspense a ccount to which the expense is
temporarily credited until payment becomes due where ,
upon either C ash or an account payable is credited and
the liability is expunged with the o ffsetting debit .
3 . A c co u n tin g fo r Ex p e n se A c c r u e d
E xpense accrued may be accounted for in three
ways which are the same in principle as those applied
to the recording of accrued income—the entries on the
books being of course reversed U nder the first
, , .
method one expense account only is opened to which ,
the accrued amount is debited and the liability credited
as illustrated below A ssuming for example that a
.
, ,
2 8 A DJU S T I NG A ND C LO SIN G P RO BLE M S
rental of $ 60 0 is p ayable at the end of the year and that
the books are closed half yearly the expense accrued
3 3
-
on J une 0 would be $ 0 0 and the following j ournal
entry would be required to bring it on the books
R ent ( O ld A c ou n t )
c
Re n t ( Ne w A cc un t )
o
T he above record it may be noted di ffers from that
, ,
shown on page 2 1 only in the accrued amount being
treated as a liability instead of an asset A fter the .
debit part of the entry has been posted and the account
is ruled o ff th e credit posting is entered in the new
,
account T h e debit balance of the old account r epr e
.
sents the charge to Profit and L oss and the credit bal ,
ance of the new account is a liability on the closing date .
A s this liability has already b een charged against in
come it is brought down as a credit so as not to be again
,
taken up in the closing entry of the next period .
U nder the second method a liability account under
”
a suitable title such as R ent A cc rued is opened at the
“
close of one period and closed by reversing the entry at
the beginning of the next T h e procedure has been .
illustrated in C hapter I I 1 0 wh ere the entries for
, ,
accrued income are o f course the reverse of those r e
, ,
quired for expense accrued .
T h e third method is t o record the liability in a sep
arate accoun t which is kept open until the liability is
paid When payment of the debt is made the credit
.
,
to C ash is o ff set with a debit to this account T h e .
perfect working of the method requires that the credit
side of the liabili ty account shall equal at all times the
debit side of the expense for which the obligation is in
D E FE R R E D C RE D I T S 2 9
curred T his is the principle applied to the method of
3
.
recording accrued income illustrated o n pages 2 and
2 4 and therefore no further illustration is here required
, .
4 . Ta x e s A c c r u e d
I n considering the taxes accr ued chargeable to cur
rent operations it is sometimes contended that as the
,
amount of the liability is unkno wn no real liability can ,
be said to exist For this reason as taxes are not
.
,
usually payable during the period covered by th e m ,
there is a temptation to defer their incidence to a later
period T h e we ak n e ss o f this argume n t and practice
’
is that though the real amount may be unknown it i s
, ,
still a liability which must sooner or later be met .
T herefore the tax charges for the year should be esti
mated as accurately as p ossible and the portio n accrued
against current operations should be charged thereto .
A ny di ff erence when t h e real amount becomes known
must be taken up in a later period I n accounting for .
taxes a T axes A ccrued account is credited period b V
period with the amount charged to current operations ,
such amounts being su fficient to accumulate at the end
of the year the estimated tax liability When the taxes .
are paid the T axes A ccrued account is debited with the
actual amount I f this is more than the estimate an
. ,
asset remains on the books ; i f less than the estimate a ,
liability still exists which must be taken up in the esti
mate o f the next year and thus equitably distributed
over future operations T h e asset is deducted from or
. ,
the liability is added to the estimated amount of taxes
,
for the next fiscal year and is thus equitably spread over
future operations .
3 0 A DJ US T I NG A ND C LO S I NG P RO BL E M S
5D . e fe r r e d In c o m e
Deferred income rep resents p ayments received and
taken up on the books during the current period for
which services in part must be rendered during future
periods O n the books of the business which makes the
.
disbursement the payment represents an asset ; on the
,
books of the recipient of the payment it becomes a lia ,
b ility T hus any service which from the point of view
.
,
of the payer is prepaid expense becomes from the point ,
of view of the payee deferred income R entals a d v e r .
,
t is in g contracts magazine and newspaper s u b s cr ip
,
tions and any other charges or fees received in ad
,
vance of the rendering of service constitute deferred
income .
I t may be noted that while such income gives rise
to a liability for service which may or may not entail ex
pense it does not represent a financial liability in the
,
strict interpretation of the term inasmuch as it does not ,
require a future disbursement as does expense ac ,
er n ed T herefore the motive of deferring the taking of
.
the fees into income until such time as the work is done
is not due to the necessity of showing the liabilities in
full but to the conservative accounting principle of
,
crediting income only to the period in which it is actually
earned .
6 . A c c o u n t in g fo r De fe r r e d In co m e
method of handling deferred income items is
T he
first to credit the income account with the amount r e
c e iv e d and charged to C a sh ( or the amount due and
charged to an account receivable ) and then to adj ust ,
the accoun t by j ournal entr y as follows
D E FE R RE D C RE D I T S 3
1
R ent I ncom e ( Old A cc ou n t )
R ent I nc om e ( New Acc ou nt )
A s the debit part of the entry is posted before the a c
count is closed and the credit part is posted to the new
account the e ff ect of the adj ustment is to subtract the
,
amount deferred from the current income and set it up
as a liabi lity which becomes income during the succeed
,
ing periods T h e liability thus o ff sets the asset cash r e
.
T h e following account in which six months
’
ce iv e d .
,
rent amounting to $ 60 0 is assumed to have been r e
c e iv e d in advance illustrates the post ing work at the end
,
of each month :
RE NT I N C M E O
Jan 3.1 D f rr d e e e J n 1 C h a . as
P rofit d Lo an ss .
Fe b . 1 De f rr d
e e
A n alternative method is to carry the amount r e
ce iv e d in a liability accoun t and to transfer to Profit and
L oss the current income at the close of each period .
Th e above account woul d then be kept as fo llows :
D EFERRE D RE N T IN COM E
J an 3 ro
. 1 P fit a nd Lo ss J an . 1 C ash
3
Fe b . 98
M
A pr 3
ar . 1
3
. 0
M ay
Ju 3
1
ne 0
T he advantage of this method is greater clearness an d
less clerical w ork in that it is unnecessary to close the
32 A DJU S T IN G A ND C LO SIN G P RO BLE
liability account until the obligation is writte n
entries it will b e noted are the reverse of tho
, ,
in a case where rent is a prepaid item and t h
R EVI EW QUE ST ION S
Sh oul d t a x e s b e ru d ?
acc e
W h t is m n t b y d f rr d in om P
“
a ea e e e c e
E x pl in th d iff r enc b t w e en d e f rr e d in om
a e e e e e c e
in om ?
c e
E x pl in th d iffe r ence b etw e n d e fe rr e d x p n s
a e e e e se
ac cr u ed .
C HA P T E R IV
P R O F I T D E T ER M I N A T I ON
1 . De fi
n it io n o f fi
Pr o t
Profit consists o f the surplus remai ning from the
employment of capital after defraying the necessary
expenses and outla y incidental to its employment and
after the capital has been replaced or provision made
for its replacement I f there are not sufficient assets
.
left to replace the capital the result of the venture or
,
employment is a loss and the amount by which the capi
tal is diminished is the measure of this loss .
I t should be observed that while the above definition
of profit is true in theo ry it cannot always be employed
,
in practice W hat may be legally regarded as profit
.
and thus be declared as a dividend is often a matter of ,
much controversy Di fferences of opinion exist as to
.
what are the profits of a company for dividend purposes
and the subj ect has been before the courts repeatedl y .
While the law has rigorously opposed the direct pay
ment of dividends out of capital there has been no con
,
sistent recognition by legal authorities of depreciation
and its effect upon profit T h e difficulties of the sub
.
j ec t lie chiefly in the distinctions between the strictly
legal and the conservative accounting view of the prin
c iple s upon whi ch the computing of profits should be
based T hese distinctions will be taken up here and in
.
later chapters For the present the subj ect may be
.
,
further de fined and developed under the three cla ssifi
3
3
3 4 A DJU ST I NG A ND C LO S ING O L
P R B EM S
cations ( 1 ) capital profit ( 2 ) gross profit ( also
3
,
termed tradi ng operating manufacturing ) ( ) net
, , ,
profit .
2 . C a p it a l Pr o t fi
C apital profit is any net increment in asset value ,
secured in connection with capital assets but not attrib
n table to the ordinary pr o fit making operations of the
-
business ; e g the sale of a capital asset such as land
. .
,
for an amount in excess of its cost C apital loss is any .
net decrement of asset value not connected with the
p ro fit making operations o f the business ; e g a loss by
-
. .
,
fire not covered by insurance T h e theory of account .
ing in connection with the recording of a capital profit
or loss is that such profit or loss should not be merged
with the accounts relating to the regular operations of
the business but should be recorded in separate a c
counts and that the source of the profit or the cause of
the loss should be indicated .
O nly the profit which is due to the normal opera
tions of a business should be shown in the first division
of the profit and loss statement as discussed in C hapter
XX I I A ll other earnings should be set forth sepa
.
r a t e l y so that their origin may be clearly seen T he .
reason for this is that the profit derived from the trade
operations of any one period is intended to be compared
with the figures of other periods Such figures are .
often expressed in percentages I f a profit due to ex .
tr a o r d in ar y operations which are not likely to recur is
included in the figures of the ordinary operations the ,
percentages are a ffected and the value of the compari
sons is diminished .
PR O FI T D E T E RM I NA T ION 3
5
A concern for example might realize a large and
, ,
unexpected profit from the sale of a portion of its fixed
assets I f this were closed out to Profit and L oss in the
.
usual way and merged with the other items of revenue ,
a false im pression o f prosperity would be given to
stockholders and creditors I f though the profit on
.
, ,
such a transaction is large enough to be distributed as
a dividend it may be legally disposed of in this w av
, .
T h e better and more conservative method however is , ,
to carry such a profit on the books as a contingent r e
serve against possible losses on other capital adj ust
ments and to show the reserve as a portion of s u rplus on
the balance sheet .
3. Gro ss or M a n u fa c t u r in g Pr o t fi
G r oss or trading profit i s a term u sed in commer
c ia l boo kke e ping to indicate the di ff erence between the
cost of goods bought and the selling price thereof with ,
out any deduction for the expense of distribution or the
cost of management T rade discount should be de
.
ducted in ascertaining gro ss profits but not cash dis ,
counts Depreciation o f origin al cost values should
.
also be considered in determining the cos t of goods for
the purpose o f calculating gross profits .
Manufacturing or O perat ing profit represents the
di fference between the cost of goods manufactured and
the price at which they are sold without any deduction
for selling advertising or a dministrative expense
, , .
T his definition leads to a discussion of the propriety of
taking up on the books profits earned on work in process
and finished goods prior to their actual sale ; that is b e ,
fore the manufacturer has parted with title .
3 6 A DJU ST I NG A ND C LO S IN G O BLE M S
PR
4 . Pr o t fi on W o r k in Pr o c e ss
O n the theory that profits should never be antici
pated the general commercial practice is to ignore the
,
profit accrued on work in process T his rule however .
, ,
is subj ect to modification when the profits of several
periods steadily accrue on work which has been con
tracted for I f the size of the order or the size of the
.
unit of manufacture is so great that the work is spread
over several cost periods as in the shipbuilding and engi
,
neering trades and on large scale construction work it
-
is customary to add a proportion of profit to the cost
of the work in process at the time of closing the books ,
such profit being conservatively estimated in accordance
with the terms of the contract .
I n the case of large contracts running perhaps over , ,
a period of years it would seem that many unforeseen
,
contingencies might arise to delay or prevent the con
tract being fulfilled according to its terms T herefore .
,
the anticipation of a profit on work of this character
would appear to violate one of the fundamental prin
c ip le s of sound accounting I n a business the units of
.
which are small orders are frequently taken in advance
,
of shipment and a large portion of an inventory may
be simply awaiting delivery A ccounting authorities .
agr e e that the profit on such goods should never be
taken up until the goods are actually shipped Why .
,
then is it permissible to anticipate the profit on a con
,
tract with many more unforeseen contingencies to face
than goods completely manufactured and merely await
ing the buyer s instructions for delivery
’
?
T h e answer to this pertinent question is that where
the unit of production is large expediency governs ; ,
P RO FI T D E T E R M I NA T ION 3
7
where small the ordinary commercial practice is fol
,
lowed I f the pr o fit on contract j obs were taken up
.
only on their completion and several reached comple
tion dur ing the sa m
,
e period the books might show a ,
state of a ffairs vastly different from the facts I n such .
a case not only would stock holders be rightly impatient
at the delay in the distribution of profits but many o f ,
them might in consequence be so financially embar
r a sse d as to be compelled to sell a portion or all of their
holdings .
Where the contract work instead of being under ,
taken a t a round sum is done at a fixed rate of profit
,
on a cost plus basis the contingencies givi ng rise to the
-
obj ection mentioned above are greatly minimized I t .
is then not a matter of expediency but of proper a c
counting to take up the profit earned on the portion
of the work completed ; Where an ac curate and care
fully kept cost system is in operation no di fficulty should
be experienced in determining the cost price of the work
in process .
5P
. ro fit on Fin is h e d G o o d s
if goods have b een ordered and are
T heoretically ,
ready for shipment awaiting instructions from a buyer
of undoubted integrity and commercial rating it would ,
seem that no obj ection should be raised to taking up
the profit on such goods by entering the sale and debit
ing acco unts receivable T h e expense of taking the o r
.
der and the costs up to the point of its delivery have all
been incurred E xaggerated and unnecessary cautio n
.
alone seem to stand in the w av of the realization of a
legitimate profit Y et the practice of all conservative
.
3
3 ADJ U ST I NG A ND C LO SI NG PR O BLE M S
concerns is to wait until the goods are actually delivered
before taking credit for the profit thereon for the rea ,
son that as every business man knows orders are often
, ,
canceled and the cancellation accepted ; or a fire or some
unforeseen occ u rrence may prevent the realization of the
expected sale O nly the unsuccessful business man who
.
clutches at every profit in Sight so as to make the best
possible showing when his books are closed anticipates ,
the profits on goods ordered but not actually shipped .
C onservative accounting universall y condemns such a
practice .
6 . fi
l n t e r d e p a r tm e n t a l Pr o t s
A nother aspect of the problem of taking up profit
on work in process is seen where di fferent kinds of man
'
u fact u r e are carried on in the same plant or when sev ,
eral distinct enterprises combine for the manufacture of
a completed article T h e purpose of the combination
.
is to control all stages of production and thus benefit
from a series of profits throughout the various processes .
H ow are those p rofits to be taken up ? I f a profit were
added to each process from the raw state to the com
,
l t e d product a concern might when the market is
p e , ,
depressed and prices are falling find itself with a highly
,
inflated inventory and no prospect of realizing the a n
t icip at e d profits O n the other hand if one department
.
,
or branch of the business sells its product to the de
“
tm e n t next in line at cost without profit this last
p ar ,
”
department will probably secure its raw material at a “
lower price than it would have to pay for the same
product bought in the open market I f the profits of .
all dep artments are merged in the final profit it b e ,
PR O FI T DE T E R M I NA T ION 3
9
comes difficul t to measure their e fficiency and com p are
it with that of outside and compe t ing concerns .
T h e answer to the problem is that the purpose of
comb ining several di stinct types O f manufactur e is to
cut the cost of the fini shed product and this p urpose
should be kep t in view G enerall y speaking the greater
.
,
the number of stages of manufactur e the lower will such ,
cost be T herefore if credit is taken for profits as they
.
,
are assumed to arise the fin al cost of the article is O h
,
sc u r e d and the original purpose of the combination is
defeated T here would be no obj ection to recording
.
these in termediate profits for the purpose of d e te rmin
ing the e fficiency o f di fferent departments provided the ,
profits were held in reserve u ntil the sale of the final
pr o duct But to take them up on the books and present
.
them on the balance Sheet as actually earned by includ ,
ing them in the value of the work in process inventory - -
would be wrong in principle and mislea di ng in fact .
7. Ne t Pr o fit
N et profit represents the balance remaining after
charging again st gross profits all necessary O perating
expenses T o determine the net profit or loss for the
.
period of either a manufacturing or a trading concern ,
any income from sources other than sales such as inter ,
est on investments is added to the net profit on sales ;
,
and any deductions from income which are not part
of the regular opera t in g expenses such as interest on ,
notes payable or a mortgage are subtracted from the ,
gross income T h e resulting figure is the net profit or
.
los s for the period T his amount in the case o f a cor
.
,
p ate organiza tion is closed into surplus from which
or , ,
40 A DJU ST I NG A ND C LO S IN G P RO BL E M S
dividends are declared at the di scretion of the board o f
directors I n the case O f a sole proprietorship or part
.
n e r sh ip the profit is disposed of as the management
,
sees fit .
8 . Pr o b le m s of fi
Pr o t De t e r m in a t io n
I n determining the amount of the profits earned b y
a mercantile business comparatively few accounting
,
problems arise as compared with those encountered in
the O peration of a manufacturing concern T h e cost .
of the goods bought and sold and the inventory values
can be ascertained from creditors invoices ; the expenses ’
of operation other than perhap s a few prepaid items as
yet unconsumed are all chargeable against the g ross
profit ; and depreciation bad debts and any other con, ,
t in g e n c ie s can readily be provided for by charging
them to Profit and L oss and setting up adequate r e
serves .
I n determining the profits o f a manufacturing con
cern the problem is much more complex because many ,
factors enter into the cost of the goods manufactured
and sold I n the case o f a small factory organization
.
the accountant should have little di fficulty in drawing
up a proper schedul e o f depreciation rates and in classi
fy in g expenditures under the heads of either expense
or capital assets But when a manufacturing business
.
grows rapidly or requires a large capital investment in
machinery and other plant equipment for its opera
tion the probl ems tend to increase in difficul ty R e
, .
n e w als extensions
, and alterations to the fixed assets
,
may need to be constantly made and the factor of de ,
preciation may constitute such an important item of
P RO FI T D E T E R M I NA T ION 41
,
cost as seriously to a ff ect the profits available for dis
t ribu t io n if appreciably under or over estimated -
.
9 . A p p r a is a l of A s se t V a lu e s
I t is obvious that any under or over estimation of -
asset values will proportionately exaggerate the fin an
c ial weakness or strength o f a going concern U nless .
the balance Sheet figures of a business are approximatel y
correct being neither very much too high nor too low
, ,
not only are its creditors deceived as to its exact fin an
c ial position but the management itself may obtain a
,
wrong impression of stability Th e accounting will .
,
moreover fail in its primary purpose of rendering a true
,
statement O f financial conditions at a given date .
T h e argu ment has been advanced by some theorists
that the statement set forth in the balance sheet does
not in itself reflect true financial conditions ; and that
, ,
when the assets and the net worth o f a concern are u n
derstated the variation from truth is rather a merit than
,
a failing T his opinion is supported by the precedent
.
set by all conservative enterprises especially corpora ,
tions Th e assets and the net wort h of a company are
.
‘
not infrequently expressly undervalued for the purpose
of e liminat ing any possibilit y of distributing dividends
which have not been earned .
T h e argument fo r and against the undervaluation O f
assets and the necessity of present ing a true statement
of condi tion may be summed up by the following quota
tion :
I n so far as the undervaluation of certain assets is
“
merely an attempt to secure a more truthful conspectus
M d r A
a
ti g by P r f r H tfi ld "
“
o e n ccou n n , o es s o a e .
42 A DJ U ST IN G A ND C LO SIN G PR O BLE M S
of the entire situation the action ma y be j ustified An , .
argument that however t r uthful one s intent ions may ’
be he is almost sure to overestimate the value o f his
,
own possessions and therefore after having determined
,
what he really thinks they are worth his results will ,
be more accurate if he arbitrarily writes o ff certain
sums is not without force But to state that an ab so
, .
lute understatement is praisewo rthy neglects the fact
that fraud may surely be perpetrated in that manner ;
and while the react ion against overvaluation is but nat
ural and in general healthful it seems a mistake to over ,
look the value o f accuracy and to cease to hold it up as
the goal of accounting T ime was and that not long .
,
since when even the Supreme C ourt of the U nited
,
S tates stated that there is but lit tle danger that any
board of directors will ever understate the val u e O f the
assets thereby also un derestimating the profit the temp
, ,
t a t io n being in the opposite direction But certain no .
t o r io u s bear operations in the stock exchanges Show that
the unforeseen has frequently happened and the under ,
valuation o f assets with its accompanying understate
,
ment of profits and establishment of a secret reserve i f ,
the lesser O f tw o evils nevertheless falls far short of the
,
”
ideal standard of accounting .
10 . A s p e c ts of Va lu e
value of an asset may be considered from vari
T he
ous points O f view but the p articular aspect in a given
,
case will be determined by the purpose for which the
appraisal i s made A mong the many possible kinds of
.
valuation which are established facts in business are
Un i on P a cific R R
. . Co . v. U . S , 99
. U . S 40 2
. .
P RO FI T D ET E R M INA T ION 3
4
?
‘
O riginal co st value
N Present or deprecia ted value
Q Reproduction cost value
P Market or sales value
‘
P E arnin g capacity value
Q S crap or j u nk value
S L i quidatio n or forced sale value
-
While all the abo ve aspects o f valuation are a p
plica ble to the tangible assets and many o f them to the
intangible assets it is evident that the values arrived
,
—
at under one aspect would vary in some ca ses mate
r iall y— from those under another A valuation which .
l isted the assets of a bus iness at the probable price real
iz ab le un der a forced sale brought a b out by bankrup tcy ,
would be very di fferent from the valuation of the same
assets on the basis of their repr oduct ion co st were they
destroyed by fire I f the fixed assets of an insolvent
.
business were appraised at their probable market or
forced sale value this might and probably would be
-
little more than the ir scrap value T h e same assets if .
,
included in the sale o f the busines s as a flou rishing and
going concern woul d be properly listed at the ir original
,
co st value less depreciation becau se thi s would r e pre
,
sent the ir full worth to the bus iness .
I t is apparent that the value of an asset as of any ,
economic article lies wholly in the use to which it is put
, ,
i e in its operation
. .
, T herefore in mak ing a valuation
.
,
for commercial balance sheet purp oses the general-
pr inciple may be laid down that an asset is to be val
ued at its present worth to the business as a going
conce rn .
44 A DJU ST I N G A ND C L O SING P RO BLE M S
11 . Ba s is of V a lu a t io n
T he
problem of determining what a particular asset
is worth to a business may be simplified by classifying
it within one of the two broad divisions of the assets :
( 1 ) fixed and ( 2 ) current or floating T hough the
, .
line which sep arates these two classifications cannot al
ways be sharply drawn the general distinction is that
,
the fixed assets are those bought or constructed for per
manent use in the business ; the current assets are those
sold for the purposes of revenue or used for current ,
needs in the busin ess .
I n appraising the fixed assets such as p lant and ,
fixtures their worth to a business as a going concern is
,
commonly taken to be their original or cost value less ,
depreciation regardless of any subsequent decrease in
,
value due to fluctuations of the market price of the
material and labor which entered into the original cost .
I n appraising the current assets of the inventory such ,
as goods bought for resale or finished goods m anu fac
t u r e d for sale the rule O f conservative and sound valu
,
ation is that such assets are to be appraised at cost—less
—
physical depreciation unless the market or current
price is lower than cost I n this case the cost value is
.
to be O ff set by the creation of a reserve or valuation ac
count I n other words it is considered legitimate to
.
,
Show the fixed assets on the books at their original cost
despite any subsequent decrease in the cost of their r e
production Whereas in valuing the c u rrent inventory
,
assets consideration must be given to market values
,
when these are lower than the book figures When .
the market value of either a fixed or a current asset ex
P RO FI T D E T E R M I NA T I ON 5
4
cee d sits cost price the problem of appreciation a rises
, .
T his subj ect will be taken up in a later s ec tion .
12 . So u r c e s of Da t a fo r V a lu a t io n
source of the data on which the valuation is
T he
based is usually a set of double entry b o oks showing the -
original cost of the asset and the depreciation to date in
separate accoun ts Wh e re a s ingle — entry system is
.
used the books will probably prove inadequate sources
,
of information in which case the data must be sought
for in the origi nal purchase invoice I f neither book .
keeping nor invoice figures are available trade cata ,
logu e s or lists must be consulted if the asset in ques ,
tion is a catalogued item I f the asset cannot be valued
.
from any of these sources then the m em or v or the j udg ,
ment of persons of experience must be relied upon .
W here data are not available as to original cost of
important assets such as building and plant and when
, ,
an estimate based upon the op inion o f the owner or
manager is not acceptable an appraisal company which
.
specializes in this kind of work may be called in to m ake
a valua t ion S uch a company usually bases its esti
.
mates on the probable reproduction cost valu e of the
asset in question less the depreciation which it has a l
ready undergone .
1 3. C a p it a l v s. Re v e n u e Ex p e n d it u r e s
I n determining t h e cost value of the fixed assets of
a concern and especially those of a manufacturing e n
t e r pr ise the pro blem already referred to of drawing a
,
correct distinction between capital and revenue e x pe nd i
tures fre quently arises T he incorrect all ocation O f
.
46 A DJU ST IN G A ND C LO SING PR O BLE M S
items of expenditure may sometimes represent the mar
g in between the curre nt profit o r a loss I tems classi .
fie d as a cap ita l expenditure when they are properly
,
chargeable to expense may cover up a shrinkage in net
,
earnings caused by bad management or even defalca
,
tions I f expenses are capitalized a favorable profit
.
,
and loss statement may be shown which is not true to
fact T herefore attention needs to be directed to the
.
importance of drawing a careful distinction between
capital and revenue items .
C a pital expenditures are those r esulting in the ac
q u is it io n of assets of a more or less permanent nature ,
purchased to be used in the ca r rying on of the business ,
and not for sale ; or expenditures which increase the
value of assets previously acquired E xpenditures r e
.
su lting merely in the u p keep or mainten ance of the
-
foregoing capital assets constitute revenue e xpen di
tures .
T h e practical application of the distinction between
capital and revenue expenditures is sometimes di fficul t
and perplexing I f t hrough a conservative desire not
.
to overestimate asset values expenditures are recorded
,
as revenue items which are properly capital charges the ,
periodical expenses will be greater than they ought to
be with a resulting decrease in the net earnings for the
,
period S uch a policy might n ot be detrimen ta l to the
.
interests of the sole proprieto r or the partners of a busi
ness if it merely resulted in adding to the cap ital value
o f their enterprise B ut if the paym e nt of the interest
.
due to the bondholders of a corporation depended upon
earnings their j ust claims might be secur ed only in par t
,
or even temporarily ignored if ch arges were treated as
P RO FI T D E T E RM I NA T ION 47
expense which properly considered should have been
, ,
treated as additions to plant .
T h e problem is to some extent dependent upon the
drawing of a clear distinction between expenditures
which increase and those which merely maintain earning
capacity E xpenditures on alterations or additions to
.
plant made for the purpose of adding to the existing
assets and thus directly or indirectly increasing present
earning capacity are properly capital charges But if
, .
the purpose of the outlay is to replace assets wasted
during operations it Should be treated as part of the
,
cost of operation and charged against revenue .
14. M a in t e n a n c e —R e p a ir s , Re n e w a ls , and Re p l a c e m e n t s
O nly after an enterprise enters the revenue produc -
ing stage does the question arise as to whether the pay
ment o f a definite sum Should be considered the cost of
an equivalent asset o r merely the payment of an ex
pense E xpenditures on new construction or on addi
.
tions to plant and equipment are clearly a capital charge .
But when existing property is renovated or plant and
machinery is renewe d by the replacement of those parts
which have outworn their usefulness it is often d iflicu lt ,
to determine how much of the expenditure is chargeable
to the expense of current operation and how much i s to
be cap italized and charged to future operations by
means of depreciation T h e dividing line is so closely.
drawn that an arbitrary working rule must usually be
adopted suited to the needs o f e ach particular case A . .
L owes D ickinson an authority on the sub j ect says
, ,
I n the consideration of ma intenance expen di tures ,
“
A
cco u n ti n g P ractice a nd P r o ce d u r e .
48 A DJU ST I NG A ND C LO SIN G O L
P R B EM S
it is apparent at the outset that there are two distinct ‘
theories upon which this problem can be properly con
s id e r e d .
“
U nder the first method capital is considered to
,
have been invested once for all in property which is
, ,
permanent and must be kept up at the expense of in
come no additions being made to the capital account
,
except for entirely new and additional property and all ,
expenditures of maintaining or replacing the ex isting
property irrespective of the relative values at the time
,
of construction and of replacement being charged to ,
I ncome account .
U nder the second method each unit of property
“
is followed from its construction to its removal or de
struction ; upon abandonment its original cost value is
,
written o ff to income and the cost of the new structure
which takes its place is ch arged to capital .
Under the first method changes in price levels are
“
reflected in the I ncome account while under the second ,
method they are reflected in C apital account O ver a .
long period of years where prices are rising and falling
,
alternately there will be little di fference between the
,
results of the two methods in this respect provided that ,
one or the other is consistently followed throughout for
each class of assets ; and provided that proper provision
is made under the first method for dealing with prope rt y
abandoned and not replaced I f however prices are.
, ,
continuously rising or continuously falling the first ,
m ethod will give greater or smaller charges respectively , ,
to I ncome account than the second and the latter will
, ,
tend to keep the C a p ital a ccount nearer to the current
level of prices than the former T he first method per .
P RO F I T D E T E R M INA T ION 49
haps brings out more clearly the problem with which
operating o fficials have to deal—namely the mainte ,
nance of the property entrusted to them for the pur
poses o f operation — and avoids the confusion which fre
quently arises between depreciation due to wear and
tear ( which sooner or later will have to be made good
by cash expen di tures ) and appreciation arising from
,
circumstances entirely outside the operations which can ,
never be realized SO long as operations continue and ,
which Should be dealt with as a separate question .
T hus capital and revenue expenditures are readily
differentiated in theory T h e perplexities begin when
.
the theoretical pr inciples are applied to Situations which
develop in practice T hese will be discussed as the
.
probl e ms arising in the valuation of different classes of
assets ar e individua ll y considered in later chapters .
1 5Bfi
. ect of De p r e c ia t io n on fi
Pr o t
factor of depreciation enters into the valuation
T he
of every type of fixed asset and is the chief cause o f the
,
di fferences o f opinion in arriving at a correct appraisal
of asset values and conse q uently of the determination
of profits T h e factors principles and methods of r e
.
, ,
cordin g depreciation are discussed in later chapters .
H ere attention need be directed only to the im
portance in all valuations of ample provision for depre
cia tio n not only for the present but also for past periods .
T h e depreciation charge for the present period m av be
adequa te but it should not for this reason h e assumed
,
that a Similar amount has been written o ff the value o f
the asset during past years T h e tendency in the case
.
,
where more attention is paid to the ex p ediency of t h e
5
0 A DJU ST I N G A ND C LO SING PR O BLE M S
present moment than to strict regard for the truth of
financial condition is to make liberal provision for de
,
preciation during prosperous periods but to ignore it as
a factor of expense during years of financial stringency ,
in which case the figures as to the profits of any par
t ic u lar year may be misleading .
T h e purpose o f depreciation is to spread the cost
of an asset over the years of its life and thus avoid
charging the year when the asset finally proves u nser v
ic e a b le with the total cost o f its renewal T herefore .
,
the immediate e ffect of allowing for depreciation is to
equalize the profits during years of average and similar
prosperity I f the profits of lean years are fictit io u sly
.
augmented or i f losses are concealed by negl ect to pro
vide for depreciation such a policy is dangerous to the
,
stability of a concern and fraudulent to its creditors .
N ot having been shown the true condition of its assets
and the true amount of profits made they are unable to ,
form a correct estimate of the present worth of the con
cern .
16 . Effe c t of A p p r e c ia t io n on Pr o t fi
I f the valuation of assets should always include the
provision made for depreciation as an expense it might ,
appear equally logical to show any appreciation in as
set values as a profit H ere again the governing prin
.
c iple is the value of a particular asset to the business
as a going concern and not its value due to adventitious
circumstances T h e site upon which a factory is built
.
may conceivably greatly appreciate in value yet its ,
value to the occupying enterprise considered in the light ,
of earning capacity is in no way enhanced I t is there
, .
,
P RO FI T D E T E R M INA T ION 5
1
fore proper to ignore the appreciated value and to Show
,
the asset on the books at its original cost While the .
site is occupied by the factory its value cannot be real
iz ed
. I t is true the land might be sold and the factory
,
transferred to a less expensive site but the value a t ,
t ach e d to the possible realization of such a future profit
is too remote to embody in formal accounts I n the .
rare case where a fixed asset is sold and its sales value
is found to be greater than its cost it is allowable to take
,
up the increase upon the books because the profit r e
su lting from the increase has been earned .
W hile the gu iding principle in the recording of
fixed assets as with the current assets of the merchan
,
dise inventory is that no profit shall be taken up on the
,
books unless earned or realized not all accountants ,
agree with this conservative policy A lthough it is not .
recommended here many contend that when a su b stan
,
tial and presumably permanent increase takes place in
the value o f capital assets the increase should be Shown
,
in the proper asset accounts and credited to S urplus ac
count I t is becoming common accounting practice to
.
”
set up a Special account called C apital S urplus“
Spe ,
“
”
c ial Surplus ,or other appropriate title to contain sur
plus that does not arise from earnings T h e reason .
given for such a course is usually that if unearned sur
plus is mingled with earned surplus dividends may be ,
declared therefrom ; and it is a common notion that divi
d e n d s Should be declared only from earnings But .
this it is contended is neither legally nor logically cor
, ,
rect I f a corporation has an actual surplus whether
.
,
it appears in one account or in several it is proper and , ,
like wise perfectly legal to declare a dividend ; and if
,
5
2 A DJU ST I N G A ND C LO SI N G PR O BL E M S
the corporation has plenty Of cash to do so it may be ,
prudent as well .
17 . M e th o ds of De t e r m in in g Pr o fit or Lo ss
A s from the nature of things the determination of
profits cannot be deferred until all the assets of a con
cern are realized it is necessary to fall back upon esti
,
mates o f depreciation when it is required to figure the
value of the capital assets A ssuming the accuracy of
.
the information recorded on the books as to the assets
and liabilities then the difference between the net worth
,
at present and that of a former date consti tutes ( afte r
making proper allowance for withdrawals or additions
to capital ) the profit or loss as the case may be T his .
method known as the asset and liability method is the
, ,
one used in determining the profits made when the
books are kept under the single entry plan -
.
A s previously pointed out the defect of this method ,
is that it fails to analyze the cause of a profit or loss and
thus the information a ff orded is inadequate for a busi
ness of any size or importance T o remedy this defect .
,
accounts are kept under the double entry method to -
record expenses and income and thus fluctuations in net
worth T hese accounts are subdivisions of the Profit
and L oss account which provides for their s u mm ar iz
.
tion at the close of each fiscal period .
I n single entry bookkeeping profit or loss is deter
-
mined by comparing the net worth o f one period with
that of another I n double entry bookkeeping the same
.
-
profit or loss figure is obtained from the Profit and L oss
account T h e net result secured from this account
.
should agree with the net result obtained by applying
PR O FI T D E T E RM INA T ION 3
5
the s ingle entry metho d to the business facts s h own on
-
the balance sheet .
18 . Su m m a r y of Pr in c ip le s of fi
Pr o t De t e r m in a t io n
general accounting principl e has been laid down
T he
in this and the prec edin g vol u mes of this series that ,
—
profits cannot be recognized as earned and therefore
—
cannot be taken up on the books until the sale upon
which their realization depends actually takes place , .
T o this general principle may now be added the foll ow
in g which develop from the preceding discussion
1 . Profits accrued and earned during one period
but realized durin g another Should be cred
ite d to the period when earned .
2 . Profits realized on the sale of fixed assets
Should be distingui shed from profits derived
3
from operation .
. L osses i e expenses incurred in the earning of
, . .
,
profits should be charged against profits so
,
earned .
4 . C apital losses should be charged again st sur
plus where p ossible
5
.
. Profit o n work in process and finished goods
should onl y be taken up when there is con
t r a ctu a l evidence of their sale and wh e n fail
'
u r e t o t a k e th e m u p w o u ld fa lmfy th e fig u r es
as t o th e p r ofits of th e cu rr e n t a nd la ter p e
rio d s .
A ssum ing then that a correct di stinction has been
, ,
m ade between capital and revenue charges that all ex ,
pense accounts have been either charged to the cost of
5
4. A DJU ST I NG A ND C LO S I NG PR O BLE M S
manufacture or closed into Profit and L oss and that ,
adequate reserves for depreciation have been set up in
appropriate accounts the balance of the Profit and L oss
,
Should be a true reflection of the profits earned or the
losses incurred during the period under review .
R EVI E W QUE ST ION S
De fi n e n et rofi t ; gro s s profi t ; c pit l p rofi t
p a a .
Wh n m y
e a
profi t b fi gur d n work in p ro ce s s ?
a e e o
H ow m y d e p r tm n t l ffi i n y be j ud g d w ith ou t r rying
a a e a e c e c e ca
i n t e rd p r t m n t l p rofi t in t o t h e v lu
e a e a s f fin ish d goo ds ?
a e o e
N m e s e v e r l s our e f d t f v lu tio n s f
a a c s o a a or tsa a o as s e .
De fi ne pi
cat l x
a p en d it ur e s ; r e v n u e x pe n d itur s
e e e e .
S umm r i z e t h e p r in cip l es o f p rofi t d e te rm in ti o n
a a .
C HAP T E R V
C O R P O RA T E D I V I D E ND S
1 . De fi n it io n
A Share of stoc k in a corporation unlike an invest ,
ment in its bonds involves no ob li gation to p ay the holder
,
a fixed return of principal interest or dividends at any , ,
definite time S o far as property rights are concerned
.
,
it merely represents his proportionate interest in the
earnings of the corporation when these are distributed
and in its capital when the corporation is liquidated .
I f profits are earned they belong to the corpora -
tion and the stockholder has no method of getting
hold of them until they are actually declared as
dividends i e ordered by proper action of the directors
, . .
,
to be paid to the stockholders at some definite fut u re
time in the form of dividends From the standpoint of .
corporation finance therefore dividends are the profits
, ,
of a corporation which have been se t aside by formal
action of its directors for distribution among its share
holders usually in proportion to their individual hold
,
ings of the stock on which the dividend is to be paid .
Quarterly semiannually or annually as the case
, , ,
may be the corporate bo oks are balanced the profits
, ,
are determined and the directors decide what portion if ,
any shall be withdrawn for division among the stock
,
holders I f a distribution of profits seems advisable
.
,
a di vidend is then formally declared usually in the shape
5
5
,
5
6 A DJU ST I NG A ND C LO S ING P RO BL E M S
of a percentage on the par value of the stock but some ,
times as a fixed amou nt on each share T h e amount .
received by each stockholder is therefore determined by
the number of shares he holds .
I n the case of close corporations— corporations where
the entire stock and management is in the hands of a few
—
individuals corporate profits are occasionally d istr ib
u te d among the sto ckholders without the formality
of a declaration of dividends and the proceeding
is not legally O bj ectionable if all the stockholders
assent Such informal distribution is usually a e com
.
lis h e d by means of salaries that would i f it were not
p ,
for their inclusion of profits be unreasonably large I n
, .
such cases all the stockholders are also usually o fficials
of the corporation and participate either equally or upon
some agreed basis in this informal division of profits .
T h e distribution of profits in these irregular ways is
entir e ly permissible if all the parties interested assent
and no improper ends are to be attained thereby .
Wh e n however such distributions of profit are made
, ,
for th e purpose of conce aling the actual profits with a
more or less fraudulent int e nt as for instance to evade
,
t h e payment of the income tax on profits they are liable ,
to be held as dividends paid under another name put ,
“
”
in that guise for concealment and delusion .
2 . So u r c e s of Div id e n d s
U nd e r the common law dividends may be paid only
,
from profits T his common law has been r e enacted in
.
-
some form in the statutes of practically eve ry state in
the U nion U nder the N ew Y ork law for instance it
.
, ,
is unlawful for the directors of a stock corporation to
C O RP O RA T E D IVI D E N D S 5
7
dec lare dividends except from the surplus profits aris
ing from the business of such corporation T h e stat .
utes also provide that the dire ctors shall not divide “
withdraw or in any way pay to the stockholders or any
,
of them any part of the capital of such corporation or
, ,
”
reduce its capital stock except as authorized by law .
I n some few states the requirements are much lower ,
the statutes merely providing that no dividends are to
be declared that would render the corporation insolvent ,
or perhaps merely imposing a punishment for the dec
lar at io n of such divi dends I t is evident that under
.
such provisions a material im pairment of the actual cap
ital might occur before the statutory limit was reached .
T h e purpose of the prohibition of di vidends except
from profits is to protect the stock holders and the cred
ito r s of the corporation T h e capital of the company
.
was contributed by its stockholders for the conduct of
the company s business and not for the purpose of being
’
paid back to them in insta lments masquer ad ing as div
id e n d s. T h e stockholders therefore rightfully expect
, ,
that the entire capital shall be devoted to the operations
for which it was intended C orporate creditors are like
.
wise entitled to the protection arising from the retention
of the company s capital in the company s business A
’ ’
.
diversion of the capital in any part to any other p u rpose
whatsoever is prej udicial to the rights of both stock
holders and cre di tors .
O ne exception to the general rule that dividends
may be declared only from profits may be noted T his .
”
is where companies are formed to operate wasting “
enterprises such as mines quarries O il wells and patent
rights H ere the corp oration is organiz
, , ,
. ed for the ex
58 A DJU ST I NG A ND C LO SI NG PR O BL E M S
press purpose of working out the property which is rep
resented by its capital sto ck the impairment and final ,
exhaustion of this property being the O bj ect of the cor
p o ra t e operations A s stated in an E nglish decision
. :
Where a company i s for med to acquire and work a
—
property of a wasting nature for example a mine a ,
quarry or a patent—the capital expended in acquiring
,
the property may be regarded as sunk and gone and if ,
the company retains assets s u fficient to pay its debts ,
it appears to me that there is nothing whatever in the A ct
to prevent any excess of money O btained by working
the property over the cost of working it from being di
v id e d amongst the shareholders and t h is in my opinion , , ,
is true although some portion of the property itself is
”
sold and in some sense the capital is thereby diminished .
T his decision has been generally followed in the
U nited States and is regarded as establishing the rule .
I t must however be noted that in thi s case the assets
, ,
of the company were ample and there was no question
of insolvency or the charge of indi scretion in the declara
tion of dividends which formed the basis of litigat ion .
3. fi
Pr o t s A v a il a b le fo r Div id e n d s
A s dividends may be declared only fro m surplus or
net profits the determination of what constitutes profits
,
properly declarable as dividends is of much importance .
T h e general r u le is that any increased values of the
'
corporate assets over the corporate liabilities in any year
are net profits A s stated by the U nited States Su
.
preme C ourt : T T h e term profits out of which div
“ ‘ ’
N l A ph lt R
Lee v
1 M ob ile
.
,
e u ch ate
e tc . R R v T
. .
s
.
a e Co L.
e n n es se e . 1 3U
5
. 4 1 0 11 D
. S 48 6.
. . 1
C OR P ORA T E D I VI D E N DS 5
9
id e n d s alone can properly be declared denotes what mon
eys remain after de fraying every exp ense including ,
loans falling due as well as the interest on such loans .
I f it were held that dividends could be paid only from
surplus i e the excess of corporate assets over capital
, . .
,
stock and debts the rule would require that each year
,
before dividends might legally be paid from profits of
that year any prior impairment of the capital must be
,
made good T hat is if a company meets with disas
.
,
trous losses sufficient to wipe out its surplus and seri
o u s ly impair its capital its profits possibly for a term of , ,
years succeeding would have to be employed in the rein
,
statement o f its capital and until that was accomplished
dividends must be deferred I n N ew Y ork this is the .
case as the statutes expressly provide that dividends
shall be only paid out O f surplus profits _
.
T h e courts however do not always enforce this rule
, , .
O n the contrary provided that the statutes of the state
,
or the provisions of charter or by laws do not prevent -
and that the declaration of a dividend does not render
the corporation insolve nt or leave it in such an embar
r asse d condition as to render the dividend manifestly
improper no account need be taken of capital impair
,
ments of preceding years U nder such circumstances .
,
“
in estimating the profits for the year for the purpose
of declaring a dividend it is not necessary to take into ,
account th e difference in value of the assets and the im
pairment of the capital stock of the company prior to
that
Beyond this in most of the states the profits earned
C oo k on Co rp r o at io n s , 5
46 .
60 ADJU ST I N G A ND C LO SI N G P RO B L E M S
and invested or passed over to surplus in years of pros
p e r it
y do not lose their character as profits but if in , ,
su ffic ie n t profits are made in subsequent years may be ,
drawn upon for dividends .
While the laws as to dividends are construed in this
liberal manner excessive dividends should always be
,
avoided as a matter of common business prudence .
Speaking generally a corporation in active operation
,
should never declare dividends that will exhaust its sur
plus O n the contrary a su fficient reserve of surplus
.
should be maintained at all times to support the cor
a t e credit to maintain an equality of dividends from
p o r ,
year to year and to meet the varyi ng unforeseen con
,
t ing e n cie s which so frequently arise in the course o f
business operation .
T h e law is explicit in its ruling that dividends can
only be paid out of profits but legal and accounting ,
opinions di ff er sometimes as to j ust what constitutes
these profits I t is a general accounting principle that
.
profits arising from increased values of corporate prop
e r ty are not properly ap p licable to payment of dividends
—at least not until they are actually realized by sale of
the property T h e courts however have not always
.
, ,
agreed holding that if a corporation has the right to
,
—
invest its surplus in securities which is unquestioned
and if the securities appreciate in value there is no reason ,
why the profits arising from the investment cannot be
considered as the profits of the business of the corpora
tion T his as suggested is contrary to the accepted
.
, ,
theory of sound accounting T h e profits on investments
.
which have not yet been realized can be based only on
fluctuating market prices and therefore it is generall y
,
C OR P ORA T E D IVI D E N D S 61
held by accountants that the declaration of a dividend
out of such profits is equivalent to the anticipation of
profits for the purpose of dividend payments .
4 . Re v e n u e Ex p e n d it u r e s an d C a p it a l Ex p e n d it u r e s
Profits for the current year although e x pended ,
upon betterments or existing in the form of property
, ,
may be made the basis of dividends I n this case m o n ev .
may be borrowed to pay such dividends or the dividends ,
may be declared in the form of stock scrip or bonds , , .
Whether or not this Should be done is a financial not an ,
accounting matter , .
A di fficulty sometimes arises in connection with these
betterments as to what expenditures of the kind may
with propriety be charged to capital account and what
should be charged to current expenses T hus if a man .
,
u fa c t u r in
g concern purchases machinery parts and
charges them to capital account the books will Show a ,
larger net profit for the year than if the item is charged
to expense account O r the question may arise as to
.
whether some Special case is one of repairs or replace
ment the one being a charge to expense and the other
,
a charge against a reserve for depreciation T h e mat .
ter is one of bookkeeping and the actual assets of the
company are not a ffected in either case but its profits ,
legally available for dividends are directly increased or
diminished accordin g to the account debited .
T his question usuall y arises when the directors are
anxious to divert every possible penny into dividends .
T h e problem is a difficult one and its solution will vary
with the conditions I t may be safely said that what
.
“
losses can be p ro p erly charged to ca p ital and what to
62 A D JU S T I NG A ND C LO S I NG P RO BL E M S
income is a matter for business men to determine and
it is often a matter on which the o p inions of honest and
” l
c o mpetent men will di ffer .
ae
5D
. e c l a r a t io n o f Div id e n d s
I t is a well recognized principle of law that the
-
directors of a corporation and they alone have power
to declare dividends and to determine their amount .
T his right of the directors to declare dividends is inci
dent to their general power to manage the a ffairs of
the corporation and is recognized directly or by implica
tion by the statutes of every state of the U nion T h e .
right is of course subj ect to any modification imposed
, ,
by the statutes of the state or by any charter or b y law ,
-
provisions which may apply but beyond this the whole ,
matter is in the directors discretion ’
.
A s already stated statutory provisions prohibiting
,
dividends that will impair the capital or that will ren
der the corporation insolvent are found in practically ,
every state of the U nion I t is but seldom that the .
statutes go further in respect to dividends T h e char .
ter or by laws however frequentl y go much further
-
, , .
I n some cases they provide that a specified surplus shall
be attained and maintained before any dividends may be
declared ; in other cases they specify that after the reser
vation of a designated surplus any remaining profits ,
Shall be declared as dividends O ccasionally the matter .
is reversed the by laws requiring that dividends to a
,
-
specified amount Shall be declared before any profits
may be reserved as surplus Such a by law provision is .
-
r g ry v
G e o . P atch e tt, 38 Be a v 5
.95
C O RP ORAT E D IVI D EN DS 3
6
as a rule Obviously undesirable as it compels the dec
,
lar at io n of dividends regardless of the business con
d itio n s which Should control .
U sually before the date fixed by the charter or by
,
laws for the declaration of dividends or if no such date ,
i s fixed at the t ime a dividend i s contemplated the treas
, ,
u r e r is called upon for a statement Showin g the corporate
profits available for the purpose I f however the cor.
, ,
o t io n has ample surplus profits or if the business is
p ra ,
so prosperous as obviously to j ustify the proposed div
id e n d no statement is required the directors merely
, ,
declaring the dividend as a matter of course .
When the fact and the amount of the dividend have
been decided upon a formal resolution declaring it is
,
adopted by the directors T his resolution usually fixes
.
specifically the amou nt of the dividend and states to
,
whom and when it sha ll be paid T h e amount is o r .
din ar ily expressed as a percentage of the par value of
the stock though somet imes as a fixed amount per share
,
.
T h e recipients must necessarily be stockholders of the
co mpany but are usually stockholders of a specified
fut u re date and the time of payment i s usually fixed at
,
a still later future date .
T h e d irectors have full power to declare a dividend
e ff ective at any future date but they cannot antedate
a dividend T hus the d irectors coul d not on J anuary
.
1 legall y declare a dividend payable to stockholders of
5
record on the 1 th of the preceding O ctober T h e .
power to do so would open a wide door for inj ustice and
fraud .
T h e resolution declaring a dividend usually provides
for the closing O f th e stock books to trans fers of s t ock
64 A DJ U ST I N G A ND C LO S IN G P RO BL E M S
for a certain period before the dividend day i e the day , . .
,
when the dividend is to be p aid T his provision for .
closing the transfer books is usually and properly part
of the charter or by law requirements of the corporation
-
.
I t is questionable whether the directors would have
power to close the transfer books unless so authorized .
T h e reason for and the effect of this closing of the
, ,
transfer books is discussed in 1 1 .
6 . Fo r c in g De c l a r a t io n of Div id e n d s
A s already stated the charter or by laws of the com
,
-
p any may provide more or less specifically as to when
or under what conditions dividends shall be declared ,
and as long as such requirements are in harmony with
the state laws the directors must observe them I f they
, .
do not the stockholders may compel such observance by
,
legal procedure .
I n the absence of any such provisions or within the
limits of these provisions the directors have wide dis
,
cretion as to dividends T hey are responsible for the
.
proper management of the corporation and particularly ,
in the matter of dividends are held to strict account ,
ability by the law and they are therefore entitled to the
,
free exercise of their j udgment as to when and to what
amount these dividends shall be declared .
T h e courts are reluctant to compel dividends but ,
there is a point at which they will intervene to prevent
undue or improper retention of profits T h e directors .
must act in good faith I f they fail to do so and it
.
,
clearly appears that they have accumulated earnings not
required in the prosecution of the business which they
withhold unn ecessarily and improperly from the stock
C OR P ORA T E D IVI DE N DS 5
6
holders a court of equity ma y interfere and compel a
,
distribution of such earnings Th e court s will not how
.
,
ever interfere with the management o f the directors and
,
compel them to declare dividends unless it is clearly made
to appear that they refuse to do so when the corporation
has a surplus of net profits which it can without d e tri ,
ment to its busine ss divide among its stockholders and
, ,
when their refusal is such an abuse of discretion as to
constitute a fraud or breach of that good faith which
they are bound to exercise toward the stockholders .
7. Pa r t ic ip a t io n in Div id e n d s
U nless di ff ere n t classes of stock have been created ,
the profits belong to the stockholders in proportion to
their holdings of stock and the directors in declaring
dividends have no power to vary this rule T his applies .
,
however only to stockholders of the same class I f
,
.
different classes of stock have been created these may be ,
given di fferent dividend rights T hus preferred stocks .
,
may be created with preferential dividends which they
receive before other classes of stock receive anything at
all T h e di ff erence is however intentional understood
.
, , ,
by all parties and no inj ustice results therefrom
, .
A s between the members of any one class of stock
holders dividends must be paid with absolute impar
,
t ia lit y the number of shares of stock held determining
,
the amount received when dividends are paid A lso the .
time of payment and the method of payment must be the
same for all Some cannot be paid in cash while others
.
are paid in stock or scrip unless by agreement of the
,
interested parties Without such agreement all must
.
,
fare exactly alike .
66 A DJU ST I NG A ND C LO SING PR O BLE M S
8 . St a t u s of De c la r e d Div id e n d s
property of the corporation is not the property
T he
of the individual members T hey have an interest in .
the corporation property and in fact through the cor
, ,
ra t io n own it but their interest is undivided and the y
p o , ,
as individuals have no direct control W hen however .
, ,
a dividend is declared from net profits its amount is ,
immediately transferred from corporate ownership to
the ownership of the stockholders and this i s true though ,
no defin ite date or some future date was fixed for pay
ment at the time the dividend was declared T his being .
‘
so it follows that once publicly declared a dividend is
, ,
irrevocable— save in t h e case of an illegal dividend wh ich
may be rescinded at any time before its payment and —
as soon as the date arrives upon which it is payable it
becomes a debt due from the corporation to the stock
holders enforcible by legal procedure T his debt stands
, .
on a p arity with the other corporate debts ; should the
corporation become insolvent before such dividend is
paid the stockholders take their place among the other
,
creditors of t h e corporation and may enforce their cla im
as w o uld any other corporate creditor .
A s a declared dividend is a debt due from the cor
p o r a tio n to the stockholder any existing indebtedness
,
o f the stockholder to the corporation may be O ffset
against the dividend and may be deducted from it pro ,
v id e d the debt is actuall y due at the time the dividend is
payable .
9 . To W hom Pa id
A stockholder of record is one whose name appears
upon the stock books of the corporation as an owner
C O RP O RA T E D IVI D EN DS 67
of its stock D ividends are ord inarily pa y able to those
.
who at the time the dividend becomes e ffective are stock
holders of record T h e stock book therefore at this
.
, ,
time Shows to whom the dividend must be paid
,
.
T h e rul e is not however invariable
, I t may be that
,
.
stock is pledged and the pledgee has not had the stock
transferred to his own name though dividends are pay ,
able to him O r o ccasionally it happens that stock has
.
been sold be fore the declaration of the dividend but the ,
transfer thro ugh neglect or other cause has not been
, ,
recorded on the books T h e equitable ownership of
.
the stock an d the right to the dividend then vests in
the party to whom the stock has been a s sign ed but ,
the ownership of record and therefore the technical
,
ownership of the dividend still remains in the former,
owner .
T h e treasurer in the absence of notice has no con
, ,
ce rn as to these e q uitable owners T h e stock b ooks of .
the corporation are conclusive for his purposes until
their evidence is superseded by the presentati on o f duly
assigned certificates or other satisfactory evidence of a
di fferent ownership or by in formation that would put
,
”
the corporation on notice “
T herefore even though it
.
,
proves later that the holder of record is not the right
ful owner of the dividend the treasurer and the cor ,
p or a t io n are protected in payments made according to
the unimpeached record of the stock boo ks T hey have .
used all reasonable care and cannot be held for the r e
s u lts of negligence on the part of others .
I f however the treasurer or the corporation receives
, ,
notice of some unrecorded transfer involving the owner
ship o f the dividend a transfer made before the
68 A DJU ST I N G A ND C L O S ING P RO BL E M S
dividend became e ff ective or perhaps thereafter with
an assignment of the dividend—the treasurer is bound
to take notice of the facts and pay the dividend to the
rightful owner .
A s the stock books if unimpeached control ab so
, ,
lu te ly the production of a stockholder s certificate of
’
stock before dividends will be paid to h im cannot be re
quired nor can he be required to bring other proof of
,
either his ownership of the stock or of the dividends .
I f however the true ownership is not that shown by the
, ,
stock book the duly assigned certificate of stock is good
,
evidence thereof and sufficient to j ustify the treasurer in
p aying the di vidend to the assignee provided only that
the assignment was made before the e ffective date of the
divi d end .
I f there i s any real doubt as to whom a dividend
is prop erly payable the treasurer s only safe course
,
’
is to withhold payment until the matter is satisfactorily
settled by the parties themselves or until the owner ,
ship of the dividend is determined by proper legal pro
ce d u r e T his litigation may involve only the disputants
.
but it may also be directed against the corporation I f .
in any case the corporation is likely to su ffer it may ,
interplead and ask the court to decide to whom the divi
dend belongs .
I n case stock stands in the name of a married woman ,
the treasurer must p ay the dividends declared thereon
to the wife or to the husband according to the require
ments of the state in which the corporation is chartered .
I n most states of the U nion dividends are payable to
the wife when stock stands in her name .
I f stock is pledged the pledgee is entitled to any
,
C O RP ORA T E D IVI D E N DS 69
dividends declared meanwhile even though he is not a
stockholder of record provided the corporation has had
,
due notice of the pledge B ut the pledgee must ac .
count for these dividends to the pledger when the pledg e
is redeemed .
I f a corporation holds stock of other corporations .
it is entitled to receive dividends on this stock as is any
other stockholder I t cannot however pay dividends
.
, ,
on its own stock held in its own treasury When di vi .
d e n d s are payable to a corporation the dividend check ,
may be made either in the name of the corporation or ,
to the treasurer as the treasurer of the corporation I f .
stock belongs to an estate payment of dividends should
,
be made to the executor or ad ministrator I f however .
, ,
the stock passes to a legatee all dividends declared ,
after the date of th e testator s death belong to the ’
legatee but if any divi dends have been declared before
,
that date but are not y et paid they w ill belong to the ,
general estate .
10 . No t ic e of Div id e n d s
directors of a cor poration have full power to fix
T he
the amount and within the bounds of reason and good
, ,
faith the time and place of payment of dividen ds but
, ,
the stockholders must be given due notice .
Whe ndividend checks are not mailed notice must ,
be given the stockholders of the time and place at which
dividends will be paid T hese notices are sent out by
.
the treasurer or the secretary according to the regula ,
tions of the particular corporation T h e o fficer sending .
the notices must be governed absolutely by the stock
book un less he has personal knowledge or has received
,
70 A DJU S T I NG A ND C L O S I NG PR O BL E M S
formal notice of the fact that some particular stock
holder O f record is not the stockholder in fact T h e .
party to whom the dividend is to be p aid is always the
proper party to notify I f there is doubt in any par
.
t ic u lar case as to whom a dividend is to be p aid r e ,
sponsibility may be avoided by sending notices to all
the parties interested leaving the ownership of the divi
,
dend to be settled later .
I n some of the larger corporations notice of a divi ,
dend giving the time and place of payment and th e
,
period for which the stock books are closed i s usually ,
mailed to every stockholder and is published in the news
—
papers as well this latter not entirely as a legal r e
u ir e m e n t but as a general notification to the stock
q
holders and to the general public that the corporation
is paying dividends N ewspaper notice alone is held to
.
be ins u fficient notice .
T h e larger corporations when paying dividends
usually mail checks to the stockholders and this if , ,
properly done avoids any possibility of failure of notice
, .
T h e dividend checks are nothing more than orders upon
the bank for p ayment of the amount due the stock
holder but the recipient O f such a check has in the check
,
itself sufficient notice of the time and place for the pay
ment of his dividend Where checks are mailed a
.
,
newspaper notice of di vidends is usually deemed entirely
sufficient .
11 . Pa y m e n t of Div id e n d s
I t is customary to close the stock books a certain
num ber of days before a dividend is to be paid i n order
to give the treasurer an u ndisturbed opportunity to
C O RP ORA T E D I VI D E N DS 71
make up his dividend statement from the bo oks T he .
”
“
closed period usually begins on the e ffective date of
the dividend i e the date which fixes the ownership
,
. .
,
of the dividend and continues until the date of its pay
,
ment or if this period i s lengthy for such reasonable
, ,
time as will enable the treasurer to secure from the
books the data he requires for his dividend statement .
D uring this p eriod no transfers of stock will be made .
'
A s a rule the closing of the transfer boo ks works no
hardship T h e dividend as declared is payable to the
.
st ockh olders of record on a certain date and the books
are not usually closed until the day of this e ffective
date T ransfers of stock made after that date do not
.
,
therefore carry the dividend unless by special agree
, ,
ment between the parties and the fact that the tra ns fer
,
cannot be immediatel y recorded is in most cases imma
t e r ia l
. I f transfers pr ior to the declaration of the divi
dend have not been recorded such stockholders are of , ,
course shut out and to secure the dividend which right
, ,
fully belongs to them they must file due notice and evi
,
dence of the facts with the treas u rer .
A s soon as the stock books are closed the treasurer ,
is furnished by the secretary with a list of the stock
holders o f record as they appear on the date of closing ,
or otherwise the stock books are turned over to him and
he secures the names and addresses of the stockholders
h imself T h e treasurer then makes up his dividend
.
statement showing the amo u nt of stock held by each
,
stockh older and the amount of dividends due him T h e .
checks for dividends are made out and on the appointed
date are mailed to the parties to whom they are due or ,
if it is not the com p any s custo m to mail the dividend
’
72 A DJ UST I NG A ND C LO SI N G PR B
O LE M S
checks the stockholders are notified to call and receive
,
their di vidends in person .
12 . Fo r m of Pa y m e n t
Dividends are usually paid in cash and unless other ,
wise stated cash payment is always understood Divi
, .
d e n d s may however be declared from existing profits
, ,
regardless of the form of these profits T h e surplus .
“
may be in cash and then it may be divided in cash I t .
may be in property and if the property is so situated
that a division thereof among the stockholders is pr ac
t icab le a dividend in property may be declared and that
,
ma y be distributed among the stockholders ”
.
I f the profits are not in the form of cash and not in a
form to be distributed directly as property among the
stockholders the property might be sold or be used as
,
a basis for a loan of cash to be used in payment of divi
d en d s O r if the directors do not care to dispose of or
.
encumber the property which represents profits or i f ,
they wish to reserve all available cash for the use of the
corporation dividends may be declared in several dif
,
fe r e n t forms
1 . T he capital Stock may be increased and this
increase be distributed as a stock dividend ,
or any unissued or treasury stock on hand
may be used for the purpose .
2 . Bonds may be issued to the amount of the divi
dend and these bonds be distributed
3
.
. S crip may be issued against the profits and
this scrip be distributed as dividends .
“ 3 v 111 11 111 8 . W . U . T el . 00 9 3
N
. Y . 1 62
C OR P ORA T E D IVI D E N D S 3
7
Dividends in all these different forms if issued ,
under proper conditions are held to be legal l
, .
ae
1 3 . St o c k Div id e n d s
I n some few states stock dividends are prohibited
b y law as in Massachusetts E ven here however the
, .
, ,
end is practically accomplished by the declaration of a
cash dividend to the stockh olders which is then a debt ,
due from the corporation to its stockholders A simul .
t an eo u s o ffering of stock to an equal amount is made
and this stock i s purchased by the stockholders their ,
indebtedness therefor being o ff set by dividends due .
I n most of the states however no such restriction , ,
exists and stock dividends are not uncommon and , ,
under p roper conditions are not legally obj ectionable , .
I f the directors wish to retain the corporate profits to
increase the capital o f the corporation it becomes im ,
“
material whether such increase is made by awarding the
stock to stockholders as dividends in lieu o f money r e ,
taining the money for the purposes of the company or ,
by paying the stockholders the dividends in cash fro m
the earnings of the company and sellin g the stock in
the market to raise money for the use o f the corpora
”
t io n .
1 O r as stated in a later case
L
SO long as
,
' “
every dollar of stock issued by a corporation is r e pr e
sented by a dollar of property no harm can result to ,
individuals or the public from distributing stock to the
stockholders A ll that can be required in any case
.
is that there shall be an actual capital in property rep
”
resenting the am ount o f share capital issued 1 .
W ill i m v W U T l C 93 N Y 1 2
Ry C 5B rb ( N Y ) 3
* e o 6
a s
93
. . . . .
W U T l C
T H w ll o Ch i g
e v 78 ca o. et c o 1 a
N Y 1 62 E rl J ; R v B r l y
-
.
. .
, . .
I W lh m
5
i a s v . . . e . o . . a , . ose . a c a ,
19 1 P S
a 94
. t .
74 A D J U ST IN G A ND C LO SI N G PR O BLE M S
I t will be observed that a stock dividend of the kind
here considered is entirely di fferent from that derived
”
from stock watering in which the new stock does not
“
represent profits at all but is merely a dilution of the
existing capital and thus is illegal and Obj ectionab le .
14 . Bo n d Div id e n d s
The corporate bonds may take the place of cash in
payment of dividends at the discretion of the directors ,
provided only that they are issued against actual profits .
T h e argument for their issue is the same as for the issue
of stock as dividends I f the company has profits avail
.
able for dividends it may take these profits for cor
,
o r a t e purposes and replace them with bonds di s tr ibu t
p ,
ing these bonds as dividends .
1 5
. Sc r ip Div id e n d s
favorite method of paying dividends when
T he ,
neither stock nor bonds are available or expedient is ,
by means of scrip T his is practically a deferred divi
.
dend scrip being a certificate stating that the owner or
,
holder is entitled to certain rights or privileges specified
in t e
h ce r t ifica t e — usually a certain amount of cash pay
able at some fixed future date I n the issue of scrip .
dividends the same rule O btains as in the case of any
other dividends Profits must exist as a basis for their
.
issue .
U sually scrip represents existing profits which are
not in the form of money but which may be realized
upon at some future date and the money then used to
pay o ff this scrip O r there may be no intention that
.
the corporate propert y sha ll be rea lized upon the ex ,
C O R P O RA T E D IVI D EN DS 5
7
pe c t a t ibeing that at the time the scrip becomes due
on ,
cash will be on hand for its payment without regard '
to whether the property in question is sold o r n o t .
Sometimes however scrip represents an absolute
, ,
reservation of cash profits S ome other need for this .
cash is deemed more urgent than the immediate n e ce s si
ties O f the stockholders and the directors thereupon de
,
clare a scrip dividend and divert the cash to these other
needs T h e stockholders right to dividends is then
.
’
formally recognized but p ayment o f this dividend is de
ferred to a more convenient day T h e date of payment .
for this scrip dividend is entirely in the discretion of the
directors and is usually fixed on the basis of convenience
in meeting the obligation .
S crip is issued in many di fferent forms Some .
times the certificates are convertible being exchangeable ,
at a certain tim e for stock or bonds of the compan y on
demand of the holder S ometimes they are payable at
.
a date certain ; sometimes not un til money for their
payment is received from some specified source A t .
times scrip certificates entitle the holders to dividends
as would stock to the same value T h e scrip then par .
takes much of the nature of stock save that it has no
voting power .
16 . Pr o p e r t y Div id e n d s
D ividends may be paid in actual propertyalthough , ,
except in the case of corporate securities there are ,
obvious di fficulties in the way of distribution which make
such dividends rare T hus a company whose profits
.
were in land might divide this land among its stock
holders as a dividend if it could do so e quitably and no
, ,
76 A DJU S T I N G A ND C L O S I NG P RO BL E M S
obj ection could be raised T h e more usual form of .
property dividends is however that of securities o f , ,
other corporations received when the corporation sell s ,
‘
property or rights of some kind to another corporation ,
taking the stocks and bonds of that other corporation
in payment O r securities may have been bought out
.
right a t some previous time and the stock and bond s ,
so received might be divided among the stockholders o f
the receiving company as dividends T here are no o h .
j e c t io n s to such dividends provided they represent
actual profits I n 1 9 1 6 one of the great manufacturers
5
.
of war supplies paid a dividend in A nglo French % -
bonds .
U sually however dividends of this kind are de
, ,
c la r e d only when a corporation is liquidated all its prop ,
e r ty perhap s having been exchanged for stock or bonds ,
or both of the purchasing corporation I n this case
, .
the distribution is not strictly speaking a payment of , ,
dividends but is a distribution of assets and the ordinary ,
rule that dividends may be declared only from profits
does not apply .
REVI E W QUE ST ION S
W h en m a y d iv id nd b d l r d ut f pit l ? e s e ec a e o o ca a
Is it l w f ul t a b orrow mo n e y f th
o
pur p o s e f or e o payin g a
d iv i d n d ? e
W h t r igh t h v e s t o kh ol d r s s t d iv id e n d s ?
a s a c e a o
H w m y d iv id n d b p i d ?
o a e s e a
Wh t i a r ip d iv id n d ?
s a sc e
W hy t o k t n s f r b ook s u s u l l y c lo s e d b e for e
a re s c ra e a d iv iden d s
a rep id ? a
C H AP T E R VI
A C C O U N T I N G F O R D IVI D E N D S
1 . Pr o c e d u r e fo r P a y m e n t of Div id e n d s
Wh en a dividend is declared it becomes a liability ,
o f the corporation and should at once be brought on the
books I ts amount is credited to Dividend account and
.
debited to Profit and L oss or Surplus .
I n the smaller corporations dividends are usuall y
paid by check on the general bank account j ust as in the ,
case of any other company payment C ash account being ,
credited and D ividend account debited as the dividend
checks are drawn I n the larger corporations it is usual
.
to dra w one check payable to the bank for the total
amount of the dividend this check being entered in the
,
cash book and posted to Dividend account in the ledger .
T his closes the ledger account and the general books o f ,
the company are no longer concerned with that par
t icu lar dividend no matter how long some of the st o ck
,
holders may hold dividend checks before cashing them .
When a check is drawn for the total of the dividend ,
this check is deposited in the bank to the credit of a
—
special account as for instance K ingston Steel “
Works—Di v idends or W illiam K ingston T reasurer
,
” “ ”
—O r even in another bank than that in which the cor
,
p o r a t io n keep s its main deposit and the individual divi ,
dend checks are drawn on this account a special check ,
boo k being used T hese checks are mailed or otherwise
.
Ad p d b p rmi i f m B tt C rp r ti A ti
a te y e s s on ro enn e
?7
“
o o a on cc o u n ng .
78 A DJU ST I N G A ND C LO SIN G PR O BLE M S
delivered to their owners and from the bank s state , ,
’
ment of the dividend account it can be seen at an y time ,
which stockholders if any have not up to that time , , , ,
drawn their money T his does not a ff ect the general .
books of the corporation however because the entire , ,
matter i s now outside the usual course of business ; and
even though there are outstanding un paid di vidend
checks the balance in the account need not necessarily
,
show on the balance sheet .
I nstead of the plan j ust outlined some few of the ,
larger corporations make no entries for di v idend pay
ments on the cash book until the dividend checks are
paid at the bank A s reports are received from the
.
bank entries are made debiting Dividend account and
,
*
crediting C ash U nder this plan the credi t balance of
.
the D ividend account will Show at any time the amount
of the dividend still un paid I t is not unusual for divi .
dend checks to remain unpaid for a considerable time or
even indefinitely in which case this plan of r ecording
,
dividend payments has some advantages T h e C ash .
account in thi s case is also made to show its real status ,
so that dividend checks outstanding do not have to be
deducted in arrivin g at the correct balance o f the divi
dend cash .
T h e larger corporations with many stockholders usu
ally have specially printed dividend checks giving the ,
date and number of the dividend By means of an .
addressing machine the name and address of the st o ck ,
holder are stamped on the face of the check and the ,
amount is filled in on the typewriter or other printing
D ai ly s t ateme n ts are r e ce i edv f r om th e b a n k l
a on g w ith c an cel e d k fr
ch e c s om
th e p r vi
e ou s d ay .
A CC OUN T I NG FO R D IVI DE N DS 79
machine A fter the checks and amounts are verified
.
,
proved on the addin g machine and sign ed by the proper ,
O fficia ls they are p laced in window envelopes for mail
,
ing .
2 . Div id e n d Sh e e t or Bo o k
T he practice of setting aside each quarter or half
year in a separate bank account the exact amount r e
quired for the payment of dividends and drawing spe ,
c ial chec ks against this fund keeps di vidend cash e n
,
t ir e ly separate fro m the general cash of the company .
T o facilitate payment to the stockholders a dividend ,
sheet or book ( Forms 1 and 2 ) should be prepared .
A s the checks are paid a record may be made in this
book if desired but where the names are numerous this
, ,
is hardly worth while .
T h e dividend sheet or book contains a list of the
stockholders entitled to receive dividends with date of ,
dividend amount and number of each check etc T his
, , .
list is usually made up from the stock ledger each time
a dividend is declared after the trans fer books are
,
closed though in the case of companies with but few
,
stockholders such a list is not necessary When the .
stockholders are many and the stock is active it is very ,
necessary that these lists be compiled and that care be ,
taken in checking up and proving the amo u nts which
are to be paid .
T h e bound dividend book is used if at all only by , ,
small companies whose stock is not active T h e larger .
corporations use the loose sheet book T h e two exam
-
.
ples of dividend Sheet shown in Forms 1 and 2 illustrate
t wo methods of paying di vidends .
80 A D JU ST I N G A ND C LO S IN G P RO BLE M S
A CC OUN T I NG FO R D IVI D EN DS 81
82 A DJU ST I NG A ND C LO SIN G PR O BLE M S
Wh er e stockh olders come to the ofiice of the cor p o ‘
ration O r to the ba nk for t h eir dividends a space is le ft ,
on the dividend sheet for t h eir signatures Some com .
panics prefer to have st o ckholders call for their divi
d e n d s as it keeps them in touch with the corporation
and its business Most companies however have .
, ,
adopted the plan of mailing dividend checks and these ,
are always made payable to the order O f the individual .
T h e indorsement of the check is then considered a su ffi
cient r e ce ip t an d the receip t column of the dividend
,
‘
book is unnecessar y .
3. En t r ie s fo r C a s h Div id e n d s
To illustrate a simple form of entering cash divi
d en d s suppose the net profits of the K ingston Steel
,
Works for the year j ust passed amounted to
T h e directors have declared the regular annual dividend
of 5 % on the of outstanding p aid u p capital -
'
stock payable in cash in t e n d ay s from the profits for
,
the y e ar the remaining profits going to surplus T he
,
.
dividend is the seventh annual dividend that has been
declared .
T h e entries for the declared dividend and for pay
ing it are as follows :
J nu r y
a a 7
P rofi t an d L oss
D iv i d n d N o 7
e .
S ur p lu s
Se v en t h nn u l d iv id n d f 5
a 7 n th e
a e o 0 o
ou ts t n d in g c pit l st o k f th e om
a a a c o c
p n ya d e l r d th is d y by t h e b o r d
,
c a e a a
f di r ec t or s n d p y b l e J n u ry 1 7
o a a a a a .
A C C OUN T I NG FO R D IVI DE N DS 8 3
J nu ry
a a 17
FOr paym en t o f D iv id e nd No . 7 .
Frequently no D ividend account is opened in which ,
case the dividends paid are charged direct to Profit and
L oss or to Surplus account the entries for the foregoing ,
transaction be ing as follows
J n u ry
a a 7
P rofi t L os
a nd s
S ur pl u s
Ne t profi ts t r an s fe rr e d to S u rp lu s .
J nu r y
a a 17
S u rplu s 2 5
C a sh
P ay m e nt v en th n n u l d iv ide n d f
of se a a o
5 n th ou tst nd in g to ck of the
o e a s
com p n y d e l r d J n u r y 7 by t h e
a , c a e a a
bo r d f d i r ect or s n d p y b l J n
a o a a a e a
u ry 1 7
a .
a special bank account is set apart for dividend
If
checks the transfer of dividend ca sh is made as ex
,
plained in the preceding section by drawing one check ,
for the required amount D ividend or Surplus account ,
being debited and C ash credited T h e individual checks .
are then issued by the o fficers in charge of the dividend
di sbursements .
W hen dividends are paid quarterly the current ,
cre dit entries to Dividend account are sometimes
omitted entirely the cash payments be ing debited to
,
D ividend account which once or twice a y ear is closed
,
in to S u rplus account .
8 4, A DJU ST I N G A ND C LO S I NG PR O BLE M S
I t is not unusual for even the most prosperous com
pany to be temporarily short of ready cash to meet divi
dend payments T h e current assets may be three times
.
as much as the current liabilities and yet consist largely ,
of notes and accounts receivable which cannot be used
to pay dividends I n such cases the directors may bor .
row money to pay a dividend I n that event the follow .
ing entries may be made the first a j ournal ,
the others cash book entries
J nu ry
a a 5
Sur p lu s
D iv i d e n d P a ya bl
Di v id e n d of 5
% de l r
c a e d t h is d ay o n
c a pit a l st o ck of th e c om pa n y P ay
5
.
ab e l in c a sh J nu r y
a a 1 .
J u an a ry 1 3
N ot s P y b l
e a a e
Th r mo n th n o te d i ou n t d t Fir t
’
ee s sc e a s
N ti o n l B n k t
a a ur fu n d s fo
a o sec e r
p y m en t o f d iv id e n d d u e J n u r y 1 5
a a a .
J an u rya 1 3
Disc ou nt
C ash
Dis c ou n t 6% mp r ee
’
at on co an
y s th
mo nth s ’
n ot e o f
J nuary
a 1 5
Div id e n d P ayab l e
C a sh
P a ym e n t of d iv id e n d of 5
% o n c a pit a l
st ok c of th e c om p a ny .
A C C OUN T I NG FO R D IVI D EN DS 8 5
5E. n t r ie s fo r Sc r ip Div id e n d s
A nother way to pay a dividend when the corporation
is temporarily Short of cash is by an issue of scrip .
U nder such circumstances the N ovelty Manufacturing ,
C ompany with a capital stock of
be ing common st ock and preferred stock de
3
,
clares its regular annual dividend of % on both issues
5
,
payable in scrip Dividend declared May 1 1 9 2 0
5 5
.
, ,
payable J une 1 1 9 2 0 ; scrip payable in cash J une 1
, ,
192 1 .
j ournal entries for the declaration and payment
T he
3
of th is ann ual % scrip dividend on the common and
preferred stock are as follows :
M ay 1 5 92 0 ,
1
Su rp lu s
D iv i d e n d , C ommon
D iv id e n d, P r e fe rr e d
Ann u l d iv id n d f 3
a % n b o th ommo n
e o o c
and p r f rr d e t k d
e e l r d th i
s oc ec a e s
d y p y b l J u n 1 51 9 2 0 in
a a a e r ip
e sc
f t h e om p n y m t ur in g J u ne 1 5
, , ,
o c a ,
a ,
n d b e r in
19 2 1 , a g in te r e s t t
a a
J un e 1 51 9 2 0
,
Div iden d ,ommo n
C
Divi d e n d P r e f rr d
, e e
D iv id n d S r ip ( or Sc r ip P y b l )
e c a a e
Div id e n ds p id t h i d y in c r ip m t ur
a s a s a
in g J u n e 1 5 19 2 1 n d b e r in g in t e r a a
5
, ,
e s t at 7 0 .
Wh en the scrip matures an entry similar to the fol ,
lowing is necessary
86 A DJ U ST I NG A ND C LO SI NG O BLE M S
PR
J une 1 51 9 2
,
1
Div id e nd Scr ip
I nte r e st
C a sh
For pa y m en t f d iv id n d s c r ip m tur
o e a
in g t od y w ith in t e r e s t from J u n e
a
51 9 2 0
,
1 , , at
6 . En t r ie s fo r Sp e c ia l a nd In t e r im Div id e n d s
O ccasionally after a very prosperous year or a ,
longer period of prosperity during which a large su r ,
plus has been accumulated the directors declare a ,
” ”
Special dividend or bonus in addition to the regular “
dividend .
T o illustrate the entry of such dividends assume that ,
a corporation with capital stock and profits ,
for the y ear of declares its seventeenth regu
lar annual dividend of 7 and at the same time declares
its first special dividend amounting to and awards
to its employees a bonus of 1 0 % of the net earnings of
the year j ust ended T h e entries are as follows : .
J nu ry 5 a a
Sur p lu s $11
Div id n d N o 1 7 e .
S p i l D iv id n d N o 1
ec a e .
B o n u s t o E m plo ye e s
P e r s olu tio n p
r e d t hi d y by th eas s e s a
bo rd af d ir e t or s d l r in g th e
o c ec a
r egul r nn u l d iv id n d o f 7 o n
a a a e
th e pit l s t o k f t h e om p ny ;
ca a c o c a
n a d d itio n l d iv i d n d f 2 7 ; nd
a a e o 0 a
w rd ing t t h e e m pl o yee s b o n u s
a a o a
f 1 0 7 o f th n e t
o 0 r n ings o f th e
e ea
y r j
eau t e n de d ; lsl p y b l in a a a e
c sh o n th e 1 5
a th d y o f J n u r y a a a .
A CC OUN T I NG FO R D IVI D EN DS 87
D iv id e n d No 17 .
S pe c ia l Div id n d N o e . 1
B o nu s t E m p loye e s
o
C a sh
m
For pa y e n t o f i i e n d v d d nd b onu s a s
p rov
id e d fo r in es r olu tio n f th O e
bo rd a of di r ct or
e
p s ed J nu
s a s a
a ry 5 .
Special di v idends declared between the regu lar divi
”
dend dates are called in terim dividends and are de “
,
clar e d when un usual profits exist to j ustify a special
dividend or when for some reason it i s desired to antici
,
pate the regul ar dividend in whole or in part When .
dividends are paid quarterly as is the case with most of ,
the larger corporations an interim div idend is seldom ,
if ever declared T h e entries in case of interim divi
.
d e n d s would of course be the same as those of a regular
dividend .
7. En tr ie s fo r Div id e n d s A p p lie d t o St o c k Su b s c r ip t io n s
A contract between a corporation and a subscriber
to its stoc k providing that his subscription Shall be paid
by di vidends on the stock subscribed for is held bv the ,
co u rts to be inva lid both as against the corporation and
against corporate creditors A ny dividends actually .
declared before a stock subscription is paid could how ,
ever be credited against it and wou ld be a valid pay
,
ment .
T o illustrate the entries when dividends are to be
applied on a stock subscription let us suppose that ,
par value of new stock of the K anawha I ron
5
Works ( shares $ 0 each ) has been o ff ered for sale to
88 A DJU S T I NG A ND C LO SI NG PR O BLE M S
provide funds for the erection of addi tional buildings
that all this has been subscribed and a first instalment
5
,
of 0 % has been paid upon it J ohn Smith is a sub
scriber for 1 0 shares O n J anuary 5the board of di
.
.
,
rectors passes a resolution calling for the final instal
5
ment of 0 % on the entire subscribed stock payable
3
,
February 1 O n February at which time J ohn Smith
.
,
has not paid the final instalment on his stock the di
5
,
rectors declare a n annual dividend of % on the entire
outstanding stock payable Feb ruary 1 5
.
T h e entries for these transactions are as follows :
J nu ry 5 a a
Fin a l m ent n
in s tal o St o ck ( or I n s t l a
m ent N o 2 ) .
S ub c r iptio n s
s
P e r es olu t io n p s s d t h i d y b y th e
r a e s a
b o r d o f d i r t or
a ll in g f th e
ec s, ca or
fi n l in s t lm n t f
a a e n o o
f c pit l t o k o f th e
o a a s c
c om p ny a .
T his
entry will close the Subscriptions account sub ,
stitu t ing for it the Final I nstalment account A ssum .
ing that all the stockholders have paid the first instal
ment in full the First I nsta lment account is already
,
closed .
Feb ru a r y 1
Fin a l I n s t lm en t n St c k
a o o
P aym e n t o f fi n l in s t lm n t o n
a a e c a pit a l
st ok
c .
of course would be comprised in cash book
T his , ,
entries showing the names of the stockholders and
amount p aid by each T o simp lify the illustration it .
,
A C C OUN T I NG FO R D IVI DE N DS 89
is assumed that all except J ohn Smith have paid this
final instalment at the time the dividend of Februar y
3 was declared .
Feb ru ry a 3
S ur plu s
No 5
D iv id e n d .
Th e b o r d f d i r e t or s h v e t h is d y
a o c a a
d l r d th e r gul r nn u l d iv id e n d
ec a e e a a a
of 5 % n t h e p t l sto k
i o f th e ca a c o
om p n y p y b l in h n the 1 5
c a ,
a th a e cas o
d y o f Fe b ru r y
a a .
Fe b ru r y
a 1 5
D iv i d e n d No . 5
C as h
D iv id e n d pa id th is d a y a s pe r r e s ol u
t i o n o f th e b o a r d o f d ire ct or s , Fe b r u
ar
y 3 .
Fe b ru r y
a 1 5
Divi d e n d No 5 .
F in l I n t lm n t o n St o k
a s a e c
T o
pp y
a l d iv id e n d f J oh n Sm ith s o a
p tarp ym e n t a f fi n l in t lm e n t o f o a s a
$2 5 0 d n 1 0 sh r e
ue f c pit l
o a s o a a
s t o k o f th
c m p ny e co a .
8 . En tr ie s fo r C u m u la t iv e Div id e n d s
Preferred dividends for the current year must
u sually be paid before dividends may be paid the holders
o f common stock ; and i f the preferred stock is cumula “
” ”
tive all dividends on it which have been passed in
,
“
former years must be paid in full before the common
st oc k can participate .
T o illustrate the di ff erence between the two kinds
of stock sup p ose a company with preferred s to ck call
‘
,
90 A DJU S T I NG A ND C LO SIN G PR O BLE M S
ing for 7% d ividends has passed all dividends for
two y ears and at the end of the third year desires to
,
'
pay a dividend on the common stock I f the preferred .
stock is cumulative it will first have to pay all the ,
“
passed dividends on the preferred stock amounting
to —
and the current dividend as well 2 1 7 0 in all ;
while if the preferred stock is non cumulative it need
,
-
pay only the current dividend of 7
A lthough the preferred stock di vidends must be paid
before the common stock can receive any share of the
profits of the corporation these dividends do not become ,
an obligation of the company until they are formally
declared by the board of directors I t would seem .
,
therefore to be poor accounting to enter the m on the
,
b o oks as an obligation at the time they are passed I t .
is necessary however that the unpaid cumulative divi
, ,
d e n d s be shown on the balance sheet and this is best ,
done by means of a footnote stating the amount of the
contingent liability for the dividends which have been
passed .
Where a preferred dividend is passed but it is d esired
that it be shown on the books it may be done by an ,
entry Similar to the following :
S ur p lu s
U n p id a P r
rr d Div id nd e fe e e
Fo r 1 9 2 0 pr f rr d d iv id n d
e f 6% n
e e e o ot
d l re d b y th b o rd f d ir tor b
ec a e a o ec s ut
o r d r d t b h ow n u p o n t h b ook
e e o e S e s .
T his
might make the Surplus account show a debit
balance and in any event it would be reducing surplus
,
for the sake of a liability which was only contingent .
I nstead of charging the dividend against surp lus it ,
A C C OUN T I NG FO R D IVI D EN DS 91
might therefore be a be tter p lan to set up the follow ing
suspense acco unt to offset the contin gent liability of the
u npaid preferred dividend :
Di i v d e n d — P r f rr d S t k
s e e e oc
U n p id P r f rr d Div id n d
a e e e e s
F or 1 9 2 0 p r f rr d d iv id n d
e f 6% n t
e e e o o
d l r e d b th bo r d f d ir e t or b ut
ec a y e a o c s
ord e r d to be h ow n u po n t h e b ook s
e s .
9 . En tr ie s fo r St o c k Div id e n d s
Sometimes the directors declare a st ock dividend
in stead of a cash dividend T o illustrate the entries in .
such a c ase suppose that the Michigan Furniture C o m
,
pany with an auth orized capital stock of
,
has had a very prosperous year its profits amoun ting ,
to over but the direc tors desire to invest most
of their available funds in additional Shops and ma
chinery T heir regular annual dividend is
. O nly
one half of the authorized capital stock has been issued
-
.
T h e regular 1 0 % dividend is declared but i nstead of ,
be in g payable in ca sh it is made payable in stock of the
S urpl u s
D iv i d e n d No . 4
A d iv id en d f o 10 % on th e
ou ts t n d in ga c a p i ta l s t oc k of th e co m
p n y ah t h i as s d a y be e n d l r ed
ec a by
th d ir t or
e ec s,
p ay a ble in s t oc k o f
th om p n y
e c a .
Div id e n d NO . 4
C a pit a l St o k c
S t oc k is s u ed to pay st cok d iv id e nd
of
92 A DJU ST I NG A ND C LO SI NG PR O BL EM S
I f the unissued stock is being carried on the books
in U nissued or U nsubscribed Stock account the second ,
entry would be a credit to that account I f the dividen d .
were paid out of treasury stock T reasury Stock ac ,
count would o f course be credited , , .
10 . En t r ie s fo r Bo n d Div id e n d s
C orporate
bonds may at the di scretion of the di ,
rectors take the place of cash in the payment of divi
,
d e n d s provided only that they are issued against actual
,
profits T o illustrate the entries when this is done sup
.
,
pose that in the preceding example the directors with ,
the consent of the stockholders had paid the dividends ,
in bonds ; the entries would be as follows
Sur plu s
D iv i d e n d No 4 .
A d iv id n d f 1 0 % n th pit l s t o k
e o o e ca a c
of th om p ny h s th i d y b n d
e c a a s a ee e
l
c a red by th e d ir e tor p y bl in c s, a a e
th fi r t mor tg g t r e s ur y b on d f
e s a e a s o
t h e om p nyc a .
D iv id e n d No . 4
F ir t M or tg g T r ury B o n d
s a e eas s
Fir t mor tg g 4 % t r
s ury b o n d giv n
a e ea s s e
t o t o k h ol d r
s cin p ym e n t e f 10 %
s a o
d iv id n d n t h e s t o ck f th c or p or
e o o e a
t io n .
11 . En tr ie s fo r Pr o p e r t y Div id e n d s
entries when a property di vidend is declared are
T he
similar to those for bond dividends the proper s e curi ,
ties O r other property accounts bein g credited in the
second entry .
A C C OUN T I NG FO R D IVI D EN DS 9 3
12 . Ill e g a l Div i d e n d s
A lthough the laws of all of the states forbid the pay
ment of di vidends if such payment results in the im
pa irment of capital ther e are more or less frequent in
,
fractions o f this rule T h e fact that a dividend has been
.
paid out of capi tal may not be k nown to anyone except
the d irectors ; in fact the directors themselves are some
,
t imes ignorant of such an occu rrence owing to the fact ,
that they will not take the trouble or have not sufficient ,
kn owledge of accounting to inform themselves of the
,
true condition o f the company Y et they may be held .
liable bv the courts for any loss to creditors occasioned
by the payment of dividends out of capital .
E rrors as to profits may arise from many causes .
T h e bo oks of the company may Show a surplus of earn
ings w hich in r e a litv does not exist perhaps because no ,
provision has been made for bad debts or depr eciation ;
or materials have been included in the inventories w hich
have not yet been credited to A ccounts Payable ; or
merchandise m a y have been valued at the sel ling price ;
or orders for future delivery may have been recorded
as sales ; the boo k value of real estate may have been
written up ; asse t s with no value such as patents and ,
co pyrights which have expired may still be carried upon
,
the books ; j udgments against the company may have
be en omitted from the accounts T hese and other .
errors may have been made which hide the fictitious
charac ter of the apparent p rofits so that the payment ,
of dividends under such conditions results in an im
pairment of capital A n examination by a competent
.
auditor would of course disclose any such errors and
, , ‘
prevent the declaration of il legal dividends .
9 4. A DJU ST IN G A ND C L O SI N G P RO BL E M S
I n case accounting errors are discovered which have
resulted in a fictitious surplus the proper charges must ,
be made to Sho w the true condition T his may if divi .
,
d e n d s have been declared or other expenditures have
been made on the strength of the supposed surplus re ,
sult in a debit balance in Surplus account I t is per .
fe ctly proper to allow this debit balance to remain on
the ledger until wiped out by the accumulating profits ,
but in the balance sheet it should be placed on the asset
”
side and called Deficit ; yet in financial statements
it is not unusual to see it deducted from the capital
stock .
R EVI EW QU E ST ION S
Wha t or m tio n h ould b e giv e n n s p i l l y pr in ted d iv i
in f a s o a ec a
d nd h k ?
e c ec
D s r ib e s e v r l m th o d s f r c ord in g di v id n d w h e n th y
e c e a e o e e e s e ar
( ) d l r d n d ( b ) p id
a ec a e a a .
Wh t i a s a r ip d iv id n d n d h w i it r e or d d ?
sc e a o s c e
C n d iv id n d be pp l i d g in t s t o k s u b r ipti o n s r ece iv b l e ?
a e s a e a a s c sc a
If il lu t r t e t h b ook e n t r i s r q u i r d
so , s a e e e e .
W h t i th e b t w y f r or d in g in th c ou n ts th e mou n t f
a s es a o ec e a c a o
und l r d umul tiv e p r f rr d d iv id n d s ?
ec a e , c a e e e e
G iv p e f orm e n t r i
ro t r ord s to k d iv id n d ; b o n d d iv id e nd
a es o ec c e s s .
H ow n il l e g l d iv iden d s b e in d v r ten t l y d l r e d ?
ca a a e ec a
C HAP T E R VI I
—
S U R P LU S N A T URE A ND S O UR C E S
1 . De fi n it io n a n d Na t u r e o f Su r p lu s
T heexcess of the assets of a corporation over its
liabilities and capital stock is called surplus S urplus .
in the balance Sheet ordinarily designates the amount
of the profits withheld from distribution for the pur
pose o f establishing a permanent addition to the e f
fe c tiv e capital o f a concern I n a partnership or a sin .
gle proprietorship business the profit balance is retained,
’
as capital by being added to the proprietor s capital ac
count I n a corporation the profit balance is retained
.
as cap ital by being added to the S urplus account .
T h e term does not imply any specific use to which
the surplus is to be put and is thus the most compre
h e n siv e of all terms used to designate reserved profits .
”
I n E ngland the term rest is the equivalent of surplus
“
,
”
and in C anada the surplus is called the reserve fund “
.
”
I n G ermany reserve is the common term there being
“
,
no equivalent to surplus .
T hough the accumulated profits which are invested
in the business are surplus surplus need not n ece s sar ilv
,
consist of accumulated p rofits only T h e term may in .
cl u d e items other than realized profits in which case the ,
source from which the surplus i s derived if the amount ,
is relatively important is usually indicated on the bal
,
ance sheet Where a s u rplus exists it is maintained
5
.
,
9
96 A DJU ST I NG A ND C LO SI N G P RO BL E M S
as a measure of safety to strengthen the financial co n
dition of the company and to safeguard it again st u n
foreseen contingencies .
2 . So u r c e s of Su r p l u s
A surplus may be specially created on the organiza
tion of an enterprise Stockholders for instance fre
.
, ,
quently donate to the treasu ry of a corporation part of
their stockholdings to be sold for cash thus providing ,
working capital and creating a surplus not derived from
profits O n the organization of a bank stock is fr e
.
,
quently subscribed for at a premium the premium con ,
stitu t ing a capital surplus to be held in reserve and not
to be distributed as p rofits S urplus may also result
.
from the revaluation of assets from their sale at a profit , ,
or from the purchase of the corporation stock at a dis
count C onservative accounting requires that the
.
source from which the surplus is derived be Shown on
the books and that the amounts in each case be truly
stated .
S pecial surplus accounts as for example R eal E s, ,
tate Surplus S urplus from Premium on C apital Stock
, ,
may be set up to take care of substantial changes in the
value o f capital assets and to distinguish between sur
plus arising from earnings and that from other sources .
A S a general rule however any increase in the value of
, ,
the fixed assets of a business due to changing economic
conditions should not be taken up in the accounts nor
should the book values of assets ordinarily be changed
if they d e crease I f the management insists upon r e
.
cording a n estimated profi t resulting from economic
causes the increase should be cre di ted as stated above .
SUR P LU S —N AT U RE A ND S OUR C E S 97
I f the Profit and L oss account fails to absorb all
the expense of operation both profits and surplus will
,
be overstat e d I f capital expenditure is charged to rev
.
enue the costs of operation are unduly increased and
,
certain assets are undervalued ; if a revenue expenditure
is charged against c apital the expenses are less than
,
they should be I n the first case t h e surplus show n on
.
,
the books is less than the actual s u r p lus ; in the latter
case it is overstat e d .
3. Su r p lu s and fi
Un d iv id e d Pr o t s A c c o u n t
A s a ledger account Surplus is more common to the
,
corporate form of bookkeeping T his is so because as .
,
previously no ted in a business conducted by an indi
,
vidual or firm the balance of the Profit and L oss ac
,
count is usually d isposed o f through the C apital account
or accounts as the case may require and no surplus as
, ,
such is accumulated I f however it is desired to a c
.
, ,
cumulate the p rofits in whole or in p art and Show the
accumulatio n in a separate account the amount so r e ,
t ain e d from the C apital account o r accounts is trans
ferred at the close o f each fis cal period to Surplus a c
count I f the business should show a loss the debit
.
,
balance of Profit and L oss account should be trans
ferred either to the C apital acco u nt o r accounts or to the
debit Side of Surplus account I f at any time the debit .
side of Surplus account exceeds the credit Side the bal ,
ance represents a deficit or the amount by which the
,
capital of the business is impaired .
B anks usually make a distinction between Surplus
account and U ndivided Profits account E ach year a .
given amount of the net profit is transferred to Surp l us
98 A DJU ST I NG A ND C LO S IN G PR O BL E M S
account to serve as permanent working capital Whil e ,
the remainder after payment of dividends is carried in
, ,
the U ndivided Profits account Many corporations .
make no distinction between the two accounts using ,
either one or the other for all purposes S ome make .
”
use of the title S urplus and U ndivided Profits others ,
”
prefer the term Surplus and Defici ency while others ,
use only the Profit and L oss account T h e caption .
”
“
Surplus and Deficiency is preferred by many account
ants because the account may then without misnomer not
only accommodate surplus but any deficiency as well .
T his is the plan used by p ublic service comm issions in
their schedules and reports .
En t r ie s t o Su r p l u s A c c o u n t
S urplus a ccount should be debited with
1 T h e amount of dividends declared
. .
2 T h e amounts p eriodically reserved for sink ing
.
fund purposes
3
.
A ny adj ustment during the current period of
.
entries made during the previous period
when the adj ustment diminishes the profits .
4 A ny extraordinary charges affecting the
.
profits of a business
5
.
T h e balance of the Profit and L oss account if a
.
debit at the close of the fiscal period .
T he account should be credited with
1 . T h e net profit as shown by the Profit and L oss
account at the close of the fiscal period .
2 . A ny adj ustments made during a fiscal period
which should have been credited to some ex
S U RP LU S —NAT U RE A ND S OUR CE S 99
pens e or revenue account wit h in a prior fiscal
p eri o d ; or which increase the profits of a
prior fiscal period .
T he reason for ta king in to the current S u rplus ac
count all adj ustments appli cable to a prior period or ,
of an extraord inary nature is to enable the Profit and
,
L oss account to Show the resul t of O perating under nor
mal conditions I f some e xt ra or d mar y charge or credit
.
is made to Profit and L oss acco u nt the results for that ,
part icular period will be abnormal and inconsistent with
those of previous periods E xamples of the items which
.
may be charged to Surplus are a fire loss not recover
able loss from accident or damage suits shrinkage in the
, ,
value of securities or merchandi se on hand S uitable .
credits to the account would be payments on old accounts
written o ff the amount ( if small ) rea lized on the sale
,
of stock at a premium and so on , .
5. Su r p lu s fro m Sa l e of A ss e ts
When any fixed assets are sold at mor e than their
book value the excess may be set up in a sp e cial surplus
,
acco u nt only after a careful appraisal establishes the
fac t that the depreciation reserve is ample and that the
remai ning fix ed assets are carried on the b oo ks at their
true value I f the amoun t in D epreciation R ese r ve a c
.
count is inadequate the surplus derived from the sale
, ,
or a portion thereof should be us ed to increase the valu
,
ation reserve to an adequate amount T h e remainder .
,
if any may then be taken up as income and credited to
,
a separate sur plus acco u nt to Show the source of the
increased net worth .
100 A DJU ST I NG A ND C LO SING PR O BLE M S
When a concern holds a considerable amount of
temporary or permanent investments conservative pra e ,
tice requires the creation of a reserve out of surplus for
a possible decrease in their value I f this practice be .
followed and some of the investments are sold at a
,
profit the profit should first be applied to increase the
,
margin of safety against possible loss on investments
still held if this be considered necessary A ny part of
, .
the profit thereafter remaining is a proper increase to
the Surplus account .
6 . Su r p l u s an d t h e Re v a lu a t io n of A s se t s
T he depreciation allowance however carefully esti ,
mated in the first instance rarely exactly equals the ,
actual depreciation over a lo ng period O f time For .
this reason many large concerns desiring to have an
impartial appraisal made of the value of their fixed as
sets fro m time to time engage an independent appraisal
,
company which specializes in this class of work I f the .
revaluation of the property shows it to be worth more
than the amount at which it is carried on the books one ,
of two courses may be adopted T h e values may stand .
as before and the proper adj ustment be secured by
graduall y decreasing the amount of depreciation
charged in subsequent accounting periods ; or the in
crease may be taken up T h e method used will depend
.
upon the way in which the depreciation of prior pe
r io d s h a s been handled I f the depreciation charges
.
have been credited direct to the asset accounts and the ,
assets in consequence are carried at their depreciated
value any increase in the appraised value should be
,
debited to the asset account so that the book value may
S UR P L U S—NAT U RE A ND S OU RC E S 101
be equal to the appraised value—the o ff setting credit
being to Surplus account I f the deprec iation charges .
have been carried to R eserve for Depreciation the book ,
value of the assets may be increased to their appraised
value by reducing the amount in the reserve account .
Sometimes the revaluation will disclose the fact that
the property is overvalued I n this case to be conser .
,
v at iv e Surplus account should be charged and Depre
,
c ia t io n R eserve credited with the amount of the over
valuation .
7 . A c c o u n t in g fo r Su r p lu s an d Re se rv e s
illustrate the j ournal entries required for the dis
To
position o f the surplus at the end of an accounting
period assume that a certain corporation finds that dur
,
ing the fiscal year it has earned a net profit of
T h e board o f directors declares a 1 0 % dividend which
reduces Surplus and C ash by and f u rther de
clares that of surplus profits be rese rved for
future cont ingencies T h e surplus profits now remain .
ing amount to T h e j ournal entries required
to set forth the above facts are
P rofi t an d L oss
S ur p lu s
To t r ns f r n
a e et p rofi t to S ur plu s ac
c ou n t .
S ur plu s
D iv i d e n d P a yab l e
To r e ord
c d e c l a r a t io n of d iv id n d s
e .
Div id e n d P ay ab l e
C ash
To r or d
ec di v id e n d paym ent .
102 A DJ U S T I N G A ND C LO SI NG PR O BLE M S
S ur p lu s
R es e rv e fo r F tu ur e C o n tin
e n c ie s
g
To r e c or d s e tting a si d e th e r es e rv e .
A n alternative method whereby the same facts may
be recorded with fewer entries is to debit Profit and L oss
a c count direct as follows :
P rofi t an d Lo ss
D iv id e n d P ay ab l e
R e s e rv e fo Fu t ur e C o nting n cie s
r e .
To r ec or d pp ro p r i tio n o f profi ts
a a .
P r ofi t an Lo d ss
S ur plu s
T o r e or d c t r an s fe r of ba l an ce to
Sur plu s .
Div id e n d P ayab l e
C a sh
8 . Effe c t on Ba l a n c e Sh e e t
A ssume that before making the above entries the
corporate balance sheet in condensed form reads as fol
lows
BALAN E S HEE T C
Mi ll n ou A t
sc e a e Mi
s ll ou Li b il iti
s se s sce a ne s a es
C p it l S t o k a a c
U d ivid d P ro fit ( S n e s ur
plu ) s
Wh en the item of U ndivided Profits is passed into
S urplus the only change to be made on the balance sheet
,
is that the term S urplus replaces the term Undi “ “
S U RP LU S—NA T U RE A ND S OU RC E S 10 3
Profits
v id ed A fter the dividend has been declared
.
and paid and reserve for future contingencies has been
set up the balance sheet will ap p ear as fo llows :
,
B ALAN C E S HEE T
M isc e ll ane ou s A ss e t s ll ou Li b il it i
M is c e a ne s a es
C p it l S t o k
a a c
R rv for C t i g
e se e on n en
c ie s
S urplu s
EVIE W QUE ST ION S
R
N m e s e v e r l our
a f ur plu
a s ces o s s .
sk e l e t on Su p l u s cc ou n t
Se t p u a
giv in g l l th e u s u l d eb its
r a ,
a a
nd a r e dits
c .
G iv e j our n l ent r ie s f r th e d e c l r tio n n d p ym e n t o f
a o a a a a a
d iv id e n d .
W h t i u u ll y th fi n l n t v m d in t h e b ook s f a cor
a s s a e a e r a e o
p ot ation wh en d iv id ends ar e not paid ?
C H AP T ER VII I
R E S E R VE S A ND F U ND S
1 . De fi n it io n an d Na t u r e of Re s e rv e
A reserve is a part of surplus withheld from distr i
b u tio n as dividends and set aside for the special pur
,
pose indicated by its name T his purpose is usually to
.
accumulate capital out of profits for present or future
contingencies whereby the operation and prosperity of
the business are safeguarded so far as prudent financial
foresight can contribute to this end .
B e fore proceeding further it should be understood
that a reserve which is created by a charge aga inst oper
a t io n s to o ff set a capital loss is a valuation reserve ; not
a true reserve
T h e credit balances in accoun ts recording the depre
ciat ion of physical units the amount reserved for pos
,
sible losses on accounts receivable and so on constitute , ,
a bookkeeping expedient whereby the estimated losses
in asset values are recorded separate from the asset
accounts to which they are O ffsets T h e purpose O f this .
separation i s to preserve from any obscurity the original
purchase or cost price of the assets and the provision
that has been made year by year for their depreciated
value For these reasons such reserve accounts are fr e
.
”
quently called valuation accounts to distinguish them
“
from true reserve accounts set aside from surplus .
A true reserve is something set aside out of surplus
1 04
R ESE RVE S A ND F UN DS 10 5
profits after their amount has been determined A .
valuation reserve o ffsets a los s actually incurred or that
may be incur red the amount of which is estimated and
,
charged to the expense of operation before the amount
of the true profit can be ascertain ed .
T h e title of a reserve account will ordinarily indicate
whether it is a valuation account or a true reserve .
T hus R eserve for E xtensions and R eserve for C ontin
, ,
g e n c ie s are O bviously reservations of profits for the fu
t u re financing of the business and in no sense can they
be considered as involving expenses of operation O n .
the other hand R eserve for B ad Debts and R eserve for
,
Depreciation are as obviously credits representing r e
d u c t io n s in assets due to expenses involved in operation .
T hese may be termed valuation accounts because to
gether with the asset accounts they represent the value
of the assets .
2 . Ba l a n c e Sh e e t Tr e a t m e n t of Re se r v e s
distinction between the two kinds of reserves
Th e
should be clearly indicated on the balance sheet by the
method of their presentation A valuation reserve re
.
cording the estimated shrinkage in value of an asset
Should appear as a deduction therefrom on the asset side
—
of the balance sheet A true reserve an amount set
.
aside from surplus for a specific or general purpose
should be shown as a subdivision of the surplus acco u nt
among the proprietorship or net worth items .
Wh ile the above form of p resentation on the balance
sheet has the merit of clearness and truth the plan is ,
not uniformly followed T h e financial statements of
.
manufactur ing concerns usuall y Show the item of d e
106 A DJ U ST I N G A ND C LO SI N G P RO BLE M S
preciation as a deduction from the fixed assets only
when depreciation has been charged to the cost of oper
ation I n mercantile houses and in small m anu fa ctu r
.
ing businesses the depreciation charge is frequently a
matter of financial policy determined after the profits
for the fiscal period have been ascertained I n this case .
the usual practice is to show the depreciation reserve
and Similar charges among the net worth items thus in ,
d icatin g that they are reservations from profit .
T his latter method o f presentation is wrong in prin
c ipl e .I n j ustification of its use it is contended that
when operations result in a loss the factor O f deprecia
tion may properly be ignored as otherwise the deficit ,
would be further increased by the amount of the depre
c iat io n charge T herefore the proponents of this
.
,
method say if depreciation may be ignored when there
,
are no profits it should be shown as a reservation of
,
profits when conditions permit U nder no circum .
stance should a deficit be turned into a profit b y this
procedure T h e aim in all cases and at all times should
.
be truth in the statement of financial condition and
profits .
3 . Re s e r v e s v s. Fu n d s
is little or no uni formity in the use of the
T here
term fund nor is a precise distinction always made
“
” “
between the meaning of the terms reserve account
”
and reserve fund
“
Some accountants use reserve
.
“
fund as applying to the true reserve and the term ,
“
reserve account as appl y ing to the valuation reserv e
”
.
A s an actual fund of cash or s ecurities is an asset it ,
would in the interests of clearness and exactness seem
, ,
RE SE RVE S A ND F UN DS 107
advisable to confine the meanin g of fund to those ac
counts which represent cash or its equivalent set aside
, ,
for a p articular purpose and the meaning of a reserve
,
account to those set up by making reservations of sur
plus.
For instance if a certain a m ount of cash is set aside
,
at periodical intervals to meet a liab ility such as the r e
demption of bonds a fund is created I n the case of
, .
this fund actual cash is withdrawn and held and is there
, ,
for the redemption of the bonds when they fall due .
I f however instead of this a portion of the profits
, , ,
is withheld from distribution as dividends and entered
in a reserve ac coun t a res erv e is set up on the books
,
.
For example suppose a corporation does not pro vide
,
for the redemption of its bonds by a cash fu nd but
merely makes a reservation of profits b y a charge
against Surplus ; the r e Su lt is a reserve .
I n the case of the res er ve the profits have simply
,
been withdrawn fro m sur p lus and entered in another
“ ”
account R eserve for R edemption of B onds so that
, ,
they cannot be declar ed in dividends or diverted to other
—
uses merely a boo k k eeping op eration T hi s being so . ,
when the bonds fall due their redemption will not im
,
pair the capital or reduce the surplus because of the ,
reserve ; but this is all that the reserve does and the ,
directors must then take ste p s to secu r e cas h to pay the
bonds .
T o illustrate further a fund consists of a certain
,
amount of assets in a liqu id and realizable form set as ide
to carry out the spec ific purpose for which the fund is
created O n the other hand a reserve consists of the
.
,
segregation of p art of the sur p lus to a reserve acc ount ;
108 A DJU S T I NG A ND C LO SING PR O BLE M S
it prevents the di stribution o f that amount as dividends ,
but does not of itself provide fu nds for these future
needs I f a balance sheet states that
. is r e
served out of profits these profits are likely to be ah ,
sorbed in business operations or to lie as idle cash in the
bank unless earmarked for some funded purpose T his .
can be provided for only by setting aside from time to
time whatever cash can be safely taken out of working
capital and investing it in readily convertible assets .
When actual cash is set aside in this way actual money ,
is available for the specific purposes of the reserve ac
count Such reserved assets become the fund and ap
.
,
pear upon the balance Sheet as shown below .
B ALAN E S HEE
C T
M is ce ll a ne ou s A s se t s 00 ll ou L i b il iti
M is c e a ne s a es
Fund C p it l S t o k
a a c
R rv for C t i g
e se e on n en
c ie s
S urplu s
I t should be noted that the investments in the fund
need not necessarily equal the amount carried to r e
serve out of surplus although it is preferable that they,
sh ould do so O nly a portion of the reserve may be
.
covered by specific assets held in a fund the remainder , ,
of the reserve being merged in the general assets of the
business Funds when created for specific purposes
.
, ,
should like reserve acc ounts indicate the purpose in
, ,
”
their hea d ing as A ssets in Pension Fund etc “
, .
A ccounting opinion is not in agreement as to the
p ro p riet y or necessity of utilizin g the liquid assets of a
R E SE RVE S A ND F UN DS 109
busin ess for the creation of a fun d T h e contention is .
frequently raised that the most profitable investment for
any enterprise lies in the extension of its own plant and
the sphere of its operations T o accumulate a portion
.
of the cash in a fun d is to withdraw cash which might
otherwise be utilized as workin g capital and thus in
crease profits T h e increased profits fur nish adequate
.
security for the carrying out of the purpose indicated
b y the creation of a special reserve or for meeting any
O f the contingencies for which a general reserve may
be created .
4 . Re la t io n Be tw e e n Re s e rv e an d Fu n d
I t Should be clearly understood that the appearance
of surplus reserves on the balance sheet does not in
d ica te corresponding special investments T he re .
serves merely represent proprietorship items— portions
of surplus transferred to a special account by simple
j ournal entry L ike the surplus of which they form
.
part they are invested in the assets of the bus iness I f
, .
the assets consist of fixed property and working capital
onl y the reserves are no more available for the purpose
,
for which they have been created than is the general
surplus itself .
For the reserve to be ava ilable the margin of either
,
the cash or the liquid assets must be in excess of the
working capital by the amoun t of the reserve T o in .
sure funds for the carrying out of the O bj ect for which
the reserve is created a fun d as already explained
, , ,
should be created in cash or s e c u rities equal in amount
to the re serve appropriated from surplus A part from .
t h is e quality the two have no accoun tin g relationshi p .
1 10 A DJU ST I N G A ND C LO SI N G P RO BLE M S
U nless the amount carried to the fund is placed in
the hands of a trustee there is nothing to prevent its
,
utilization for some purpose other than that indicated
by its name A lso the reserve taken from surplus is
.
,
in no way secured by the fund I f the operations of .
the busines s re sult in a loss which reduces the value of
the assets to less than that of the li abilities both the ,
general surplus and the appropriations reserved from
surplus would be extin guished yet the fund might still ,
appear among the ass et s .
T o illustrate the points d iscussed above assume that ,
the balance sheet shows :
ALAN E SHEE
B C T
Asset s p l
C a it a
Iv
n me st e nt of E xt o
e n si n Li b il iti
a es
Fu d n R rv for
e se e x
E t e ns io ns
Surplu s
A ssume that a liability of becomes due
which cannot be renewed and the only liquid assets avail
able for its payment are those in the extension fund .
T h e balance sheet then becomes
ALAN E SHEE
B C T
As se t s p l
C a it a
Iv
n e st m e nt of E x t o
e ns i n Li b iliti
a es
Fund R rv for
e se e x
E t e n si o ns
Surp lu s
surp lus reserves remain as before but the fund
T he
is depleted by the amount of the debt p aid .
R E S E RVE S A ND FUN DS 1 11
A ssuming on the other hand that the bus ines s of the
, ,
year follow ing the first balance results in a loss of $ 60 ,
0 0 0 the balance sheet might then read :
,
BALAN E S HEE T C
A t
ss e s C p it l a a
I v tm t of E x t io
n es en L i biliti
e ns n a es
Fu d n
De ficit
W hile the assets are reduced by the amount of the
loss and the investment in the fund still remains intact ,
both surplus and the reserve have disappeared I n the .
first case the fund is disbursed for the purpose of liqui
dating a liability I n the seco nd case there occurs a
.
cancellation rather than a disbursement C ertain tan .
g ib le assets are lost or paid out and this may cause the
cancellation of the surplus reserved in accounts on the
credit side o f the ledger .
5S. e cre t Re se rv e s
When the fixed assets of an organization are shown
on the books at les s than the i r value to it as a going
concern the e ffect is to create a secret reserve A se
,
.
cret reserve is thus a form of u nr evealed surplus which
ma y be accumulated in various ways e g by : , . .
,
1 . A n excessive p rovision against depreciation or
p ossible losses from bad debts or from other ,
causes the amount of such provision be ing
,
deducted from the value of the asset .
2 . T h e maintenance at cost of assets which have
permanently increased in value such as land ,
and investments in secur ities .
1 12 A DJU ST I N G A ND C LO SI NG O BLE M S
PR
3 . T he carrying of an asset at a merely nominal
sum the whole or part as the case may be
, , ,
o f the proper value of the asset having been
written o ff out of the profits of past years .
O pinions di ff er as to the propriety of creating a se
cret reserve Some accountants contend that its use is
.
j ustifiable if for no other reason than that of conserva
'
tism in the valuation o f assets O ther authorities hold
.
that facts as to financial condition and operation should
be stated as honestly and correctly as possible T h e .
maj ority opinion is in favor of these latter A secret .
reserve no matter how honest the intent with which it
,
is created and manipulated cannot be regarded as cor
,
rect in principle or in accordance with the real intent
of accounting—which i s to state the truth conserva
t iv e ly .I n the hands of an unscrupulous board of di
rectors seeking to gain sole control over a highly pro fit
able enterprise a secret reserve may be created as a
,
means of avoiding the payment of dividends which have
really been earned and to which the stockholders are
,
entitled T h e effect of such non payment upon the
.
-
market value of the company s bonds and non cumula ’
-
tive preferred stock may be disastrous Stock and .
bond holders not knowing the true state of affairs may
-
be led to dispose of their holdings at less than their real
value .
T hough the creation of a secret reserve may be car
ried out with the best of intent the dangers inherent in ,
the nature of the concealm ent are such that the practice
is to be avoided unless there are sound reasons for carry
ing the asset s on the bo ok s at less than their cost
,
values T h e arguments for and against the practice
.
R S E E RVE S A ND F UN DS 11 3
are su mmed u p by A rt h ur L owes Dickinson as fol
lows :
“
E ac h case must be j udged on its own merits .
W here the directors or managers have exercised a
wise discretion in provi d in g in advance for contingent
losses incid ent to the nature of the business which can
, ,
not from a rea sonable point of view be considered as
, ,
in excess of the amounts which a wise foresight would
provide it would seem that no exception should be taken
,
to the undisclosed provision thereof T his would apply .
p articularly to cases in which the business conducted
was of a fluctuating or speculative character or in which ,
its success was largely dependent on the maintenance of
very high credi t such as a bank R eserves in such cases
, .
may well be larger than in others where such conditions
do not exist provided that they are made on the same
,
sort of basis continuou sly and not merely spasmodically .
I n all such cases the sudden disclosure of heavy deficits
or losses which are clearly incident to the nature of the
business but only occur at irregular in tervals may ,
easily be disastrous to the interests of the stockholders
by unduly depressing the market price of the capital
stock and it would seem to be not only the right but
,
the duty of d irectors to protect them against such con
t ingen cie s by making ample secret reserves when profits
permit Where however reserves are made largely in
.
, ,
excess of any possible contingencies the amounts pro ,
v id e d should be disclosed in the Profit and L oss accoun t
and probably also in the balance sheet so that all those ,
interested may be in a position to form a reasonably
correct opinion as to the financial position S o far as .
*
I A ti g P r ti d P r d r p g 1 5
n
“
c cou n n 1
ac ce an o ce u e, a e .
114 A DJU S T I N G A ND C LO S ING P RO BLE M S
the maj or ity of corporations and businesses are con
cerned publicity in such matters is undoubtedly most
,
desirable ; and all reserves to meet contingencies which
may occur in the future but have not yet occurred , ,
”
should be fully disclosed .
6 . Fu r t h e r C l a s s i fi c a t io n of Re s e r v e s
two kinds of reserves previously discussed may
T he
be further distinguished and illustrated by classifying
” ”
them as voluntary and necessary
“
A voluntary or
“
.
true reserve provides out of profits for the expansion
or security of the business ; or for a contingency that has
not yet arisen but may ari se in the future and provision
for which is merely evidence of prudent foresight A .
brief summary of the purpose o f such reserves follows :
1 . To provide a pe r manent increase in capital ,
either for the expansion of the business or
for the further security of its creditors— such
as the insurance reserve of steamship com
i s or an insurance company s reserve for
’
p an e
possible depreciation of securities .
2 . T o provide additional cap ital with which to
meet emergencies or unexpected losses with
out encroaching o n the nominal capital
3
such as losses due to accident or fire .
. T o provide for the equalization of dividend pay
ments by retaining part of the profits of pros
pero n s years and drawing upon this reserve
during lean years .
A necessary or valuation rese rve provides for losses
t h at have actually o ccurred N o financial statement .
R E SE RVE S A ND F UN DS 11 5
ma y be said to set forth the true financial condition of a
business which fails to include when necessar y such r e , ,
serves as those for
1 . Depreciation on fixed assets .
Bad debts .
Depreciation on stock in trade - -
.
E xpenses incurred of an unknown amount .
L osses incurred the resulting money value of
,
which can only be est imated .
6 . Depletion of wasting assets .
T henecessar y or valuation reserve represents an
estimated loss which is to be closed out to operation as
soon as the actual expenditure is known T h e true or .
voluntary type represents surplus profits distinguished ,
from the profits available as dividends by setting them
aside for a special pu rpose .
7. O p e r a t io n of Tr u e Re s e rv e A c c o u n t s
T hekind of business and the financial policy of its
management are the factors which determine the reserva
tions of surplus O n the balance sheet of a corporation
.
,
for example there may appear such items as R eserve
,
for I mprovement Surplus D ividends Pension R eserve
, , ,
R eserve for C ontingencies etc indicating that the , .
,
financial policy of the concern is to withhold part of the
profits for the purposes designated in the account titles .
T he reserve is set up by a debit to Surplus and a credit
to the reserve W hen the purpose of the reserve is
.
about to be fulfilled the entries depend upon whether the
transaction represents ( 1 ) an un usual loss or ( 2 ) a ,
capital expenditure .
A DJU ST I NG A ND C LO S ING PR O BL E M S
A n unusual loss due to fire accident a fall in the , ,
value of investment securities and so on may properl y , ,
be debited to the reserve instead of to Profit and L o s s ,
the correspond ing credit being to the account with the
asset the value of which has been diminished by the loss
, .
T h e result of charging the loss against the reserve instead
of against operations is that the current profits from
ordinary business are clearly sho wn and are available
for dividends .
A capital expenditure to provide additional plant ,
the cost of which is covered by the reserv e should not ,
ordinarily be charged thereto because to do so would ,
result in creating a secret reserve I f for example the .
, ,
balance sheet shows
ALAN
B C E S HEE T
F ix d
e A s se t s p l
C a it a
Le ss -
De pr e R rv for P l
e se e a nt A ddi
c ia t io n t io ns
Liqu id A ss e t s
and is spent on the purchase o f additional plant ,
the charge of this amount to the reserve would show
ALAN E SHEE
B C T
F ix d A t
e s se s C a it a p l
L —D pr
ess e e
c ia tio n
Liquid A s se t s
RE SE RVE S AND FUN DS 1 17
C as h
is decreased by when the p urc h ase is
made but thi s expenditure is not a loss because assets of
,
equal value are obtaine d T here is no j ustification in .
charging to reserve anything which cannot legitimately
be charged against profits T h e debit in this case should .
be to an appropriate asset acco u nt making the balance ,
sheet read
BALAN C E S HEE T
Fix d A te s se s C p it l 00 a a
L —D pre ss e R rv for P l nt A ddi
e e se e a
i ti c a on tio n s
Ne w A s s e t s
A qu r d
c i e
Liqui d A sse ts
A s no useful purpose is now served b y reserving or
earmarking the surplus for a purpose that has been ful
filled the R eserve for Plant A dditions may be closed
,
out to the general surplus or to G eneral R eserve or U n
divided Profits as determined b y financial policy .
8 . O p e r a t io n of V a lu a t io n Re se rv e A c co u n t s
In
the accounting of valuation reserves the purpose ,
is to show the amount of a particu lar loss incurred and
charged to operations but not yet paid T herefore in .
,
setting up the reserve the corresponding debit to the
credit posting is alwa y s to operating expense T here .
after the reserve account is debited with the amounts
,
credite d to appro p riate asset a ccounts when the loss is
recorded or paid .
1 18 A DJU ST I NG A ND C LO S IN G P RO BLE M S
T he valuation reserves co m mon to almost every kind
of business are those for depreciation of fixed assets and
for estimated losses on accounts receivable T h e method .
o f operating these accounts When transactions are com ,
plicated is left for discussion in later chapters A ny
, .
other valuation account s operated would depend upon
the nature of the business A transportation company .
,
for example or any other con cern incurrin g serious lia
,
b ility for accidents or damage would ordinarily protect ,
its capital and shareholders by charging to the cost of
operation su fficient to cover the average loss incurred .
T o illustrate the R eserve for I nj uries and A ccidents
,
of a transportatio n company would normally be based
on an estimated percentage of the revenue received to
be applied to the indemnification of inj ured passengers ;
the R eserve for I n j uries to E mployees of a m anu factu r
ing concern might h e figured as a percentage of the pay
”
roll and added to the labor cost o f the p roduct ; and the
R eserve for Damage C laims might be accumulated from
the source responsible for the damage or where the dam
—
age occurs as from the sales of a concern shipping a
fragile article or from the freight earnings of a railroad
company .
EVI E W QUE ST ION S
R
W h at is a t ru e r e s e v e ? r
W h at is a v lu tio n r es e rv e ?
a a
W h at is t h e c orr e t b l nc e s h ee t p r e s e nt ati o n
c a a of a va lu o
ati n
r es rv e ?
e
E x pl in th e
a d i ffe r e n ce b et w ee n f u n d s an d res e rv es .
W h at is a s e c etr r e e rv e ? s
W h at is t h e e n t r y t b m d e f
o e a or a volu nt r y or t ru e
a r es e rv e ?
G iv e a typic l j ourn l e n t r y f
a a or a v lu tion r e s e rv e
a a .
Part II
Capital Sto ck , an d De pr eciati o n
C HAP T E R IX
B O N D S A N D B OND I N VE S T M E N T S
1 . Na tu r e of Bo n d Iss u e s
A bond is a promise under the seal of a corporation
admitting indebtedness and agreein g to repay the in
d e b te dn es s together with in terest thereon at specified
dates and at an agreed rate A corporation may borrow
.
money by the issue of either notes bonds or a bond and , ,
mortgage I f the amount borrowed is relatively small
.
or if it is borrowed from a few persons or for a short
time the e v idence of indebtedness would or di narily take
,
the form of corporate notes I f the amount borrowed .
is lar ge and is raised in a single sum the a ck n owle dg ,
ment of indebtedness may take the form of a bond and
mortgage on real property I f the sum is a large one
.
and is to be borrowed for a number of years the loan is ,
usually raised by a corporate bond issue .
C orporate bo nds as here discussed are to be dis
, ,
tingui sh e d from the real estate bond and mortgage T he .
distinctive feature of the Corporation bond is its div is ibil
ity whereby the loan is participated in by a large number
of investors T o the or d in ary mortgage there are as a
.
rule onl y two parties the borrower ( the mortgagor ) and
,
the lender ( the mortgagee ) T h e bond issue of a cor .
o r a t io n may be o w ned by any number of persons
p ,
whose interests are pl aced in the hands of a trustee b e
cause the bondh olders cann ot co n venientl y ac t indi
vidually .
12 2 BON DS, C AP I T AL ST O C K, D E P RE C IA T ION
While both c orporate note s and bonds are formal
promises to pay money the di fference between the two is
,
that the bond must be executed under seal whereas the ,
corporate note need not be so executed A lso the cor .
a t io n bond is u sually although not in variably se
p or , ,
cured as to interest and the repayment of principal by
a lien or mortgage on cert ai n specified property and
sometimes in addition by the creation of a sinking fund
held in trust to safeguard its redemption at maturity .
B onds are issued in various denomin a tions $ 1 0 0 or ,
being the customary amounts and are sold by the
,
issuin g corporation to the general public— usually
through the mediu m o f bankers or brokers T h e pe .
r io d of tim e covered by the issue before the bond is r e
deemed by the repa y ment o f the loan varies I t may .
run from five to fifty years or more L oans for a .
shorter period than five years are usually negotiated
by means of the short term notes or real estate mort
-
gages already mentioned or by bank credi ts, .
2 . " in d s of Bo n d s
While there are any number of classific ations into
which corporation bonds may be divided depending ,
upon the nature of the securities o ffered the pur pose of ,
the issue and the conditions attached to the payment of
,
interest and principal these details are of more interest
,
to the investor than to the accountant H ere all that .
is required to note is that bond s may be divided int o
two kinds—registered and coupon A registered bond is
.
so called because interest and principal are payable onl y
to the person in W hose name it is registered on the cor
p or ate books A s the instrument
. cannot be transferre d
BON DS A ND B ON D I N V E ST M EN T S 12 3
to another party by assignment it is not negotiable A , .
coupon bond i s a negotiable instrument and for this
reason evidence as to whom interest pa v m en t is due de
pends upon the possession o f the coupon attached to the
—
bond usuall y one for each payment until the date of
its maturity N o regi ster is kept on the c orporate books
.
of the owners of coupon bonds and the interest a s due , ,
thereon can be co llected only by presentation of the
,
coupon T his coupon consti tutes a small promissory
.
note payable to bearer and p ayment is usually made
through the bank of the investor who holds the bond .
O ne bond issue is distinguished from another by the
name of the issuin g corp oration the date of its maturity , ,
the interest it bears on its f ace value and in some cases
the purp ose for which it is issued T hus the figures .
“
U S 4s as q uoted in the st ock exchange r e
’
5
. .
,
ports signi fy U nited S tates 4 % bonds due in 1 9 2
, .
3 . Bo n d Pr ic e s and Va lu e s
pr incipal sum to be repaid when the bond is r e
T he
”
deemed at its maturity is known as the par of the “
bond T h e rate o f interest which the security bears is
.
always paid on this par value regardless of the market ,
price i e the price at which purchased from or sold to
,
. .
,
a broker or other financial agent When the bond .
changes hands through the medium of a broker the lat ,
”
ter usually charges a commission or brokerage of “
Bonds are rarely issued or sold at par i e the price , . .
,
at whi ch they are offered to the public or purchased and
sold by brokers may not represent the amount on which
interest is to be paid When bonds are sold above or
.
1 2 4. BON D S, C A P I T AL ST O C K , D E P RE C IA T ION
below p ar they are said to be sold at a premium or dis
,
co un t The br okerage premium and discount are com
.
, ,
u t e d on the par value of the bonds T h e m arket value
p .
of a bond is the price it may be expected to realize on
the open market Among the factors which determ ine
.
the price at which bonds are issued or at which the y
pass from hand to hand are
l . T he underlying secu rit y which guarantees re
payment .
T h e length of time before maturity
3
2 . .
. T h e interest rate .
4 . T h e c redit rating of the iss u in g corporation .
A s bonds are redeemable on their dates of maturity
at their nominal or face value no attention need be paid ,
to fluctuations in market value when account ing for them
on the books I f they are held until maturity the r e aliz
.
ible amount is known ; if the y are sold before maturity
the di fference bet ween the market price realized and
their book value constitutes the pr o fit or loss as the case
may be T h e method of accounting for bond invest
.
ments will be taken up in the following chapter .
4 . C o m p u t in g Bo n d Va lu e s
T he
method of computing the price of a particular
bond requires consideration before taking up the prob
lems which arise in connection with premium and dis
count on bonds I n this case the problem is a matter of
.
simple arithmetic and knowledge of the meaning of the
terms used A ssume for example that an issue of 7
.
, ,
per ce nt bonds is quoted at an d it is des ired to
p urchase an investment therein of the par value o f
B ON DS A ND B ON D I N V E S T M E N TS 12 5
four months a fter the date when interest is due .
H ow much will the bonds c st o ? worth r e pr e
sents 5 0 bonds at a p ar value of $ 1 00 T h e bond is .
quoted at a premium of to which mus t be added
brokerage of of 1 per cent X 5 0 .
T his premium however does not include 4 months in
’
, ,
t e r es t at 7per cent accrued on the bo nds at their date of
p u r chase which amounts to
, T herefore the ,
total cost of the bonds would be : ( their nominal
value ) premium and brokerage
acc rued interest :total 1
While a premi u m paid on a bond app ears to be a
loss and a discount received a ga in at the time of its
, ,
pur chase as neither a ffects the par value of the bond at
,
its matur ity the loss or gain is only apparent A pre
, .
mium is paid on a bond purchase bec aus e of the high rate
of interest the bond iss ue bea rs or because of some other
des irable featur e A s has been mentioned a lready the
.
,
nominal rate of interest on a bond is fix ed whereas the ,
market rate of interest fluctuates As thi s market rate .
fluctuates so is the price of the bo n d a ff ected T hus if
5
.
, ,
the current market rate is % and a bo nd carries a n in
t e re st rate of it may be sold at a premium sufficient
to reduce the in terest rate to O n the other hand i f
the figures are reversed if the bond bears 5 interest
,
an d the market ra t e is the bond woul d be o fl ere d at ’
a disco un t sufficient to provide app roxim ately 6 % on
the money invested .
T here are therefore t wo fixed points in the history
of a bond :the original cost or money invested and the
—
principal or par the money to be received at mat u ri ty .
B etween the se two p oints there is a gradual chan ge in
12 6 B ON DS , C A P I T AL ST OCK , D E P R E C IA T ION
t h e value of the bond : if bought below p ar it must rise
to p ar ; if bought above p ar it must s ink to par A t any .
intermediate moment between t h ese t w o points ther e is
an investment value which can be calculat e d and which
is j ust as true as the original cost at the date of purchase
and the par value at the date of maturit y .
I n the business world it is usual to speak of interest
rates as so much per annum I n the maj ority of cases .
,
however the interest although it is either designated or
, ,
understood to be per annum is nevertheless not paid ,
by the year ( that is on ce a year ) but in semi ann ual or
,
quarterly instalments Where the inte rest is payable
.
otherwise than annually the rate per annum is only ,
nominally correct For example if the interest on a
.
,
6% bond is payable half y early the e ffe ctive rate -
would be :
I nte r s t e r n e d d ur ing fi r t pe r io d o n or igin l lo n
e a s a a
I n t r t e r n e d d ur ing s co n d pe r i o d n or igin l l o n
I nte r es t e rn ed dur in g s ec o n d pe r io d on th e fi rst $ 3
e es a e o a a
a 0
T he total interest earnings during the year therefore , ,
would be which is at the effective rate of
o n the original investment as compared with a nom inal ,
rate of
5N
. o m in a l In t e r e s t v s. Effe c t iv e In t e r e s t
With respect to all bonds bought above or be low ‘
p ar there are always two rates of interest involved :( 1 )
a nominal or cash rate which i s a certain percentage of
,
p ar and which is indicated b y the coupons ; and ( 2 ) an
B ON D S A ND B ON D I NVE STM EN T S 12 7
effective or in come rate which is a certain per centage of
,
the amount originally invested and remaining invested .
T h e e ffective or income rate is the actual retu rn received
on the price p aid for the bond T hus ten $ 1 0 0 bonds .
,
bought at a premium of 1 0 % would cost As
s u m in g that the nominal rate of interest is 6 % payable
annually the investment of
, would yield an annual
return of $ 60 T herefore if. yields $ 60 interest
, ,
$ 1 0 0 would yield of thi s sum or or ,
interest which is the e ffective y ield on the bonds
, .
I n actual practice the determination of the e ffective
interest rate is rarely so sim ple a proble m as in the fore
going example Bonds run for many years and are
.
usually purchased as a permanent investment rather
than as a speculation and therefore as a rule many in
,
t e r e st dates must elapse befo re the time of their r e
demption M or e ov er as previously stated interest is
’
.
, ,
payable semiannually and this further complicates the
computing of the e ffective interest rate S ince a pre .
mium paid on a bond is in e ffect a reduction of the inter
est each coupon o f $ 60 in the above example includes
,
two elements— the e ff e ctive interest of on the
investment and the difference between the two which ,
must be regarded as a return of part of the premium
itself so that at the date of the maturity of the bond the
,
premiu m is extinguished T hus the payment of the .
coupon of one period changes the principal on which the
e ffective interest is calculated for the next period T h e .
determination of the e ffective in terest rate on bonds
which have many periods to run involves the computa
tion of compound interest for each period therefore ,
bond tables are usually used to ascertain this rate .
12 8 B ON DS , C A P I T AL ST OCK , D E P R E C IA T ION
6 . A m o rt i zt i
a on an d A c c u m u l a t io n
A s a premium p aid on a bond is not received at its
maturity to carry the investment on th e books perma
,
uently at a price paid above par is w rong in principle .
T h e premium represents a gradually diminishin g asset
value which value decreas e s at each interest payment by
,
the amount of the di fference between the nominal and
e ffective interest rates T h e discount represents a
.
gradually increasing value augmented at each date of
interest payment by the amount of the difference b e
tween the nominal and e ffective interest rates .
T h e gradual change in investment value between
the p u rchase date of a bond and its maturity as pre ,
v io u s ly noted is ignored by some investors who during
,
the whole period carry the investment at either its origi
nal cost or its par value I f carried at cost the a ssu m p
.
tion is that the investment value remains at its original
figure until the day of maturity and is then instantly ,
changed to par either by a loss of all the premium or a
sudden gain of all the discount I f carried at par value .
th e assumption is that the premium paid is a loss and
th e discount a gain at the date of the purchase of the
bond T hese methods of treatment are unscientific and
.
are only resorted to on account of the labor involved in
computing intermediate values .
T h e proper method of treatment is to distingui sh
between the nominal and e ffective interest at each inter
est payment date T hus if a bond is purchased at a
.
,
premium the effective rate is l o wer than the nominal
rate and the di fference between the two rates should be
use d as a reduction o f the premium p aid T his p rocess .
is called amortization .
BO ND S A ND B ON D I N VE STM EN T S
'
12 9
I f the bond is purchased at a discount the actual ,
return on the money invest ed will be greater than the
nominal rate of the bond T h e di ff erence betwe e n the
.
nominal and the e ff ec tive rate should be added to the
cost of the bond so that at maturity its book value will
be increased to par T his p rocess is called accu mula
.
tion T h e method of accounting for bond premi u m and
.
discoun t will be d iscussed in the following chapter .
T o illustrate the process of amortization take a $ 1 0 0 ,
bond bearing a nominal rate of 4 % which has two years
to r un A s su me that it is purchase d for
. thus
yielding I nter e st is payable se miannually .
T h e fir st c o upon r e ceived would be for $ 2 at the end
of the first six months % on
. 3 for six months
is T h e amortization is therefore 47 T h e in . .
t e r e st for the n e xt six months is figured on the principal
after writing o ff amortization for the first period T h e .
3
principal for the second period is and interest
at % on this for six months amounts to T he
amortization here is 48 Proc eeding in the same way
. .
it is foun d that the amortization for each of the remain
ing two periods is 49 T h e total amortization at the
—
. .
end of the fourth period would therefore be the
amount p aid as a premi u m at the purchase of the bond .
D iscount is handled in the same way the variation ,
being that the par value is reached by acc u mulation in
stead o f amortization .
7. zt i
A m o r ti a on Pr o b le m —A n A lt e r n a t iv e So l u t io n
A n alternative method of amortizing the premium or
accumulating the discount on bonds is to proceed from
maturity or par value back to the book value by deter
1 0 3 BON DS, C A P I T AL S T O C K , D E P R E C IA T ION
mining t h e pr es ent worth o f t h e bo nd at the di fferent
interest periods T his is the simplest of all methods of
.
computa tio n and may be made clear by an illustrativ e
problem .
A ssume that first mortgage bonds payable
J anuary 1 1 9 2 5and bearing interest at
,
, payable
,
J anuary 1 and J uly 1 are bought on J anuar y 1 1 9 2 0 , ,
at a price whic h is to yield 4 % e ff ective interest and
that this price is I t is required to set up
a schedule showing the total income the amortization , ,
the net income and the book value of the bonds at the
,
end of each in terest period By worki ng backwards and .
obtaining each value from th e next later value by addi
tion and division the amortization for each period may ,
be ascertained G iven the amount to be amo r tized the
.
,
net income and book value can be readily figured .
Th us b e ginn in g at m t ur it y w ith p
a ar
an d a d d in g t o it th e inte r e s t d u e J an u a r y 1, 1 9 2 5
Th e n d isc ou nting th is by div iding by t h e e ff e cti v e
in t er st
e r te w h i h giv e s
a , c
na mely , t h e v lu o f t h e b o n d s o n e p e r i o d b e for e m
a e a
t u r ity . T o o b ta in t h e n e x t v lu e d d t h e c ou p o n d u e a a
J ul y 1, 1 9 2 4
an d d iv id e g a v
a in byv lu e o f t h e b o n ds
gi in
g th e a
t w o p r i od s b e for
e t h i r m ur e e at ity
a n d by
p ro ce d in g in l ik m n n e r s u cc e s siv e t e rm s m y
e e a a
b e o b t in d s f
a e s d e s ir d
a ar a e .
B ON DS A ND B ON D I N VE ST M EN T S 1 1 3
T he method of calculation can be more clearly shown
in schedule form as set forth below :
R EVI E W QUE ST ION S
Wh a t is a bond ?
W h at are t h e fa c t or s wh ich d e t e r m in e th e m arket v al u e of a
b on d ?
x l
E p a in th e v e int e r e s t r t e
e ff e c ti a .
E x pl in
a mor ti z ti on ; c umul tio n
a a a c a .
Se t u p t h e p ro p r j our n l n t r i s t o
e ac or d t h e f ct s y e r b y
e e re a a
y e a r g
as i v n ine t h c h e d ulee in
s ns w e r t ,
th e mor t i z
a t i o n o a a
p ro b l e m o n p ge 1 2 9a .
C HA P T ER X
A C C OU N T I N G F O R BOND S
1 . In v e s t m e n t V a lu e M e t h o d
extent of the accounting for bonds purchased
T he
varies with the magnitude of the transactions From .
the standpoint of the purchaser who buys a few bonds
as either a permanent or a temporary investment elabo .
rate accounting procedure involving amortization and
accumulation may be unnecessary for several reasons .
For one the return on the investment will be relatively
,
small ; for another the price of bonds depends on condi
,
tions other than their nominal rate of interest thus mak,
ing the e ff ective rate di fficult for the average inves tor
to calculate For these and other reasons the customary
.
practice for small investments is to carry the bonds at
their purchase price and to consider the premium or the
discount as a loss or gain at the time of maturity or sale
of the bonds .
Where however investments in bonds and other se
, ,
cu r ities are part of the ordinary business operations ,
the accounts should be kep t on an investment value basis .
U nless the books show the e ffective interest on the total
investment the investor cannot tell whether a contem
,
plated selling pric e will result in a loss or a gain T h e .
simplest method of recording the effective interest is
to divide the total premium or discount by the number of
interest periods yet to run and to take the result obtained
3
1 2
A C COUN T I NG FO R B ON DS 1 3
3
as the amortiza tion or accumul ation for each period .
While this method is not strictly a ccurate in that the ,
elemen t of interest is ignored it is sufficientl y so for the
,
purp o ses of the average inves tor .
2 . A c co u n ts fo r Bo n d In v e s tm e n ts
W hen t h e tru e investment value of the bonds is to
be shown on the boo ks accounts are opened with :
,
1 . E ach k ind of bond investment
A ccrued interest ( if any )
3
2 .
. B ond income
4 B ond premium
5 Bond d is co unt
The bond acc ount should be headed with t h e dis
t in guishi n g name of the bond is su e —such as N ew Y ork
C ity l 95—
7 and should show the bonds at the ir
par value A ccrued I nterest accoun t records the inter
.
est accrued when the bonds are p u r chased or when the
books are closed B ond I ncome account shows the in
.
come derived from the investments T h e premium and .
discount accounts show the amounts paid either above or
below the par value of the investment and the gr adual
reduction of these amounts as the bonds approach
mat u rity .
3 . A c c r u e d In t e r e s t on In v e s tm e n t
I nterest on a bond accr ues from day to da y although
not payable until the end of some fixed period such as ,
six months C onsequently the purchase price of a bond
.
,
is fixed usually to cover not only its face value but also
the amount of intere st which has accrued since the last
1 4 3 B ON DS , C A P I T AL ST O C K, D E P R E C IA T ION
interest date E ven if the bond be purchased for a flat
.
fixed price regardless of interest the accrued interest
, ,
should nevertheless be calculated for the purpose of
showing the cap ital value of the accrued interest which
will short ly be collected in cash .
A ccrued interest purchased constitutes an asset an
a lo g ou s to an account receivable ; therefore an A ccrued ,
I nterest on B ond account is debited with the amount of
the accrual at the date of t h e purchase of the bond .
W hen the next coupon is collected A ccrued I nterest on ,
B ond account is closed into B ond I ncome account so
that the latter may show the true income in interest
to date .
T o illustrate the operation of the above accounts ,
assume that two 6 % bonds of the par value of
each with interest payable February 1 and A ugust 1
5
, ,
are purchased on May 1 T h e interest which has ac .
cr u ed thereon since Februar y 1 or during a period of
3
5
,
three and one half months amounts to $ A t the
3
5
-
.
,
time of purchase $ is debited to A ccrued I nterest on
,
Bonds and on August 1 th e balance of this account is
,
closed into Bond I ncome acco u nt A fter the lat ter ac .
count is credited with $ 60 ( the amount of the coupons
collected ) its balance will be $ 2 T his sum represents 5 .
the actual interest received for the period o f two and
one half months d u ring which the bonds have been held
-
.
4 . Pr e m iu m on Bo n d s
A s already explained a bond at its maturity date is ,
redeemed at its face value and therefore any premium
paid in excess of p ar cannot be permanently carried on
the books as a realizable asset ; it must be amortized
A C COUN T I NG FO R B ON DS 1 3
5
over the life of the bond T o do t h is the nominal interest
.
rece ived on the coupon is first credited to B ond I ncome
acc ount after which a j ournal entry is made debiting
,
that a ccount and cr e diting B ond Premium account with
the amoun t to be amort ized ( see C hap ter I X ,
T o illus trate the method of accounting for the pre
mi um ass u me that
, worth of bonds ar e p ur
ch ased for that the no m inal interest is 4 % and
that the bonds have two years to run I nterest is pay .
able semiannually and the e fl e ctiv e in terest rate is
’
T h e first coupon received would be for at the
end of six months % on 3 for s ix months i s
T h e amortiz
.
ation is therefore T he
interest for the next six months is figured on the prin
c ip a l after writing o fl the amortiz ation for the first
’
period T herefore % on
. 3
for six months amounts to T he
amortization here is Go
ing further the amortization for each o f the remaining
,
t wo periods i s as follows :
3
% on for s ix
mo nt h s is
T he amortiza tion here is
3
% on fo r s ix
m o n th s is
The amortiza tion here i s
T h e total amortizatio n as computed by the above
arithmetical method is as against the
premium to be amortized T h e discrepancy . is ,
due to the fact that the e fl e c t iv e interest rate if deter
’
,
mined algebraicall y or if a scertained by consulting a
3
1 6 B ON D S , C A P I T AL ST O CK , D E P R E C IA TION
bond table would be found to be a small fraction less
,
than T his would slightly decrease the e ffective in
t e r e st and thus increase the amount to be amortized .
S uch small discre p ancies are usuall y written o ff to P rofit
and L oss .
5J
. o ur n a l En t r ie s
The j ournal entries re quired to record
facts are
Bo n d s
B o n d P r m ium
e
C ash
A t end of six months
C a sh
B o n d I n om e c
Bo n d I n om
c e
B o n d P r e m ium
A t end of one year
C as h
B o n d I n om e c
B o nd I n c om e
Bo n d P r e m ium
A t end of eighteen months
C as h
B o n d I nc om e
B on d I nc om e
Bo n d P r m ium e
A t end of two y ears
C a sh
B o n d I n c om e 2
A C C OUN T I N G FO R B ON DS 3
1 7
B o n d I n c om e
When the bonds are rede emed the entry woul d be
C a sh
6 . Dis co u n t on Bo n d s
L ikebonds bought at a premium those purchased ,
at a discount should be carried in Bond account at par ,
with their discoun t credited to B ond D iscoun t account .
A ssuming the same purchase as in the foregoing illus
t r at io n but at a discount instead of a premium the j our ,
nal entry would be as follows
B o nd s
Cash
on d Di cou n t
B s
T o r ec or d th e p ur h s e t d i ou nt
c a a a sc
f 1 0 0 X Y R R Sinki n g Fu n d 4 s
’
o . .
1 9 2 1, of th e p a r of e ach .
A s the di scount will ultimately be collected from
the obligor of the bonds when their par value is paid at
maturity it co nstitutes a deferred credit ; but like a pre
, ,
mium it app lies neither to the moment o f purchase nor
,
of maturity I t represents an increase of income r e
.
ce iv e d in advance above the nominal interest and should
be dis tribu ted over the ent ire life of the bonds T his .
is e ffected by add ing to the nominal interest at each
interest date the difference between the nominal and
e ffective interest and then recording the e ff ective inter
,
est cm the investment in B ond I ncome account and
d ebiting t h e additional interest to B ond D i scount ac ~
1 8 3 B ON DS , C A P I T AL ST O CK , D E P R E C IA T ION
count T his additional interest allowed to accumulate
.
,
until the maturity of the bonds equals the discount ,
received at their purchase T h e entries in this case so .
,
far as the amounts are concerned are the same as in th e ,
preceding example—but whereas the amortization of a
premium constitutes a credit entry the accumulation of ,
a discount is a debit entry as follows : ,
B o n d I n om
c e
Fo r a mou nt f ou po n
o c .
B on d Dis c ou n t
B o n d I n omc e
Fo r mou n t f d i ou nt w r it ten
a o sc o ff .
Further illustrative entries of the di scount covering
the life of the bond are unnecessary as they are sim plv
the reverse of those given in the preceding section .
7. Pr o t fi and Lo s s on Sa le of Bo n d s
When bonds are sold before maturity the Premium ,
or Discount account is closed into Bond account to deter
min e the full book value of the investment T he price .
received is then credited to B ond account to show the
profit or loss on the sale and the net result of the invest
ment after which the profit or loss can conveniently be
,
closed into B ond I ncome account .
Suc h is the procedure in the recording of ordina ry
transactions I f however the investment is made by a
.
, ,
trustee acting in a fiduciary capacity who is legally r e
quired to distinguish between the principal sum invested
and the income therefrom the above method of account ,
ing would not be correct T h e p r ofit or loss on the sale .
A C C OUN T I N G FO R B ON DS 3
1 9
of the bo nds would not a ffect income at all but wo ul d
be regarded as an in crea se or decrease in the capital sum
in vested and woul d be so shown on the trustee s books ’
.
8 . A c c o u n tin g fo r Bo n d Iss u e
T he disc ussion so far in thi s chapter is confined to the
accounting r equi red on the boo ks of the holder of the
bonds B onds in this case are an as set T h e treatment
. .
of bonds as a liab ility on the books of the issuing cor
p or a t io n is t a ken up in thi s and the followin g sections .
Problems arise in accoun tin g for a bond issue similar
to those which ar ise in conn ection with an issue of cor
p o r a t io n stock I n
. the case of regist ered bonds a record
of in di vidual ownership is u sually kept in a bond register
s im il ar in its rul ing to the r egister or record of stock
holders ( see V olum e 1 1 page ,
I f the bond is
registered as to pr incipal but bears coupo ns for interest
payments a record of individual hold ings should be
,
made But if the bo nds are payable to bea rer and the
.
possession of a bo nd is evidence of its ownershi p no ,
detailed records for bondh olders are required .
I n the financing of co rporations the customary pr o "
c e d u r e is to sell the b ond issue e n blo c to bankers or to
an underwriting syndi cate O ften the terms of such .
sales are complicated and the entries required to record
the tran sact ions corr e ctly must o b vio u slv express the
facts of the terms W hen the transaction is s imple as
.
,
for instance the sale of the whole of the bond is sue for
,
cash th e entry required is
,
5
% M o rt g a ge B on d s P ay ab le
1 40 B ON DS , C A P I T AL ST OCK ,
D EP R EC IA T ION
When only part of an authorized issue is sold the ,
balance remaining unissued for the present the entries
would be :
,
U ni s us e d 5
% M or t g g a e B on d s
C ash
5
7 M or tg
0 a
ge B o nd s P ay a b le
O n the balance sheet the balance in the U nissued
Bonds account is trea t ed as an o ffset to the Bonds Pay
able account T h e Unissued Bonds account as its name
. .
imp lies shows at any time the amount of bonds unissued
, .
9 . In t e r e s t on Bo n d Iss u e
I nterest payable on a bond issue should be entered
in a special Bond I nterest account T hi s account which .
,
has no relation to the regular I nterest and D iscount
account is debited with the checks paid in liquidation of
,
the interest charge L arge corporations with many .
thousand bonds outstanding usually deposit the interest
payable on registered bonds as it falls due in a special
bank account and issue the individual interest c hecks
against this deposit When interest is payable on the
.
presentation of coupons to a trust company which is the
custodian of the interests of the bondh olders a check ,
is issued for the full amount in favor of the trustee .
When the coupons are redeemable at the company s ’
o ffice the periodical amount is charged in full to Bond
,
I nterest and credited to C oupons Payable A s the .
coupons are presented for payment C oupons Payable ,
account is charged and C ash credi ted with the amounts
of the red eemed cou p ons .
A CC OUN TI NG FO R BON DS
10 . Pr e m iu m and Dis co u n t on Bo n d Is s u e
Th e
same principles applied by an investor in bonds
are applicable to the treatment of a premium received or
a discount granted on the books of the corporation which
issues the bonds A premiu m represents the price r e
.
c e iv e d for a higher than market rate of interest and a
- -
discount is in consideration of a less than market inter - -
est rate I t is therefore necessary to enter the bonds on
.
the b ooks at their par value and carry the premiu m or
discoun t in separate accounts to be amortized or accu
m u late d as the case may require over the life of the
, ,
bonds T h e entries to bring the premium or discount
.
on the books assuming a , bond issue at a pre
mi u m or discount of would be
C a sh
Disc ou n t on r l M or tg g Bo n d
G en e a a e s
G e n e r l M or t g ge B o n d P y b l e
a a s a a
'
01
G n r l M or tg ge Bo n d s P y b l
e e a a a a e
P r m i um
e n G n r l M or t g ge
o e e a a
B ond s P y b l a a e
dates when the payments of interest are due are
T he
usually made to coincide with the close of the fiscal period
of the corporation which issues the bonds A t this time .
the entry covering the periodical adj ustment of the pre
mium or discount would be :
P r e m ium on on d s
B
B on d I nt e r e st
Bo n d I nt re est
D is c ou n t on B o nd s
1 42 B ON D S , C A P I T AL ST OCK ,
D E P R E C IA T ION
W hen the date of interest payment d oes not coincide
with the end of the financial term at the closing of the ,
b o oks the accrued bond interest should be taken up on
the books as an accrued expense ; at the same time the ,
portion of the premium or discount accrued to that date
should be amortized or ac cumulated as the case may r e
quire .
I n the case of a bond investment or purchase it
should be noted that the Premium account always shows
a debit balance and is credited for amortization ; and
that the D iscount account always shows a credit bal
ance and is debited for accumulation I n the case of a
bond issue the entries are reversed—as illustrated above
.
R EVI E W QU E ST ION S
W h at a cc ou nts r q u ir e d w h n t h t ru in v st m en t v lu f
are e e e e e a e o
a b on d i t b s h ow n n t h b ook ?
o e s o e s
G iv e j our n l e n t r i
a t i llu s t r t t h e b ookk e e pin g f
es o a e mor tiz or a a
t i o n f b o n d p r m ium
o e .
W h t e n t r y h oul d b m d e w h e n b o n d p ur h
a s e a d e old b s c ase ar s e
for e m t ur ity ?
a
S t up l dg r
e e c ou n t s t
e a c h ow l l t h e f t s r e s ul tin g f ro m
o s a ac
a n or igin l i u e f b o n d t d i ou n t
a ss o s a a sc .
W h t nt r i s
a e e r e q u i r d w h th d t
are e f in t r e t p y m n t
en e a es o e s a e
d n ot c o in cid e w ith t h e n d f t h e fi c l p r i od ?
o e o s a e
C HAP T ER XI
S I NK I N G F U N D S A N D A NN UI T IE S
1 . De fi
n itio n an d Pu r p o s e
A sinking f u nd is composed of actua l assets ( u su all v
money or securities ) either set aside and all owed to
a cc umulate at compoun d interest or added to by con
tr ibu tion s from tim e to time T h e theory of s ink ing
.
fund operations is that a ny large sum required for the
future finan cing of a busines s can best be accumulated
by setting as ide certa in amounts a t peri o dical intervals .
T herefore such a f u nd is created to redeem or ext inguish
a debt or to provide against anticipated losses or to meet
, ,
any other obligation the ma t urity o f which entails an
un usually large outla y and for which in consequence
special fina ncial provision must be m a de in advance .
T h e accum ulation of the fund is not necessarily de
p endent upon the in terest earned on the amount origin
ally deposited nor need the amounts deposited be
,
allowed to accumulate at compound interest But as a
ru le the redemption o f long —
.
term obligations is provided
for by the set ting aside o f certain regular amounts which
are left to accumulate in this way T h e figur in g of these
.
amounts arithmetically involves laborious calculations
whi ch can more readily be solved algebraically or by the
use of annuity tables I t is however necessary for the
.
, ,
accountant to unders ta nd the arith metical principles on
which the solution of s inking fund and ann uity prob
14 3
1 44 B ON DS, C A P I T AL ST OCK ,
D E P R E C IA T I ON
lems are based and the more simple phases of the sub
j e c t are taken up in this chapter .
2 . M e th o d s of C r e a t in g a Sin kin g Fu n d
O f the various ways of figuring a sinking fund the
most common and the s implest are :
1 . E qual ann ual amounts may be set a sid e b —
as for
instance if it is desired to accumulate
in twenty years would be set aside
,
each year T h e interest earnings not being
.
,
considered part of the fund go into the gen ,
eral income .
2 . T h e amount of an annual inst alment is de
t e rm in e d which at a given rate compounded
,
will amount to the required sum in the given
time and thi s sum is set aside and invested
3
each year .
. A certain amount based on the volume of pro
—
duction as for instance $ 1 per ton of ore
min eral— is set aside T h e interest earnings
.
may or may not be added to such funds .
O f the three above methods the figuring of the sec
ond method alone presents any difficulty T h e annua l .
instalment in this case represents an annuity and the
method of computing an annuity needs brief considera
tion .
3 . C o m p o u n d In t e r e s t
computing of an annuity is based on the prin
T he
c iple of compound interest whereby interest is earned ,
on both the principal or orig inal indebtedness and on
, ,
the interest as it accrues from period to p eriod T h us .
,
S I N KI NG UN DS
F A ND ANN UI TI E S 5
14
3
i f $ 1 is invested at % compound interest d u ring the ,
first period simple interest only is earned and at the ,
end of the first period the principal to which the simple
interest is added is A t the end of the second
period this sum with compound interest amounts to
, ,
X or A t the end of the third
period interest compounded on at % brings the 3
amount to X or and so on for
any num ber of periods .
W hen the point is reached where the number of
decimal places becomes unwieldy the result is rounded ,
o ff or up to the number o f figures required to insure
,
approximate accuracy depending upon the number of
,
periods to be computed A s a general rule compound
.
interest figures are carried to six places of decimals only
I f the seventh figure is less than 5
.
it is simply dropped
I f more than 5the seventh figure is dropped but the
.
,
sixth figure is increased by one .
T h e interest rate is always stated as so much a year ,
but interest may be compounded semiannually or quar
t er ly the most usual period being at the end of each six
,
months I n this case the rate of interest will obviously
.
be computed at half the annual rate and the amount of
interest compounded at the end of each year will be
slightly in excess of the amount that would be com
pounded at the end of a yearly period as shown by the ,
following table
A mou nt E nd
of O ne Y r
ea
X
4
BON D S, C A P I T AL ST O C K , D E P RE C IA T ION
4 . Co m p u t a t io n of C o m p o u n d In t e re s t
T hecomputation of compound interest arith
m e tically is a laborious proceeding and for this reason
compound interest tables are usually consulted T hese .
tables give the compound interest on $ 1 for any number
of periods at any customary rate With the figures
, .
available as to the compound interest on $ 1 the com ,
pound interest on any number of dollars can of course , ,
be readily computed by simple arithmetic .
W hen tables are not available and it is necessary to
make the arithm etical calculation the figuring can be
33
,
condensed by the use of the principle that X X 9 X
A shorter method of figuring is X X 333
33 33
2 7
X X X For instance $ 1 placed at
3
X ,
% compound interest would at the end of 1 6 periods
amount to as calculated below
1 s t pe i r od
2 nd p e r i od X
4t h p r io d
e X
8th pe r i od X l 12
. 5
509 =
l 6th pe r i o d X
5A . n n u it ie s a n d Amo unt of an A n n u it y
A n annuity may be defined as a series of pa yments
of like amounts on which interest is regularly com
pounded at stated periods T he amount of an annuity
.
is the su m of all the payments plus the compound in
t e r e st earned T h e periodical payments are termed
.
” ”
rents or rents of an annuity T h e rents may be due
“ “
.
at the end of each period ( as is usually the case ) or at the
beginning of each period I f due at the end of each
.
period the compounding of simple interest begins at the
,
S I N KI NG FUN DS A ND ANN UI T I E S 1 47
end of the second period I f due at the beginnin g of
.
each period the compounding of simple interest begins
,
at the end of the first period An ann uity due at the .
end of each period is an ordinary or im mediate annuity .
”
O ne due at the begin ning is called an annuity due “
.
T h e periodical interv als between payments may be o f
—
any length a y ear a half year a q uarter or a month
,
-
, , .
T o i llustrate the computation of an annuity assume ,
that an agreement provides for four im mediate annuity
payments of $ 1 0 0 at intervals of six months and at 6 %
per annum T h e amount of the ann uity at the end of
.
the second year would be determined as follows :
I r
nt e e s t
l s t pa y m e nt end o f 6 month s
I nt e r e mo nth s
st en d o f 12
2 md p y m n t n d f 1 2 mo n t h
I nte r t n p r in ip l f $ 2 0 3
a e e o s
end f 1 8 mo n th s
3d p ym nt en d of 1 8 mo nth
es o c a o o
r a e s
I n t r t n p r in ip l f
e es o c ae nd o f 2 y e r
o a s
4th p y m e n t e n d
a f 2 md ye ro a
$ 40 0
the amount of the i m mediate annuity at
T herefore
the end of the second year would be $ 40 0
figure the amount of an a nn uit y of many periods
To
requires so many fi g ures that the arithmetical solution is
tedious if not impracticable T h e computation may .
,
however be s implified by employing the following rule
,
T o find the amount to which an im m ediate a n nuity will
accumulate in a given number of periods at a g iven rate ,
figure first the compound interest which wi ll accum ulate
1 48 BON D S, C A P I T AL S T O C K, D E P RE C IA T ION
on $ 1 at the same rate and for the same period ( I f n o .
compound interest tables are available $ 1 must be multi ,
plied by the interest rate plus $ 1 the required number , ,
of periods and from the product thus derived $ 1 is de
ducted to give the compound interest on $ 1 for the r e
quired number of periods ) T h e compound interest on .
$ 1 must now be divided by the simple interest and the ,
quotient will be the amount of the rent of $ 1 for the
required number of periods at the given rate H av ing .
found the amount to which a rent of $ 1 will accumulate ,
it is then a matter of sim ple arithmetic to find the amount
of a rent of any number of dollars .
T hus if it is required to find the amount of an an
5 5
,
nu ity of $ 0 0 payable half yearly for 2
, years at 6 % -
compound interest the solution would be : ,
$1 om pou n d d f 5
c e 0 pe r i o d s
or at 3
%
S u bt r tin g t h e p r in cip l
ac a
L e v in g th
a e c om p ou n d int e r e st on $1 fo r 5
0 p e r io ds
D ividin g this by the interest for one period 0 3
5
, .
,
equals 9 68 7 which is the amount to which 0 rents
3
,
or periodical payments of $ 1 each at % compound in
t e r e st will accumulate in 2 years I f 50 rents of $ 1 5
5
.
amount to 9 68 7 by multiplication 0 rents of
$2 5 0 amount to i e the amount to which an
5 5
. .
,
annuity of $ 0 0 will accumulate at 6 % in 2 y ears paid ,
semiannually .
6 . Pr e s e n t W o r th of an A n n u it y
T he
preceding problem covers the method of figu r
ing the future amount of a series of rents or equal p a y
S INKIN G F UN D S A ND AN N U I T I E S 1 49
ments ( the principal ) plus compound interest We have .
here to consider the present worth of a series of equal
payments T h e present worth of a single sum to be r e
.
ce iv e d in the future is a smaller sum which put at inter ,
est will amount to the future sum T o illustrate the
, .
method of ascertaining the present worth of a single
sum it is required to find the present worth of $ 1 due in
3
, ,
four years with interest at % per annum T h e required .
figure must evidently be such that wh e n multiplied four
times in succession by the result will be $ 1 T here .
fore by using the reverse process division the required
, , ,
figure may be obtained C arrying the decimal to six .
places only the result is
$1 1 r e s e nt w ort h of $1 at 1 pe i r od
3
p
5
.
9 70 8 74: 1 0 9 4296 2 pe r iod
3
s
5 9 15
.
9 42 96 142
9 15
1 42 -
I . 8 8 8 48 7
H aving found the present worth of $ 1 the present worth ,
of any number of dollars can readily be figured by sim
ple multiplication .
T o find the present worth of an annuity involves
computing the present worth not of $ 1 but of a series , ,
of future payments W e can of course find the present
.
, ,
worth of all the payments ; but labor is saved by com
puting the total in one operation T o do this we have .
first to compute the compound discoun t at the time and
rate T he com p ound discount is the di fference between
.
the amo u nt and its present worth T hus in the example .
,
above 88 8 48 7 is the present worth of $ 1 for four
3
.
,
periods at 70 and the compound discount therefore is
,
5
1 0 B ON DS ,
C A P I T AL ST O C K , D E P R E C IA T ION
$1 1 1 1 1 ; in other w 53
ords the com
3
8 8 8 48 7
53
. .
,
poun d discount of $ 1 for four periods at % is 1 1 1 1 . .
When this di ff erence or discount is divided by the inter
est we obtain which as may be noted , ,
is the sum of the present worth of the above se ries of
four payments From this a rule may be constr uct ed :
.
,
T o find the present worth of an annuity of $ 1 for a given
tim e at a given rate divide the compound discount for
,
that time and rate by the simple interest for one period ,
both expressed decimally .
We can now apply this rule to the figuring of a
series of ann uity payments A ssume for example that
3
.
, ,
it is required to find the present worth of a series of 0
annual payments of with interest at We
first ascertain what $ 1 will amount to at the end of 0 3
years at T his by the multiplication of $ 1 by
,
thirty times is found to be I f $ 1 amounts
to this figure then by division
, 2 1 77 will amount . 335
to $ 1 on the same basis From this result we obtain the
3 5
.
compound discount on $ 1 for 0 years at % per annum
5 335
,
viz : 76862 2 ( the di fference between
. 2 1 77 and .
I n accordance with the above rule we divide the
compound discount 768 62 2 ) by the annual rate
. 5
i e the present worth of an annuity
3
.
.
,
of $ 1 for 0 years at T herefore the present worth
3
of a series of 0 ann ual payments of at % com 5
pound interest would be , X
I t may assist in acquiring a clear idea of the work
ing of an annuity if we illustrate the use of a present
worth calculation Suppose that an investor wishes to
.
purchase an annuity which will ret u rn an income of
S I N KI NG F UN DS A ND AN NUI T I E S 5
1 1
3
for 0 years T h e insurance company figures
.
the present worth of such a series of payments as above .
A n analysis of the annuity payment shows
that part of it represents interest on the principal and
part of it a return of the principal .
Th e or igin l p r in ip l in v te d is
a c a es
Th fir t nn u it y p y m n t
e s a a e is
5
% on is
Di ffe r e n c e r ep r e sen ts r e tur n on r
p in c ip a l
Ne w pr in cipal = p r e s e n t w or th at r od
2 9 pe i s
I f the series of payments is analyzed to the ot h period 3 ,
it will be found that the final payment extinguishes the
principal which has been returned together with interest
on the decreasin g present worth for each period .
7. A n n u it y Pa y m e n t s an d Sin k in g Fu n d
problem of finding the unknown present worth
T he
of a series of future payments is the reverse of finding
the series of payments required to build up a known
future worth T his future worth may represent a sum
.
borrowed which has to be rep aid with interest on the de ,
creasing capital by a series of equal instalments O r
, .
the future worth may represent the amount to be ac
cumulated by equal payments in a sinking fund for the
purpose of paying o ff future indebtedness .
T o illustrate the figuring of the first problem assume ,
that a loan of is made under an agreement to
repay it in four equal instalments which are to include
principal and interest on the decreasing capital at
,
I n the prece ding section we saw that is the
5
1 2 BON D S, C A P I T AL S T O C K , D E P R E C IA T ION
3
present worth at % of an annuity composed of four
payments of $ 1 each I f now four payments of $ 1
.
, ,
repay an original indebtedness of it IS a sun ple
matter to figure the four payments required to repay
an original indebtedness of $ 1
3
.
A s an ori ginal debt of at % is repaid by
four instalments of $ 1 therefore a debt of $ 1 is repaid
,
by four instalments of
$1
. 2 69 0 3
and a debt of by four instalments of
A ssuming that the instalments represent not the
payment of a debt with interest but the accumulation
,
of a fund of for the payment of a future obliga
tion the problem involved is to find the annuity which
,
will accumulate at compound interest to the required
amount in the given time R eference to
. 5above , ,
shows that $ 1 set aside annually and compounded
3
,
amounts after four years on a % basis to
T herefore if a fund of
, is created by the pay
ment of $ 1 in four instalments a fund o f , is
created by the payment of
in four instalments .
A s the figuring of sinking fund and annuit y pay
ments is based on the calculation of either the amount
or the present worth of an annuity it is necessary to ,
keep clearly in mind the method of their computation
and the di ffere nce between the two T h e procedure and
.
the rules may be briefly summarized as follows :
S I N KI NG FUN DS A ND ANN UI T IE S 1 3
5
To figure the amount o f an annuity
1 . Find th e compoun d interest on $ 1 for the re
quir e d periods at the given rate interest
onl y not including principal )
, .
2 . D iv ide the compound interest by the sim e
-
m
interest both expressed decimally
, .
To figu re the present wort h of an annui ty
1 . Find the compound disco u nt at the time and
’
rate the difl e r e n ce be tween the prin
c ipal and its prese nt worth ) .
2 . D ivide the compound discoun t by the simple
in terest both expressed decimally
, .
C ompound in terest is found by multiplyin g the
principal by one plus the rate of interest the n um
be r of times there are period s us ing the number of ,
peri o d s as the power of the ratio of in crease e g , . .
,
X T h e original prin cipal is then sub
tr acted and the remainder is the compoun d interest .
T he compoun d di sco u nt is found by dividing the
prin cipal b y one plus the rate of interest the num
b e r of tim es there are period s usin g the numbe r of ,
periods as the power of the ratio of decrease e g , . .
,
T h e result consti t utes the present
worth an d if subtr acted from the original principal the
rema inder is the compoun d disco un t .
8 . A m o rt i zti
a on an d Sin kin g Fu n d
O n compar ing the in sta lments req u ired for the r e
pa yment o f the debt and the creation of the sink ing
5 3
fu nd ( page 1 4 ) a difl e re nce of $ 0 is noted which is the
’
3
annual interest at % on the origin al amoun t I f inter .
est is to be added to the s inking fu nd contribution the ,
1 4 5 B ON DS , CAP T I AL ST O C K , D E P RE C IA T ION
amo unts paid would be the same in both cases G radual .
payments on account of a debt or gradual ac cumulation ,
with the O bj ect of canceling a debt b y a Single payment
in full amount to the s ame thing and exemplify the
,
same principle T he application o f the principle how .
,
ever di ffers involving amortization in one c ase and ac
, ,
cumulation in the other T h e di fference between the .
two methods is illustrated in the following tables :
A M O RT I " A T ION OF D E BT OF
Ba l a nce 3
% I r nt e e s t
r
P inci p l
a on P r i ip l
nc a
A C C U M U L A T ION F UN D
3% I t r t n e es T o t l A mou t a n
C o t r ib u tio n
n A umul tio s cc a ns A umul t d cc a e
sinking fund method accumulates a fund suffi
T he
cient to pay o ff the entire debt at its maturity the inter ,
est o u the debt being paid separately T h e amortization .
method accumulates nothing but gradually reduces the ,
debt b y applying the exc ess of the periodical payment
Th*
l l ti
e f
c a cu a i ti m t izi
on o i p rti l rly t fh wi l d
a n nu es, a or at o n , e tc s a a cu a ec n ca an
lt p ly b p f ly l m p h
.
,
d iffi cu wh i h
r o ce s s one m d c c an s c a r ce e a e e r e ct c e ar a e age s
r d i th i b j t d d ir t g i t P t t l gt
.
,
A
O .
Th e d wh
s tu i i
ent o s n te e s te n s su ec an es es o o n o i a en
f r d t y f I Sp r g rri
,
”
i
s re er Th
e o em b d
c c ou n t a n c t o n ve s t e nt y a ue an e ne. or o
ot h er w rk f o im il r
s o a s a n at u r e .
S I N KING UN DS
F A ND AN NUI T I ES 1 5
5
over the interest on the princ ipal to the reduction of the
prin cipal .
9 . A c c o u n tin g fo r Sin k in g Fu n d
method of operating and accounting for a Sink
The
ing fund wh en this is created to retire an issue of bon ds
or meet any other long term obligation is usually pre
-
scribed in the trust deed T his instrument designates
.
the trustees of the fu nd responsible for the coll ection
and investment of income and usually provides for ,
l . T he amount to be invested periodicall y in the
fund .
T h e kind of investment
3
2 . .
. T h e method of redeeming the bonds .
T h e creation of a s inking fund reserve out of
profits
5
.
. T h e payment of the expense of administering
the fund .
6 . T h e periodical accounting fo r the funds in the
possession o f the trustee .
bookkeeping entries required to record the
T he
operation of the fund are thus dependent upon the pro
’
visions of the trust deed Where these are elaborate the
.
,
entries are proportionately numerous T h e proced u re .
may be simplified by considering the entries under the
heads of
Payments into the fund .
I nvestments made by the trustees .
I ncome and expenses of the fun d .
R edemption of the debt and closing
counts .
5
1 6 B ON DS
, C A P I T AL S T O C " , DE P R E C IA T ION
10 . Sin k in g Fu n d Re se rv e
When the sinking fund is created for the purpose of
liquidating a debt a S i nking Fund R eserve account is
,
usually opened in which a portion of the surplus is set
,
aside equal to the amount of the assets carried in the
fund T h e obj ect in this case is to indicate that the
.
a ssets in the fund are derived from profits which have
been reserved for the purpose of its creation I f no .
reserve is set up and the Sinking fund under suitable ,
title appears among the assets this does not indicate
, ,
definitely that the latter are being reserved out of profits .
Without the restriction of a sinking fund reserve the ,
assets may be acquired by the sale of additional capital
stock or they may be secured by a reduction of other
assets I f the deed of trust requires the setting aside of
.
”
the sinking fund instalments out of profits a reserve “
,
account in addition to the fixed account would then be
required .
A S inking Fund R eserve account is sometimes found
on the balance sheet with no o ffsetting asset account .
T h e indication here is that the profits which are being
reserved for the purpose of the fund have been reinvested
in the business I n this event there is no assurance that
.
specific funds will be available to meet the liability for
which presumably a Sinking fun d was desired
, , Sin k .
ing Fund R eserve account merely represents an appro
p r ia t io n of surplus for whatever purpose may be indi
ca t e d .
11 . Re c o r d s of Pa y m e n t s in t o t h e Sin k in g Fu n d
entries required to Show the orig inal and sub
T he
sequent payments into the fund are
SI N KI NG FU N DS A ND ANN U IT I E S 5
1 7
C a s h in Sin in g F k u nd
C a sh
To r or d pe r iod i l t r
ec ca a n s fe r fs o ca sh t o th e
s in k in g f u n d t ru t s ee a cc ord in g t o th e t e rm s
o f th t f t g e m n t
e
'
us a r e e .
Where the trust deed provides fo r the creation o f a
sink ing fund reserve the following and other entries to
be given later are required :
,
P rofi t an L o or S ur p lu
d ss s
R rv f Sink in g Fu n d
ese e or
To r e ord th p r iod i l ppro p r i ti o n f
c e e ca a a o
p rofi t t id
s r rv f s inkin g
se as e as a ese e or
fu n d .
trust deed may provide also that the reserve
T he
shall at all times equal the cash in the fund in which ,
case the reserve account must be credited with the in
come from the fund and debited with the expenses of
its operatio n T hese entries will follow later
. .
12 . Sin kin g Fu n d In v e s tm e n ts
A t periodical intervals the trustee o f the sinking
fund hands in a report covering the investments made
with the proceeds of th e fu rid the expenses in connec ,
tion therewith and the income derived from the invest
,
ment T h e fund may be used to purchase outside se
.
cu r itie s or the bonds for the redemption of which the
,
fund is created may be bought T hese may then be .
Can celed imm ediately ; otherwi se the y should be held
like any other investment the in terest received thereon ,
being paid into the fund .
I f the cash in the f u nd is used to purch ase outsid e
investments entries are r equired to Sh ow the cost o f the
,
1 8 5 B ON DS , C A P I T AL ST OCK , D E P R E C IA T ION
securities the expenses incurred and the in com e
, , r ef
ce iv e d thereon as follows : ,
I nv es t m e nt s k u d
fo r Sin in g F n
k u d
C a s h in Sin in g F n
T o r e or d in v s tm nts f in k in g fu n d from
c e e o s
s in kin g f u n d c sh by th e t ru t a ( L is t s ee .
h r e the
e e ur i ti s p ur h s d
s c w ith t he ir
e c a e ,
pr i e ) c .
Sink ing Fu n d E xp en s e s
C a sh in Sin in g k F un d
To r or
ecx d e pe n se s of s in k ing fu n d as it e m
izd b e low
e .
C a sh in Sin ing F n k
u d
Sin in g nd k Fu I n om e c
To r e ord oll e ti o n f in om e
c c c o c on in v e s tm ent
a n d in t e r e t n c h b l n ce
s o as a a .
1 3
. Tr e a t m e n t of In c o m e an d Ex p e n se s
Practice varies in the treatment o f income derived
from and ex p enses due to sinking fund operations
, ,
.
Some accountants consider them as charges or credits
to the current Profit and L oss while others treat them ,
as increases or decreases of the sinking fund reserve I f .
the income and expense accounts are closed into Profit
and L oss the j ournal entries re quired are :
,
P rofit an d L oss
Sink in g F u n d E x p n s e s e
To c l ose t t h e c urr e n t ch r ge s t o o pe r
ou a o
a t i ns .
Sinkin g Fu n d I nc om e
P rofi t n d L o s s a
To l o co ut th e c ur
se r en t inco m e from s in king
fu nd .
S I N KI NG F UN DS A ND AN N UI T I E S 5
1 9
I f income an d expense are treated as increases or de
creases O f the reserve S ink ing Fund E xpenses and ,
S i nk ing Fund I ncome accounts may be omitted and the
income and expense posted directly to the reserve a c
count as follows
C as h in S inki n g Fu n d
R rv e f
ese or k
S in in g F n u d
To r ec or d th e c oll o
e ct i n by t h e t ru t e f in
s e o
t e r e st an d in c om n e o s in kin g f un d in v es t
m e nts .
Res e rv e for Sin in g F n d k u
C a s h in s in in g _
k F un d
To r or d t h p y m n t f th e e x pe nse s
ec e a e o of the
s in kin g f u n d b y th t ru s te e e .
14 . Re d e m p t io n of De b t
already stated the sinking fun d may have been
AS ,
-
’
invested in the corporation s own bonds I n that case .
,
the bonds may be canceled at their maturity O therwise .
,
the outside secur ities in which the fu nd has been invested
may be sold and the p roceeds app l ied to the redemption
of the debt T h e following entries cover the purchase
.
and the cancellation of the bonds :
T r e s ur y
a B on d
k un d
s in Sin ing F
C sh in Sin kin g Fu n d
a
T o r or d in v s t m n t
ec f s ink ing e e o f und in
b o nd f c or p o r t i o n
s o a .
B on d s O u t t n di n g
s a
Tr ur y Bo n d in
eas s Sink in g F un d
T o r e ord c n ce l l t i o n
c a a o f b o n d ( t m t ur it y )
s a a .
sale of the securities in the fund and the r e d e m p
T he
tion of the bonds with the pr oceeds thereof require :
1 60 B ON DS , C A P I T AL ST O C K , D E P RE C IA T ION
C a s h in Sin in g F k
u nd
Sin i n gk n F u d I n v e s t m e nt s
To r e ord l e f s e ur iti in th e s inkin g fu n d
c sa o c es .
B o n d s O u t s t n d in g
a
C h in Sin k in g Fu n d
as
T o r e c ord r e d m pt io n f b o nd
e o s .
1 5. Ad j u s t in g En tr ie s
amount realized on the sale of the securities will
T he
rarely exactly equal their book value and therefore the
di ff erence will require adj ustment T his is effected by .
charging or crediting the r e serve account with the de
crease o r increase in the amount realized on the sale .
T h e entries required are :
Sin kin g Fu n d I n v st m n t e e s
S ink in g Fu n d R e e rv e s
Sink in g Fu n d R e rv se e
S ink in g Fu n d I n v e t m e nt s s
To dj u t t h e d iff e r e n e b t w e n th e b ook
a s c e e an d
r l i z e d v lu e f s e cur ities s ol d
ea a o .
I f the amount realized on the sale of the securities is
less than the sum required for the redemption of the
bonds a further contribution must be made to the fund ;
,
if the amount realized is in excess of requirements the ,
trustee wi ll have a balance on hand O ne of the follow .
ing entries would then be required
C a sh in Sin ing F k und
C a sh
T o in c r e s th e fu n d t mou n t r e q u ir
a e o a ed fo r
r e d e m pti o n o f b o n d is s u e
S I N KI N G FUN D S A ND AN N UI T IE S 1 61
C a s h in Sin k in g Fu n d
TO r ord r c
ec e ei
pt of b al a n ce of fu n d in h a n ds
o f t ru s t e e .
16 . Dis p o s itio n of Sin kin g Fu n d
U pon the payment of the bond issue the reserve must
be di sposed of in some way I t has served its purpose .
of retain ing profits in the bus iness for the redemption
of the O bligation and it now remains for the directors
to determine what is to be done with it A s the reserve .
represents a withdrawal of profits from surplus it may ,
be thrown back into surplus and thus increase the amount
available for dividend distribution S uch dividends may .
be pai d in cash if ava ilable or if a s u fficiency of liquid ,
assets is wanting they may be paid in capital stock by
,
means of a stock dividend T h e bookkeeping entries .
which are requir ed to close the sink ing fun d reserve into
the Surplus account and to distribute it as a stock
dividend are
Re s e rve fo r Sin in g Fk un d
S ur plu s
To c lo e s in ki ng
s fu n d r ese rv e .
S u rp lu s
St oc k D iv i d e n d P a y a b l e
T o d is t r ib u te s ur plu s d e ri v ed f rom s in kin g
f u nd re s e rv e .
St o c k Div id e n d P a yab l e
C a pit a l S t oc k
To r ord
ec t h e inc re as e in c a pita l s t oc k out
s ta n di n g .
1 62 B ON DS ,
C A P I TAL ST OC " , DE P R E C IA T I ON
17 . Illu s t r a t iv e Pr o b le m
acquire facility in mentally j ournalizing th e en
To
tries required to record a series of sinking fund t ran sac
tions the following series of facts are p rese nted for
,
j ournalization
A n issue of y ear
100 2 0 bonds is sold
-
for cash at par .
T h e trust deed requires the creation of a sink
ing fund reserve and the periodical setting
aside of out of profits for this pur
pose .
Provision is made for periodicall y setting aside
cash equal in amount to the periodical in
crease in the reserve .
T h e cash in the sinking fund is to be invested
in interest bearing securities
-
.
I ncome is collected periodicall y from the in
vestments in the Sinking fund and the first ,
collection amounts to $ 1 0 0 .
E xpenses amounting to $ 2 0 0 are incurred and
paid at the end of the second period .
A t the end of the 2 0 year period the bonds out
-
standing are redeemed .
Th e sinking fund reserve is disposed of by clos
ing it into S u rplus .
j ournal entries which are necessary to
T he r e c or o
the foregoing transactions are as follows :
B o n d O u t t n d in g
s s a
To r c or d iss u e f b o n d s
e o .
S I N KI N G F UN DS A ND AN N UI T I E S 3
16
P ro fi t Lo
an d ss
S inki n g Fun d R rv ese e
T o r or d t h ec p r i od i l tt ing e e ca se
id
as f p rofi ts
e s o r s e rv fo a a e e r
s inkin g fun d .
C a sh
To r e or d
c s et t in
g a si
pe io de r d
1c a ll y t h e a mou n t o f ca s h t o b e
i n v e te d
s .
I n v est m e n t f Sink in g Fu nd
s or
Sin kin g Fun d C sh a
T o r e or d in v e t m en ts o f
c s s in king
fu n d h cas .
Sink ing Fu n d C a sh
Sin k ing F un d R s e rv e e
To r ord in c om ol l e t e d pe r iodi
ec e c c
ca l l y f rom s ink in g fun d r e e rv e s .
k u d R rv
S in i n g F n ese e
k
S in in g F u d C sh
n a
To ec r ord p ay m e nt f x p o e e ns e s of
m in t in in g s inking f u n d
a a .
S ink in g Fu n d C a s h
F u n d I n v e st m e nts
Sink in g
To r ord th s l e f in v es tm
ec e a o e nt s .
B o n d O u t t n ding
s s a
S in k in g Fu n d C h as
T o r ord d i po s l f r e rv u p o n
ec s a o es e
p ym e
a nt f t h e b on d i u o ss e .
Sin k in g Fu n d R e se rv e
S ur plus
1 64, BON DS, C A P I T AL S T O C K , D E P RE C IA T I ON
R EVI E W QUE ST ION S
G iv e th r m et h o d s o f fi gur ing ink ing fu nd
ee a s .
W h t i n nn u ity ?
a s a a
G ive a rul e f fi gur in g c om pou n d int r e s t
or e .
G ive a rul e f fi gur ing n nn u it y
or a a .
G iv e n x p l n tion o f th e pr e s en t wor th f n nn u ity
a e a a o a a .
W h t f cts e u u l l y s h ow n in t ru s t d ee d ov e r in g t h e c r ea
a a ar s a a c
t io n f o s in ki n g fu n d ?
a
W h t j our n l e n t ry i r e q u ir e d t r or d t h e r c ipt f in
a a s o ec e e o
te s t
re n o s in k in g fu n d w h n t h
a t ru t de d p rov i d e th t
e s ee s a
a ll c umul ati o n s s h l l b e
a c dd e d t t h e s ink in g f u n d ?
a a o
C HA P T E R XI I
D E P RE C IAT I O N P RO B LE M S
1 . Pr in c ip le s and Po lic ie s
I n V olume 1 C hapter XX I X elementary con sid
, ,
e r a tio n is given to the principles of depreciation .
T herein are taken up the causes of the shrinkage in as
set values the accounting required to record the shrink
,
age and the methods most commonly employed in de
,
t er m in ing the depreciation rates I n this chapter fur
.
ther consideration is given to some of the matters dis
cussed in the first vol u me I n the following chapter
.
the records required in accounting for the depreciation
of the fixed asset items are taken up and examples are
g iven of more complicated bookkeeping entries than
those hitherto shown A s an introduction to the chap
.
ters in this volu me the reader is referred to V olume I .
I n studying the general principles which govern the
depreciation charge it should be remember ed that the
,
depreciation policy varies widely in di fferent industries
and somet imes in Similar businesses in the same kind of
industry I n some cases depreciation i s treated as a
.
matter of appraisal to be determined less by the facts
of the case than by expediency and present financial
condition ; in other cases especially when the business
,
is flourishing and the plant is kept in a high state of
e fficiency repairs and replacements are often considered
,
to o ffset the depreciation charge ; and in cases where
16 5
1 66 B ON D S , C A P I T AL ST O C K , D E P R E C IA T I ON
the plant and equipment are fairly homogeneous in their
character blanket rates are used to cover groups of as
,
sets in the expectation that the law of averages will
bring about an equitable depreciation charge .
2 . A p p r a is a l of De p r e c ia t io n
When there is no fixed policy as to the method of
figuring depreciation a common practice especially in
, ,
small enterprises is to appraise the assets of the busi
,
ness at inventory time and charge the cost of operation
with the difference between the new appraised value and
the book value of the assets T his method has little to
.
recommend it beyond its simplicity while in the case O f ,
an organization of any size it is impracticable because
of the large amount of clerical work involved in making
the appraisal of widely di fferent and fluctuating asset
values I f these values are to be truthfully stated they
.
must h e figured on some consistent plan subj ect of , ,
course to adj ustment as chan ging conditions in d icate
, .
A further disadvantage of the appraisal method is
that asset values fluctuate with changes in market con
dit io n s and the tendency when making the appraisal is
,
to take into consideration present market values rather
than actual cost and the ac tual facts of depreciation .
T h e effect of depreciation in most cases is only dis
c e r n ib le over a long period of years and to attempt to ,
value and revalue the assets at short intervals is im
practicable C onsciously or un consciously the ap
.
,
praiser is compelled to estimate the Shrinkage by one
of the standard methods of rate determination and the ,
figures in consequence are based on calculations loosely
made and not consistently adhered to W hen loose ap .
D E P RE C IA T ION P RO B L E M S 1 67
p ro x imations and guesses replace carefull y calculated
rates the j udgment is easily biased by the needs of the
,
moment and the circumstances of the case Provision .
for depreciation then becomes a matter of expedience
liberal amounts are written o ff in profitable years and
very little if anything in lean years For this reason
, , .
,
if for no other the appraisal method is to be condemned
, .
3D
. e p r e c ia t io n Re p l a c e d b y Re p a ir s an d Re n e w a ls
An asset such as a building which depreciates Slowly
, ,
and the utility of which is not greatly decreased by wear
and tear s h rinks in value as much through inadequacy
,
and obsolescence as through actual physical decay .
T herefore a liberal policy as to repairs and renewals
cannot in such a case compensate for its depreciation .
I t is generall y conceded that in only one case may an
allowance for depreciation properly be replaced by a
charge for repairs and renewals I n such a case the .
machinery or plant must consist of units of so short a
life that the mere fact that the equipment is maintained
in operating condition indicates that extensive renewals
must continually be made to operate it at all T h e de .
preciation charge is then covered by the expense of r e
placements and repairs .
4 . Le a s e h o ld s
L and is frequently leased for business p ur p oses the ,
lessee erecting his own plant ; or if a building a lready
exists on the land the lessee p ays for the necessary im
p r ov e m e n t s and alterations A t the end of the
. lease ,
the plant together wi th such improvements as are not
,
in the form of movabl e fix tures becomes the property ,
1 68 B ON DS , C AP I T AL ST O C K , D E P RE C IA T ION
of the ow ner of the land or freehold U nder these cir .
c u m stan ce s the maxim u m term of life of the impr o ve
ments is limited by the unexpired term of the lease of
the property to which they are attached I f the enter .
prise is to avoid a loss of capital on the termination of
the lease provision should be made by means of a de
,
preciation charge for the amortization of the original
cost of the plant and improvements made by the lessee .
I n the event that improvements include the erection of
buildings their cost should be prorated over the period
,
o f the lease and charged o ff as rental expense When .
a tenant holds premises for a term of years under a
lease which requires that he make his own repairs and
improvements the ordinary re p airs shoul d be charged
,
to current ex p ense .
5E
. s t im a t io n o f Va lu e s
I n estimating the value of an asset any initial ex ,
p e n di tu r es which it is certain will not need to be dupli
ca te d with the passage of time should be eliminated from
the calculation I t is also im port ant not to omit any
.
expense which must necessarily recur when the p lant
is re newed A careful analysis of all charges for r e
.
pairs and renewals is therefore necessary in determining
the cost of the asset and thus the amount to be depre
c ia t e d . T h e only case where repairs are properly a
capital charge is where a run down plant is purchased -
at a reduced price with the intention of restorin g it to
fir st class condition
-
.
I n estimating the depreciated values two precautions
in particular should be observed First the estimates .
,
should be reviewed at intervals and corrections made
‘
D E P R E C IA T I ON P RO BLE M S 1 69
for errors revealed with the lapse of time I n case of .
doubt as to the proper one of two rate s the better policy
,
is to choose the higher because a mistake is more easily
,
corrected by increasing the values shown in asset ac
co u nts than by making unexpected charges to the Profit
and L oss account .
T h e second caution relates to the assets covered by
the calculation While it is obvious that the same rate
.
will rarely be applicable to radically di ff erent assets as ,
sets o f the same type may also require di fferent rates .
I f a single percentage is used to co ver the whole equip
ment of one dep artment the rate may be quite n u
,
trustworthy since the true rate of depreciation may vary
with each piece of equipment— depending upon the na
ture of the work the amount of idle machine time and
, ,
other conditions A ccuracy demands that each kind of
.
equipment have its own depreciation r ate and that a
department rate when t h is is computed be a composite
, ,
of the var ying rates within a department .
6. M e th od s of Ra t e De t e r m in a t io n
T he work of fixing depreciation ra t es will be sim
p l ifie d if records are in existence w h ich furnish informa
tion regarding the purchase price and the cost of all
repairs made to every part of the plant and machinery .
S uch records ( to be described in the following chapter )
are valuable whether used for revi sing existing or mak ,
ing future depreciation rates
, .
Whatever method of determination is employed the ,
rate when finally adopted shoul d be consistently adhered
to over a period of years thus testing the accurac y of
,
th e original calculations .
q u i r e m e n ts O are m e t y
a CCO U Il U Il g I e use 0 one 0
the three plans described in V olume 1 , C hapter XX I X
1 . Fixed proportion methods
Per cent of diminishing value method
3
2 .
. S inking fund method
O f the above methods the fixed proportion plan may be
based on either the life or the output of the asset and the ,
sinking fund method may be modified in di fferent ways
—as discussed in following sections .
I n the illustrations of the different methods of figu r
ing depreciation which follow it is assumed that the
,
assets Shrink to their scrap value I n actual practice
.
no industrial plant depreciates in this way A fter a .
new plant has been in operation for a decade or more ,
values become fairly fixed when a certain point is
,
reached where replacements must equal the depreciation
if the eq uipment is to render s atisfactory service T he y .
are then charged to the depreciation reserve .
Fix e d Pr o p o r t io n M e t h o d s
fixed proportion methods are so termed because
T he
the depreciation charge is figured in proportion to one
of the three following bases
1 . T he life of the asset measured in years
T h e life of the asset measured in working ho u rs
3
2 .
. T h e output of the asset
T he corresponding methods of figuring are known
I . Straight line method
-
Working hours m e thod
3
2 .
. Service output method
D E P RE C IA T I ON P RO B L E M S 1 71
1 .
-
z
'
S traigh t L n e M U nder this method the
e tk o d .
original cost of the asset less its scrap value is divided
, ,
by the estimated number of years of its li fe the result ,
ing figure being the ann ual charge for depreciation as ,
shownin the following table
ST RAI G H T LI N E M E T HO D
-
C o s t $6 5
5. E s tim t d l if 1 0 ye r
a e S r
e a s . c ap v lu e
a
A mou t T ot l n a
W ritt A mou t
en n
ff 9 %
o W r itt en
A u lly
nn a Ofi
’
The per cent condition given in the right hand -
column of the above table represents the ratio of the
equipment s net worth to its cost A t the end of the
’
.
tenth year the per cent condition is or this
being equal to the scrap value of the machine .
T h e advantages of the straight line method lie in -
the s implicity of its calculation and application and for ,
thi s reason it is more widely used than any other T h e .
only disadvantage is that the same amo u nt of deprecia
tion is rigidly charged a nnually regardless O f fl u ctu a
tions in wear and tear T hus if unexpected conditions
.
,
arise which necessitate working overt ime a machine ,
estimated to last for 1 0 years may be worn out in half
the time C ons e q uentl y the ap p lication of this met h od
. ,
1 72 BON D S, C A P I T AL S T O C K , D E P R E C IA T ION
to machines and other assets sub j ect to fluctuating use
makes necessary the revision of the estimated future
life when the conditions of their operation may be
changed .
2. W ork ing H ou rs M e thod T his method avoids .
the rigidity of the straight line method by making the
-
depreciation charge proportionate to the use of the
machine T his relationship is e ff ected by estimating the
.
number of working hours of a machine and making the
charge for the actual hours worked T o illustrate an
5
5 5
5
.
,
asset costing $ 6 with a scrap value of $
,
and an
estimated li fe of working hours would be charged ,
with 0 6 depreciation for each hour of its operation
. .
A feature of this method of calculation is that it
makes possible the application of the depreciation
charge direct to the product and in consequence the plan
is often used where costs are computed under the
m achine hour and sold hour methods ( see V olume I I I )
- -
Where complete cost records are not available the plan
is of course not practicable
3
.
, ,
. S ervice M e tho d I n this case instead of figu r
.
,
ing depreciation on the time use of the asset it is com ,
p u t e d on the output or service rendered in volume ,
weight or quantity Where wear and tear can be
, .
measured in this w ay this method has much to r e co m
,
mend it For example certain types of grinding and
.
,
crushing machines or furnaces which burn out rapidly
have usually a known capacity beyond whic h they can
not be economically or in some cases safely operated
, , .
Depreciation in these instances is an appreciable item of
cost and to charge it directly to product is the most satis
factor y method of distribution .
D E P RE C IA T ION P RO BLE M S 3
17
’
8 . Pe r C e n t of Dim in is h in g V a lu e M e t h o d
U nder the fixed percentage of diminishin g value
“
”
method the depreciated amount is figur ed as indicated
by its name T hus if the original cost of an asset is
.
,
and the depreciation rate is the first amount
written o ff is $ 2 0 the second amount 5 ( %
2 5
5
,
of the third amount ( 7
2 0 of
and so on until at the end of the eighth period the
residual value is found to be I f the scrap
value of a machine is estimated at $ 1 0 0 and its
5
life at 8 years 2 % would thus be the approximate rate
,
to apply to its dim inishing value T h e exact figuring .
of the rate involves the use of an algebraic formula and
as a rule the rate is found to be a decimal figure U sing .
the same figures a s in the example illustrating the opera
tion of the straight line method the rate of depreciation
-
with the aid of logarithms is found to be By
applying this rate to the original cost and to the dimin
ishing value it is foun d that at the end of the tenth
,
year the depreciated value exactly equals the scrap value
as shown in the table below :
PE R C ENT I I NI S HING VALU E M E T HO D
OF D M
C o s t $65
5 . E s t im t e d l i f 1 0 y r
a S r p v lu
e ea s . c a a e
A mou t W ritt n T ot l A mou t
n e a P C n t er en
O ff W ritt O ff C o d itio n
en n
1 74 B ON D S , C A P I T AL ST O C K , D E P RE C IA T I ON
A study of this table Shows that the amount writte n
o ff the first year is more than t wice that of the fifth
year and about eight times the amount written o fl the "
fin al year .
T h e above table illustrates the chief feature of the
fixed percentage method viz that the depreciation ,
.
,
charges are heaviest when repairs are lightest and vice ,
versa I t is comm on knowledge that the installation and
.
use of an asset for however brief a period at once places ,
it in the class of a s e cond hand article though the asset
“
-
ma y be so little used as to be equal to new T herefore .
the decreasing amounts written o ff year by year more
nearly approach the actual facts of depreciation than
do the equal amounts written o ff under the straight line -
method .
T h e above method is perhap s applicable more to
certain types of assets— such as highly specialized
machinery which has little or no market value or which
—
may at any time become obsolete than it is to average
conditions T h e in eth o d finds favor among engineers
.
and accountants because of the feature mentioned above
—the equalization of the repair and depreciation charges .
While this consideration must be given weight when
only one asset of relatively high value is to be depre
c ia te d in a large plant where new machines are bein g
,
constantly installed and old ones discarded the law of ,
averages tends to equalize the repair and depreciation
charges A uniform rate of depreciation such as the
.
,
str aight line method may then as nearly approximate
-
the actual fact s as does the more flexible diminishing
value meth od or any other plan which aims to give the
,
actual depreciation value y ear b y y ear .
D E P RE C IA T ION P RO BL E M S 17 5
9 . Sin k in g Fu n d M e t h o d
T his
method of figuring depreciation also known as ,
the compound interest method in no wa y d ifl e r s in prin
,
c iple from the methods of computing annuity and sink
ing fund payments described in C hapter X I A S there .
stated in the creation of a sinking fund the element of
,
interest on the debt for the repayment of which the fund
is created is ignored whereas annuity payments include
,
interest on the decreasing principal of debt which is
gradually being repaid I f for the debt to be repaid is
.
substituted the account to be depreciated ( the di fference
between original cost and scrap value ) the arithmetical ,
solution is worked out in the way already described .
A pp lying these principles to the facts already given
— 5
an asset costing $ 65with a life of 1 0 years and a
scrap value of — and assuming the rate of interest
to be the problem i s to find the equal periodical pay
ments which at 4 % will amount to in 1 0 y ears
5
.
A ccording to the rule in of C hapter X I the amount ,
of an annuity equals the compound interest for the ‘
period divided by the rate for the period both expressed ,
decimally $ 1 compounded at 4 % for 1 0 years equals
.
that is the amount of an annuity of $ 1 for
5
,
1 0 years at 4 % equals 480 2 4 $1 )
5
.
divided by 0 4 which equals $ l 2 oo6l 2
.
, I f an annuity
. .
of $ 1 for 1 0 years at 4 % accumulates a fund of
$ l 2 oo6l 2 5
. b y division a fund of
, is created by
annuity payments of at the same interest and over
the same period—which is the solution to the problem .
T h e following table fur nishes the proof of the above
calculation and shows the operation of a sinking fund in
tabulated form .
1 76 BON DS, C A P I T AL ST O C K , D E P RE C IA T ION
S I NKI NG FUN D M E T HO D
C 5
o st $ 65 . E s tim te d l ife 10 ye r s
a a . Sc r ap v lu e
a
A mou t W r itt n n e
O ff I lud i g nc n
I t r t A r A umul t d
n e es ce e cc a e Ne t P e r C e nt
t io To t l ns a W or h
t C o d itio
n n
ls t y r o nt r ib u tio t fu d
ea c n o n
I t r t t 4%
. .
n e es a
c nto r ib u tion t fund o
I t r t t 4%
.
n e es a
c o t r ib ut io
n n to fu d n
Itr t
.
n e es at 4%
c nto r ib u tion t fu d o n
I t r t t 4%
.
n e es a
c nto rib u tio n to fu d n
I tr t
.
n e es at 4%
c o t r ib u tio
n n to fu d n
Itr t
.
n e es at 4%
c nto r ib u tion t fu d o n
I t r t t 4%
.
n e es a
c o t r ib ut io
n n to fu d n
I tr t
.
n e es at 4%
c o t r ib ut ion t fu d
n o n
I t r t t 4%
.
n e es a
c o tr ib ut io
n n to fu d n .
S tudy of the foregoing table reveals that the amounts
carried to the reserve increase at an accelerated rate with
the life of the asset due to the interest accretions which
,
from in the first year grow to in the ninth
year A n increasingly heavy burden is thus laid on
.
operations during the later years of the life of the asset
D E P RE C IA T ION P RO BL E M S 1 77
when the repair charges are h igh resulting thereby in ,
an unequal b u rden on the product For this reason . .
where the depreciation charge a ff ects the cost of produc
tion to an y extent one of the preceding methods is to
,
be preferred .
While ordinarily the creation of a sinking fund im
plies that an actual fun d of cash or other assets is set
aside for accumulation at compound interest the use ,
of the compound interest principle in the figuring of
depreciation doe s not necessarily M ply that the depre
c ia tio n charge is to be accumulated in this way T he .
mathematical device may be used merely as a convenient
means of figuring the estimate I f no fund is created
.
,
and therefore no interest is earned and compounded the ,
amount to be written o ff annually Should include the in
t e r e st accretions T h e s inking fund method is theo
.
r e tically misapplied when used as a mathematical device
only I f an actual fund is created and compound inter
.
est actually accumulated the method is to be r e co m
,
mended for the reason that the depreciation charge is
then e q ualized .
10 . Co m p os it e De p r e c ia tio n Ra t e
When estimating the amount of depreciation ap
plicable to the various assets of a large plant each item ,
is not of course separately considered L ike assets are
, , .
grouped in classes the divisions are based on similari
,
ties and the length O f life of a group of like machines is
,
determ ined by the conditions under which they are
operated A composite depreciation rate is then fig
.
u r e d for each group and fro m these group rates the total
amount of depreciation incurred by the plant as a whole
1 78 B ON DS , C A P I TAL ST OC K , D E P R E C IA T ION
is calculated T h is composite rate is based on the aver
.
age life of the di ff erent classes of assets and the average
amount of depreciation T h e method of computing .
such a r ate is set forth in the follow ing table
C O M P O SI T E D E P R E C IA T ION
Sc r p V lu
a a e De pr o
e c ia t i n
o l
T ta
From the above table it is seen that the total amount
to be depreciated is and the annual amount
T herefore the division of the first figure by ,
the s e cond gives the average number o f years of life
of the whole plant viz years I f , .
, .
is credited annually for y e ars to D e preciation R e
serve the accum ulation t herein will represent the value
,
o f the entire plant ( when new ) less its estimated scrap
value .
R EVIE W QU E ST ION S
W h t i t h ppr is l m th o d f fi gur in g d p r e i tio n ?
a s e a a a e o e c a
G iv e t h r m eth od f l ul tin g th d pr i t i n r t
ee s o ca c a e e ec a o a e .
W h t t h r e b e m y b u d in o n n tio n w ith t h e fix e d p
a e as s a e se c ec ro
p or t i o n m t h od fefi ur in d r i t
o i o n ? ec a
g g p e
W h i h m th od f fi gur in g d p r e i t io n i u d t
c e o q u l i z e th e e c a s se o e a
nn
a l h r g f d p r i t io n n d r p i r ?
ua c a e or e ec a a e a s
W h y m y th r t
a f d pr i t i n
e a e f m h in r y b in c r ea e d
o e ec a o o ac e e s
w h en p l n t b gin t w ork n d y n d n igh t h i ft ?
a a e s o o a a s s
C HA P T E R XI I I
D E P R EC IA T I ON ON TH E BOOK S
1 . C la s s i fi c a t io n of Pl a n t It e m s
assets of a plant are usually grouped according
T he
to their nature similar assets bein g segr egated A uni
, .
form depreciation rate can then be set up for each segre
gated group T h e following subdivisions are tabulated
.
as probably covering the broad classification of the as
sets O f a large manufactur ing concern :
B uildings
E ngines and boilers
Shaftin g
G eneral machin ery
Special machinery
Machine tools
H and tools
J igs dies patterns flasks etc
, , , , .
Power plant
4
1
- E lectrical machiner y
C ranes
4
1
-
12 . H oists
E ach of the above items may of course be further
subdivided or the group accounts may be supplemented
,
with individual asset accounts when it is necessary to
watch closely the depreciation of particular items of
equipment T hus in a steel plant se p arate accounts
.
,
1 79
1 82 BON DS, C A P I T AL ST O C K, D E P RE C IA T I ON
,
D E P RE C IA T I ON ON THE B OOK S 18 3
Form 3(
. b) P l ant L dg r
e e Ca rd ( r v
e e rs e )
1 80 B ON DS , C A P I TAL ST O C K , D E P R E C IA T ION
are sometimes opened with a ll blast furnaces so that ac
curate depreciation charges can be o btained in each ca se .
2 . Re s e r v e A c c o u n t s
A separate reserve account should be opened wit h
the di fferent classes of assets comprised under the gen
eral heading of plant and machinery or with each asset
which represents a large investment I f one reserve ao .
count covers all the fixed assets the rate of depreciation ,
cannot be readily determine d in a given c ase A stone .
building for instance does not depreciate so rapidly as
, ,
a frame building and if a separate reserve account is
kept with each building the facts of depreciation are
,
much more clearly recorded .
When the plant is extensive and runs into thousands
of items a subsidiary plant ledger is required to Show the
details of the investment in equipment of various kinds
and the depreciation charges in each case .
3 . Pl a n t Le d g e r
While the plant l e dger serves the same inventory
purpose in its relation to plant as does the stores ledger ,
to stores ( see V ol u me I I I C hapter X I ) its operation
, ,
is slightly di ff erent T h e debit side of a stores item card
.
shows the purchases made its credit side the amount ,
consumed and its balance the value on hand at any time
,
.
A plant ledger card gives the same general informati o n
as to plant items but in a di ff erent form O n one S ide
3
.
or face of the card ( Form a ) a complete description
of the machine and its location is given in the heading
and an entry is also made of the original purchase price .
I n the s paces provided below details are entered of the ,
D E P RE C IA T ION ON T HE B OOK S 1 81
cost of ins tallation and repairs a di stinction be ing made ,
be tween repairs which are chargeable to expen se and
tho se which are ch argeable to capital value T h e entries .
relating to expens e are merel y memorandum entries for
”
the purp o se of showing the career of the asset T h e“
.
record as a whole furnishes a comple te his tory of the
cost of the as se t to date
3
.
O n the reverse side o f th e card ( Form b ) the ful l
cost i e the asset or capital cost of the plant items
, . .
,
to da te the ann ual depreciation ra te and the ann ual
, ,
charge are sho wn together with the a nnual not the
, ,
monthly amounts w ritten o ff the asset T o credi t in
, .
de ta il on the plant item ca rds month by month the nu , ,
m e r o u s small sum s charged to production for deprecia
tion woul d not o nlv entail cons iderable clerical work
but would be a needless proced u re since these charges
are alr eady listed on the depreciation schedule T hus .
the reverse side of the card f u rnis hes the record of the
ann ual depreciation charges only and represents the D e
pr e ciation R e serve acc o u nt o f e ach plant asset the orig ,
inal as set value of which is shown in the headin g .
I n large organi zations the plant ledger is usually
divided into sections with the various ite ms classified
,
under the heads as previously suggested
, .
4. Co n tr o llin g P la n t A c co u n t
A general ledger plant account may contr ol the sub
sid ia ry plant led er or a separate controll ing acco un t
g ,
may be opened for each section thereof if the subdivisions
are not t oo num erous A t the end of the accountin g
.
peri od the control acco u nt is charged with : ( 1 ) the
total purchases of plant ; ( 2 ) the cost of installation if
1 84 B ON DS , C A P I T AL ST O C K , D E P R E C IA T ION
3
an y ; and ( ) the full cost of plant additions m anu fac
t u r e d or constructed by the factory sta ff T h e amount .
of the purchases is ob tained from the purchase j ournal ,
the cost of installation from time tickets and stores requi
s itio n s an d the cost of plant additions from a summary
,
of all plant addition cost sheets ch argeable to the cur
rent period A t the end o f each cost period the balance
.
in the general ledger Plant account ( assuming only one
controlling account ) should equal the total of all the
asset values shown on plant item cards .
5C
. o n t r o llin g De p r e c ia t io n Re s e r v e A c co u n t s
E ach general ledger Plant account requires an o ff
setting Depreciation R eserve account which is credited
a t the end of each fiscal or cost period with the current
depreciation charges as shown on the depreciation
schedule T h e detail credit ent r ies p osted to the plant
.
item cards at the end of each financial period should
aggregate the various amounts credited to the controlling
Plant account or accounts at the end of each c ost period .
I f the financial b ook s are closed half yearly as is -
sometim e s the case half yearly depr e ciation credits will
,
-
of course be made to the plant ledge r reserve accounts
, .
Th e point to o bserve is that when the financial statement
is d rawn up the estimated values o f the plant assets
,
should be given as at that date—which requires that the
depreciation charged to production in Depreciation R e
serve account be brought u p to dat e and deducted from
the controlling Plant account .
6 . Illu s tr a t iv e J o u r n a l En t r ie s
j ournal entries required to record the deprecia
T he
tion charges are presented in V olume 1 C hapter X X I X , ,
D E P R E C IA T I ON ON T HE B OO KS 18 5
and the method of handl ing this element of expense in
c o st accounting is exp lained in V olume I I I T here r e .
ma ins to ill ust rate the method of operating an asset a c
count and its o ff se tt ing reserve acco u nt when the entries
are compli cated by the fact that ow ing to the rapidity ,
O f the depreciation the amounts carried to reserve may
,
not be always sufficient to equa l the value of the asset
withdrawn from servi ce or destroyed .
T o ill ustrate the foregoing problem assume that a ,
conce r n s A uto mobil e Delivery T ruck and Depreciation
’
R eserve acco u nts contain the follo wing entries and that
the rate of depreciation is 2 % per year 5 .
AU TOM O B I LE D E L Iv E R v T RU K C
J an
. 1 T ru c k s 1, 2 , 3
, a nd
4 at
RE SE B vE FOR AU TOM O B I LE D E L Iv E Rv T RU K C S
J an 1 R r for T ru
ese v e c k 1
k
.
R rv for T u
k3
e se e r c 2
R rv for T ru
ese e c
As sume also the follow ing transactions
1 O n J ul y 1 truck 1 is destroyed by fire and is
5
.
repla ce d by truck purchased on open a o
count for
2 T ru ck 2 proves un sa t isf actory and on August
5
.
1 is traded in for $ 8 0 on the purchase of
tr uck 6 cost ing T h e diff erence is
paid in cash
3 3
.
T ruck is totally destroyed in an accident on
5
.
September 1 I t is insured for $ 7 0 . .
T h e j ourn al entries as of S eptem b er 1 to record the
above series of facts ar e lis ted below in the same order
1 86 B ON D S , C AP I T AL ST O CK , D E P R E C IA T ION
as given I t should be noted that the fir st requirement
.
in each case is to charge O perat ing E xpense wit h the
accrued depreciation to date
O pe r E x pens e
a tin
g
rv e fo Depr eci ti on n T ru ck
Re s e r a o 1
D epr i t io n o n t ru ck 1 f
ec a 6 mo n th s or .
A u t o De l iv e r y T ru k 5 c
R e e rv f D p r e i tio n f T ru k 1
s e or e c a o c
Sur p lu s
A ou n t P y b l e
cc s a a
A u t o D l iv e ry T ru ck 1
e
Re p l ce m e nt o f t ru k 1 w ith t ru ck
a c 5 .
O pe r a t in E x pe ns e
g
R e rv e f De pr e ci ti o n n T ru k
se or a o c 2
De p r e ci t i o n n t ru k 2 f o 7 mo nth s
a o c r .
A ut o De l iv e r y T ru ck 6
Res e rv e f or D e p r e ci a t i o n of T ru k
c 2
Aut o D e l iv e r y T ru ck 2
C ash
S ur p lu s
O pe r E x pe n s e
a t in g
R e e rv e f D pr eci tio n n T ru ck 3
De p r ec i t io n o n t ru k 3
s or e a o
a f 8 m on t h s c or .
Re s e rv e fo D pr ci tio n on T ru ck 3
3
r e e a
A u t o De l i v e r y T ru ck
I ns ur a nce C om p an
y 7
I n ur n A dj u t m ent
s a ce s
T o r eco r d ins u r ance .
DE P RE C IA T I ON ON T H E BOOK S
I n s ur A d j u t m e nt
A u t o D l iv r y T ru ck 3
a n ce s
e e
To c lo se T ru k c ou n t in t oc a c in s ur an c e
a d j u tm nt
s e .
I n s ur a n ce A d j u st m e n t
S ur p lu s
To t r n fe r g in by
a s a
_
a cc i d ent .
7 . Le d g e r A c c o u n t s and En t r ie s
A fter the above entries are recorded the balances o f ,
all accounts a ffected as of S eptember 1 woul d be as
follows :
A U T O DEL I V ERY T RU C K S
J uly 1 T ru k 1 c
A g 1 T ru k 2
S p t 1 T ru k 3
u . c
T ru k 3
e . c
B l n a a ce
p
Se t 1 B a
. l ance
R E ER V E
S FO R D E RE IA
P C I
T ON
J uly 1 T ru c k 1 J an 1
k ru k 1
.
T ru J uly
k3
A ug 1 c 2 1 T c
T ru k 2
.
p T ru
T ru k 3
Se t 1 . c Aug 1 . c
Se t 1 p . c
O P ER AT IN G Exp EN SE
J uly 1 De pr . on T ru c k 1
3
Aug 1 . 2
p
Se t 1 .
AC C OU NTS PAYAB L E
J uly 1 T ru c k5
1 88 BON DS, C A P I T AL ST O C K, D E P RE C IA T ION
IN S URAN E C C OM P AN Y
p
Se t 1 T ruck 3 I
IN S URAN E C AD J U ST M EN T
p
Se t . 1 T ru k 3 c Se t p . 1 T ru c k3
Surplu s
S UR LU P S
J uly Lo ru k A u g 1 G ain ru k
k3
1 ss on T c 1 on T c 2
I
.
Se t p . 1 G a in on T ru c
final entr y to record the depreciation accrued on
T he
trucks 4 , 5
and 6 at September 1 would be :
,
Op r
e E pe n s e
a ti n g x
rv
R e s e e fo r D e p e c i a t i n r o
r
Dep e c ia ti n t c 4, 8 o
n th s ru k mo
52 ,
6, 1 mon th
R EVI E W QUE ST ION S
W h at is l e dg r ?
a p ant l e
E x pl in a ookk ping e x pe d ie nt by w h ich th e um o f th e
th e b ee s
d t il e a f th e pl n t l d g r
s o lw y q u l th t o t l v lu e f
a e e a a s e a s e a a o
:
p l nt a h ow n b y t h g n e r l l d ge r
as s e e a e .
G i v j our n l e n t r ie i l lu st r tin g t h e o pe r ti o n f
e a s s pe c i fi c d e a a o a
p r i t i o n r es rv e
ec a e .
W h t n t r y is r e q u i r e d w h n n
a e se t i s ol d f l e s th n e a as s or s a
o t v lu but fo mor e t h n b ook v lu e ; i e c o s t l s s d e
c s a e r a a . .
, e
r e ci t i o n ?
p a
C HAP T E R X IV
C AP I T AL S T O C K I S S UE S
1 . Pu r p o se of C o r p o r a t e St o c k A c co u n ts
I n V olume I C hapter XXX I I I the nature of a
, ,
corporation the kinds of stock issued and the simplest
,
method of accounting therefor are taken up A s there ,
.
explained the amount of capital stock which a corpora
,
tion may lega lly issue is stated in its charter and thi s ,
amount cann ot be increased without legal formalities to
protect the rights of the original contributors T here .
fore the corporate accounts Should be so kept as to
,
show at all times :
1 . T he amount of the authoriz ed issue .
T h e amount actually issued
3
2 . .
. T h e balance unissued .
A s previously stated the above information can be
,
conveniently and readily shown by maki ng a memoran
d um entry of the amount of the authori z ed issue at the
top of the ledger accou nt and recording below the
amou nt actually issued U nder simple conditions .
,
where a sole proprietorship or a partnership is trans
formed into a sma ll corporation and the capital stock
issued is promptly paid for in property or cash this ,
method may be foll owed and only one capital stoc k a c
count is r e quired B ut when the issue involves the offer
.
of some or all the capital st o ck for public or private sub
scri p tion and the p a yment of shares in insta lments the ,
1 89
1 90 B ON DS , C A P I T AL ST OC K ,
D E P R E C IA T I ON
accounting is of necessity more detailed and the entries
become more complex .
2 . Re c o r d in g A c t u a l Is s u e s
simplest of all methods and the one r e com
T he
mended by the maj ority o f accountants is to avoid all ,
formal entries and to set up the cap ital stock only as
issued I f the subscription to and payment of the
.
issue are simultaneous the j ournal entry required is
,
C a pit a l St o c k
T his entry indicates that cash has been received i m me
d iat e ly upon the allotment of shares and that the sub
s cr iptio n s have been paid for in full .
When the stock is first subscribed for and then paid
for at a later date two additional accounts are required
,
to Show the amount of ( 1 ) capital stock subscribed for ,
and ( 2 ) subscriptions received T o illustrate the opera .
tion of these accounts assume that the authorized issue
,
is for that the subscriptions amount to $ 1 0 0 ,
0 0 0 ; and that cash is received in payment of s u b scr ip
tions at a later date than the subscriptions .
When the subscriptions are taken up the entr y is ,
S ub s cr ib e r s
C apit a l St o c k S u b s c r iptio n s
W hen the cash is received in payment of these su b scr ip
tions the entry is
,
C AP I T AL ST O C K I SSUE S 19 1
A nd when the shares of stock are issued by the com
pany the followin g entry records the fact upon the cor
,
p o r a t e books :
C apita l S t oc k S u b s c r ipt io n s
C a pital St oc k
final result of these various post ings is a debit
T he
to C ash of o ff set by a credit to C apital Stock
of — as in the previous example .
T h e ledger accounts and the method of presenting
the facts on the balance sheet are as follows :
S U B R I B ER
SC S
C ash
C A I AL
P T ST O C K SU B R I
SC PT O I N S
p l
C a it a St oc k u r r
S b sc ibe s
u r r
S b sc ibe s
C A I AL
P T ST O C K
p l
C a it a St o c k S u b s c r ip
t io ns
B ALAN E SHEE C T
C as h
advanta ges of the above methods are ( 1 ) that
T he
the accounts record only actual financial transactions as ,
until the capital stock is either paid or subscribed for no
formal entry is made on the books of account ; 2 ) that
the amount of the authorize d issue a p pears only as a
1 92 B ON DS ,
C A P I T AL ST OC K , D E P RE C IA T ION
memorandum note at the top O f the C apital Stock
count and any other data relat ing to the issue must be
sought for in the minute bo ok of the corporation .
3. Re c o r d in g T o t a l A u t h o r i zd e Is s u e
When formal entry is required of the t otal author
“
1zed issue the simplest method is to set up an
, Author
iz
”
e d C apital S tock a ccount o ff set by an U nissued C ap “
”
ital Stock account T o illustrate assume the same .
,
—
facts as in the preceding examples authorized I ssue
and subscriptions which are paid for
some t ime later
T h e authoriz
.
ed issue is brought on the books b y
U n is u e d C pit l St o k
s a a c
A u th or i z d C pit l e a a St oc k
AS subscriptions are r e cel v e d for stock
Su b sc r ib r s e
C pit l St o k S u b r ipt i o n
a a c sc s
When the subscribers pay for their sub scriptions
C a sh
u
S bs c ib e r rs
When the s t ock is issued
Ca pit l S t
a o k S u b rcipt i on sc s
U n is u d C pita l St o k
s e a c
L edger accounts for the above entries would appear
as follows
U N I SSUE D C A I AL
P T ST O C K
Au th oriz d C p it l
e a a St o c k p l
C a it a St ok
c Su b s c r ip
t io ns
C A P I T AL ST O C K I SSU E S 19 3
AU T H R I E D CA I AL
O " P T ST O C K
U ni u d ss e p l
C a it a St ock
S U B R I B ER
SC S
p l
C a it a St o c k S u b sc r ip
t io
ns
C A I AL
P T ST O C K SU B R I SC PT OI N S
u r
S b s c ib e r s
A trial balance set up from the above accounts would
be
U n i u d C pit l St k
ss e a a oc
A u th or iz d C pit l St o k
e a a c
C a sh
A s the unissued capital stock does not represent an
asset it should appear upon the balance sheet as shown
,
below
ALAN E SHEE
B C T
Au or th i z d
e C a pit a l
ok St c
U ni u d ss e p l
C a it a St o c k
I ss ud
e a nd u
O t st an ing d
e ff ect of the above entries is the same as when
T he
stock is recorded only as issued I t should be noted that .
the memorandum account of U nissued C apital Stock
1 94 BON DS, C A P I T AL ST O C K , D E P R E C IA T ION
disappears as soon as the entire issue of stock is floated .
I t would then be proper to change the ledger account
”
A uthorized C apital S tock to read C apital Stock “
”
Authorized and I ssued .
4 . Pa y m e n t b y In s t a lm e n t
I f the stock is paid for in instalments and in response
to regularly issued cal ls an instalment book is kept in ,
which is carried the detail as to the acco u nts due and paid
by subscribers T he methods of handl ing each call on
.
the ledger may be illustrated by the j ournal entries for
recording the following facts :authorized issue $ 2 0 0 ,
0 0 0 ; stock subscribed for two calls have been
made each for , balance not yet called for .
T h e j ournal entries for the above facts would be as
follows :
U n i s u e d C pit l St o k
s a a c
A ut h or i z d C pit l Stoc k
e a a
T r e c ord u th o r i z e d is s u e
o a .
Sub s c r ib e r s
U n iss u e d C pit l Sto k a a c
To r or d s ub sc r ipt io n s m de
ec a .
I n st lm ent N o 1
a .
Sub c r ibe r ss
T o r e or d fi r s t c l l
c a .
I n s t lm e n t N o 1
a .
To r e or d p y m en t o f fi r s t
c a ca ll .
I n sta lm e nt NO . 2
S u b s c r ib e r s
To r or d
ec sec ond ca ll .
C AP I T A L ST O C K I SSUE S 19 5
In s ta l m nt N o 2
e .
TO re co r d pa ym nt e o f s ec o nd ca ll .
T he ledger accou nts and the balance sheet woul d
AU T H RI E D CA I AL
O " P T ST O C K
U ni u d p l o k
I
ss e C a ita St c .
UNI SS UE D CA I AL P T ST O C K
S U B R I B ER
SC S
U ni u d ss e p l
C a i ta St o
c k I ns ta lm e nt No 1
I
.
ns t a lm e n t No . 2
Ba l a n ce u
S b sc i ti r p on s
Not C a ll d
e
Ba l a nce
IN ST AL E N
M T No . 1
I n s t al m e nt NO 1
I
.
n s ta lm e nt NO 2 .
IN AL E N
ST M T No . 2
B ALAN E S HEEC T
C a ita p l S t o k A ut hor c
U n ll d
ca e u
S b sc i tir p on s . izd nd I u d
e a ss e
1 96 B ON DS , C A P I T AL ST O C K , D E P RE C IA T ION
5 . A c c o u n t in g fo r Diffe r e n t " in d s of Sto c k
When more than one kind of capital stock is iss ued ,
separate account s are required to record the amounts
issued taken up and paid for in each case A ssuming
, .
an authorized issue of of both com mon and pre
ferred stock of which , is subscribed and paid
for some t ime after the subscription the entries are : ,
U n i s u d C pit l St o k C ommo n
s e a a c ,
U n i u d C pit l St o k P r f rr d
ss e a a c , e e e
A u th or iz d C pit l St o k C o m e a a c ,
m on
A ut h or iz d C pit l St o k P e a a c ,
re
f rr d e e
T o pl th e
a ce u th or iz e d is s u e u po n
a
t h e b ook s .
Su b sc r ib e r to C pit l St o k C mmo n
s a a c ,
o
Su b s r ib r t C pit l St o k P r f rr d
c e s o a a c ,
e e e
S u b c r ipt i o n
s t C pit l St o k s o a a c ,
Su b s c r ipt io n s to C apita l St o k c ,
r f rr e d
P e e 1.
To r e or d th u b s r iptio n m
c e s c s a de .
C a sh
u
r r s t C pit l St o k
S b s c ib e o a a c ,
C ommo n
S u b r ib r s t sc C pit l St o k
e o a a c ,
P r f rr e d e e
T o r e rd p y m nt f s u b r ipt io n
co a e o sc s .
S u b r ipt i o n t C pit l St o k Co mmo n
sc s o a a c ,
S u b r ipt io n t C pit l St o k P r f rr d
sc s o a a c e e e
U n iss u d C pit l St o k C ommo n
e a a c ,
U n i u d C pit l St o k P e
ss e a a c ,
r
f rr d e e
T o r e or d th e is s u e f s t o ck c t ifi
c o er
c at e s .
C AP I T A L ST O C K I SSUE S 1 97
T he ledger accoun ts for the entries given above
woul d be
AU T H R I E D CA I AL
O " P T STO C K , CO M M O N
AU T H R I E D CA I AL
O " P T S TO C K , P R FERRE D
E
UNI SS UE D CA I AL P T ST O C K ,
CO M M O N
Au or iz d u
S b sc i tirp o
I
th e ns
UNI SS UE D CA I AL P T ST O C K ,
P REFERRE D
A u horiz d u
S b sc i tirp o
I
t e ns
S U B R I B ER
SC S To C A I AL
P T ST O C K ,
CO M M O N
u r p on C as h
I
S b sc i ti s
S U B RI B ER
SC S To CA I AL
P T ST O C K , P REFERRE D
u rp o
S b sc i t i ns C as h
I
S UB RISC PT O I N S To C A I AL
P T ST O C K , CO M M O N
U ni u d u r r
I
ss e S b s c ibe s
S UB RI SC P TI O N S To C A I AL
P T ST O C K P REFERRE D
,
U ni u d u r r
S b s c ib e
I
ss e s
C AH S
u r r
S b sc ib e s, ommo
C n
S ub r ib r
sc e s, P r f rr d
e e e
A trial balance d rawn from these accounts would
a p pear as follows :
198 B ON DS , C A P I T AL ST C O K , D E P RE C IA T ION
A ut h or iz ed C pit l St o k C o mmo n
a a c ,
A u th ori z e d C pit l St o k P r e fe rr d
a a c ,
e
U n iss u d C pit l St o k C ommo n
e a a c ,
U nissu ed C pit l Sto ck P r e fe rr d
a a , e
C a sh
balance sheet entry as before would be , ,
B ALAN E SHEE
C T
Au th . C a italp St o c k ,
Commo n
U ni u d ss e
I ss u ud e an d O ts t an ing d
A u th C p l . a it a St c , o k
P r f rr d e e e
U ni u d ss e
I ss ud e an d u
O t stan ing d
R EVI E W QUE ST ION S
W h at in f orm ati on sh oul d the c a pit a l st o kc acc ou nt s a lw ays
Show ?
G iv e j our n l n t r y w h i h w i l l p l ce th e u th or iz e d mou n t
a a e c a a a
of p i
cat a l s t o k n t h e b ook s
c s foo rm l e n t r y w h e n it is a a a
o n l y pa r t i l l y is u e d
a s .
Wh t gen e r l l e d ge r c ou n ts e r e q u ir e d to Sh ow t l l t im s
a a ac ar a a e
l l t h e in form ti o n n ee d d in y our n s w e r t q u t io n N o 1 ?
a a e a o es .
G iv e en t r ie s r e q u ir e d t Sh ow th e r ec eipt o f p rt i l p y m e nts
o a a a
on s u bsc r ipt io n s t o apit l st o ck c a .
C H AP T E R XV
PRE M I U M S A N D D I S C OU N T S ;
T REA S URY A N D O T HE R S T O C K
1 . Dis co u n t and Pr e m iu m on St o c k
Thelaw of the State of N ew Y ork does not permit
the sale of corporate stock at a di scoun t though there ,
is no legal inhibition of its sale at a premium Where .
capital stock is sold at a premium the proceeds in excess ,
of the par value represent profits due not to operation
but to the earning power and stability of the concern .
For this reason although actual cash has been received
, ,
conservative practice does not commend the d istr ibu
tion O f stock premiums as a dividend T hey are usually .
held in a premium account or trans ferred to a special
surplus account or to a permanent reserve account until
such time as they can be used to extinguish an asset of
doubtful or wasting value .
T h e entries recording the sale o f stock at a premium
S u b s c r ipti o n s
C a pit a l Stoc k
P r e m ium o n St oc k
Su b s c r iptio ns
T he Pre mium on S tock account may be looked upon as
representing an account s imilar to capital surplus and
not as an increase of ca p ital due to o p eration .
199
2 00 BO N DS ,
C A P I TAL ST OC K , D E P RE C IA T ION
I n the maj ority of states as in N ew Y ork stock , ,
cannot legally be issued below par but when SO issued ,
in those states where it is permitted the entry recording ,
the discount should be to the expense a ccount D iscount
on Stock I f the premium is carried permanently on
.
the credit side of the balance sheet consistency would ,
demand that any discounts on stock be carried on the
asset side until extinguished by premi um s r e alized by ,
assessments levied on shareholders or b y appropriations ,
of income or surplus for the purpose .
T h e stock of a manufacturing or trading organiza
tion is rarely sold above p ar when the corporation is first
organized but the stock of a bank or tru st company is
,
frequently sold in this way for the purpose of creating
a surplus which appears on the balance sheet under the
”
head of C ontributed Surplus
“
.
O ne requirement in the case o f national banks is the
creation of a permanent surplus equal to 2 0 % of the
capital and for this reason the stock of such banks is
usually issued at a premium of thus providing the
legal surplus re quired .
2 . St o c k W it h o u t P a r V a lu e
I n certain states the law permits the issue of capital
stock without par value I f a corporation is organized
.
with shares the value of each share represents
,
one thousandth part of the concern s net asset value and
-
’
such value will of course fluctuate with the changing for
tun e o f the enterprise .
Stock without par value should be recorded on the
books at its sales price C apital Stock a ccount being
,
credited with the realized value and C ash or other assets
T REA SU RY A ND O TH ER ST OC K 2 01
received charged therewith An acco u nt with such stock .
would appear on the ledger as below :
C A P TAI L ST O C K W IT HU
O T VALU E
P AR
N umb r of h r r t ir d u ing
e s a es e e , s N um b r of h r i u d
e s a es ss e at l
sa e s
pri t whi h th y w r r dit d
ce a c e e e c e e pri D b it C h or S
ce . e as u b scr ip
t thi
o ount wh n old
s acc e s . t ionsor y oth r ount an e acc as c as e
m y r q ui r
a e e .
T he
corpora te balance sheet should contain a nota
tion in the form of either a footnote or a note in the body
,
of the statement of the number of such shares outstand
,
in g and the amount p aid in on each I n this way the .
amount of each unit of interest may be readil y deter
mined O ther classes o f stock and s u rplus are stated
.
, ,
in the regul ar mann er .
3. Tr e a s u r y St o c k
T reasury
stock consists of shares regularly issued for
legal consideration but later reacquir ed by the corpora
tion which issued them A s explained in V olume 1 .
,
C hapter XXX I I I treasury stock may come back into ,
the possession of the issuin g company by donation or by
purchase below above or at par , , .
I n some enterprises and part i c ularly in cases where
it is di fficult to place a correct value upon the property
to be acquired and exploited the financing of the under ,
taking is e ffected by means o f the sale of treasury stock .
A m ine or other specul ative enterprise for example usu , ,
ally issues at the outset its entire au thorized capital stock
in payment for the property acquired I ts assets then .
consist wholly of property procured by the issue of fully
paid shares the owners o f which are liable to no further
,
contribution T o provi de workin g funds some of the
.
,
2 02 BON DS, C A P I T AL S T O C K, D E P R E C IA T I ON
shareholders usually don ate a portion O f their hol dings
to the company for resale T h e obj ect of this proceed
.
ing is to enable a portion of the stock of the corporation
to be sold at its market price in those states where the
original stock issue cannot be o ffered for sale at less ,
than par T reasu r y stock can be resold like any other
.
,
propert y at the price it will bring on the open market
, .
4 . A c co u n t in g fo r Tr e a s u r y St o c k
While the term treasury stock is usually used to sig
n ify dona t ed stock it should be remembered that treas
,
ury stock may be acquir ed by purchase as well as by
donation I n either c ase it is treated like an asset on the
.
’
corporation s books Whether purchased or donated
. ,
it should be debited to T reasur y Stock account at par
“
T h e o ff setting credit for purchased stock is of course , ,
wholly or partly to C ash ; the o ffsetting credit to donated
stock may be set up in either of two ways .
F irs t M e th od S ince donated treasur y stock is ac
.
quired without the exchange of any other asset or the
creation o f any liability the capital surplus of the busi
,
ness is thereby nominally increased and credit for the
donated treasury stock should be made to a special sur
plus ac count I t is not sound practice to credit the par
.
value of this treasury stock to general Surplus account
for two reasons :First it might be taken to represent
,
profits earned by the company which of course i s not, , ,
true T h e increase in surplus brought about by the
.
acquisition of donated stock is not due to the operation
of the business and consequently the amount should not
,
be included in the general surplus I n the second place .
,
the par value is no criterion by which to gauge the value
T R EA SU RY A ND O T H ER STO C K 2 0 3
of the treasur y stock T h e fact o f its donation I S ev1 .
dence rather that it is not worth its par value Gonse
, , .
quently the credit should be made to a special surplus
,
ac count a convenient title for which is Surplus from
,
“
D onated S tock T he value at which it should be car
”
.
ried requires further consideration .
When treasury stock is received by donation the e h
tr y is :
,
T r e a ur y St o k ( t p )
s c a ar
S ur p lu f ro m Do n
s a te d St o c k
I f the stock is later sold for cash the bookkeeping ,
required is a debit to C ash and a credit to T reasury
Stock fo r the amount r e ceived I f it is sold at par .
.
then Surplus fro m Donated Stock represents a real sur
plus because the net result o f the transaction is an in
,
crease in cash equal to the p ar value of the stock do
n ate d I t is unusual however for treasury stock to
.
, ,
realize its par value I f it is sold below par the entr y
.
,
given above will leave a debit bala nce in T reasury S tock
account T h e balance should be transferred to Surplus
.
from Donated Stock by the following entry °
S ur pl us f rom D o na t ed St o c k
T r e as ur y Stoc k
leaving in Surplus from D onated Stock a balance
equivalent to the actual cash received from the sale of
such stock which is the real value of the stock donated
T he account m
.
,
a y then be closed into Surplus .
I f the treasury stock i s sold above par C ash should ,
be debited and T reasury Stock credited with the actual
amou n t received T here will then b e a credit balance
.
2 04 B ON D S , C A P I T AL ST OCK , D E P R E C IA T ION
in the T reasury Stock account T his balance r epre .
sents a profit and as such may be closed into Surplus
from D onated Stock I n this case as in the preceding .
one Surplus from Donated St o ck represents a real sur
,
plus be cause it is o fl se t by an asset cash T h e surplus , .
derived from the sale of donated s tock is not usual l y
considered as available for di vidends because it does
not represent ordinary business profits T h e better .
practice is to hold the donated surplus in a special sur
plus O r reserve account .
S e cond M e th o d U nder this method the donated
.
stock is assumed to be a reduction or concession on the
price of the property for which capital stock is issued ,
and therefore the value of the stock reacquired is cred
ite d to the property account involved T h e e ffect of .
this is to red u ce the book value of the propert y and
not to Show a nominal profit as under the first method .
T his method is conservative and i s favored by many ao
c o u n t an t s on the ground that an y reduction in the book
,
valu e of property acquired by a corporation is to be
recommended because of the natural tendency in such
cases to overestim ate the value of property acquired for
capital st o ck .
T o illustrate the a ccounting involved when donated
‘
stock is handl e d in this way assume that the entire cap i ,
tal stock issue is given in p ayment for certain property
rights and p art of the issue is returned to the corpora
,
tion T h e entries are as f o llows
.
P ro p r ty R igh t
e s
C pit l St o k
a a c
T r ord giv in g f n t ir i u e f
o ec o e
pi e ss o ca
t l s t o k fo pro pe rt y r igh ts s e c ur e d
a c r .
T RE S URY A ND
A O T H ER ST O C"
T r e s ur y
a St oc k
To r or d
ec par v lu e a o f S h a re s o f s t c o k
do n te d
a to t re u ry
as .
When the treasury stoc k is sold the nature of the ,
entry depends upon whether the price se cured is the
same or is abo ve or below the fi gu re at whi ch the treas
ury stock is carried I f the same the en try is : .
,
C as h
T r e ur y
as St o k c
I f so ld above this figure the entry is ,
Ca s h
Tr ea ur y St k
s oc
C pit l S u p lu ( f
a a r s or e x ces s
)
I f sold be low this figu re the entry may be ,
C ash
C apita l S u p lur s
( fo r de fi c it
)
Tr ury
ea s S t oc k
5T
. r e a s ury St o c k Pu r c h a se s
N otinfrequently a corporation purchases its own ,
st ock on the open market or in some othe r way S uch .
purchases are covered by principles and rules of law .
T h e entries required to record the transaction when
made at par consist of a debit to T reasury Stock and
,
a credi t to C ash T h e stock is usually held in the treas
.
ury unt il sold when the entries are reversed I f a bal
, .
ance is left by the sale of the s t ock below or above par ,
the amount of it sho u ld be transferred to S u rplus from
T reasury S tock because it is an increase or decrease in
surplus although not due to the operation of the busi
ness .
2 06 B ON D S , C A P I T AL ST OCK , D E P RE C IA T ION
When treasury stock is acquired by p urchase below
p ar the excess O f the p ar value over the price paid
,
represents a temporary increase in surplus T h e ent ry .
for such ac quisition of stock would be
T r e s ur y
a St o ck
C a sh
Sur p lus f ro m T r e a s u ry St o ck
I f the treasury stock is sold at its purchase price ,
the entry made at the time of the purchase is merely
reversed T h e entries necessary if the stock is sold
.
above or below its purchase price need brief discussion .
6 . Tr e a s u r y Sto c k Pu r c h a s e Be lo w Pa r
A ssuming that stock o f the par value of $ 1 0 0 is pur
chased for $ 80 and sold for $9 0 the original entr y
, ,
would be :
T r e ury
as St o ck
C ash
S ur plu s f rom T r e as ur y St o k
c I.
e ffect of the sale at $ 9 0 is to leave a debit bal
The
ance of $ 1 0 in the T reasury Stock a ccount a n increase ,
in cash of $ 1 0 and a credit balance in the special surplus
,
ac count of $ 2 0 By making the following entry
.
S ur plu s rom T r e ur y
f as St o k
c
T r e ur y S t k
as oc
the surplus account will contain a credit balance of $ 1 0
which represents a real surplus because it is o ff set by
an incre a se in cash of that amount .
A ssuming that the st o ck is sold at $ 70 a debit bal
3
,
ance O f $ 0 wo uld be left in the T reasur y Stock a ccount ,
TR EA SU RY AND O T H E R ST O C K 2 07
o ffset by a decrease in cash of $ 1 0 and a balance of $2 0
in the special surplus account By making an entry
3
.
transferring the debit balance of $ 0 to Surplus from
T r e asur y Stoc k a debit balance of $ 1 0 is left in the
i
,
latter account which represents the loss on th e t ran sa c
tion When the actual profit or loss has been a scer
.
t ain e d the special surplus account which represents it
,
should be closed into general Surplus .
7 . T r e a s u r y St o c k Pu r c h a s e A b o v e Pa r
When treasury stock is acquired by purchase above
par it is debited at par and C ash is credited for more
‘
than par ; the excess must be debited to some account .
I f the stock is purchased above par there is good reason ,
to beli e ve it m ay later be sold at a profit T herefore it .
,
is better not to charge the premium against ge neral Sur
plus but to hold it in a suitable suspense account such
,
as T reasury Stock A dj ustment A ssuming that stock .
of the par value of $ 1 0 0 is purchased for $ 1 1 0 the orig ,
inal entry would be
Tr eas ur y St o c k 1
Tr eas ury St o k Adj u tm
c s en t
C ash
I f sold at cost the above entries are reversed ; if sold
5
,
at less than cost say at $ 1 0 the following entry would
, ,
be required
C a sh
T r e as ur y St o k c
T his leaves a credit balance of $ in T reasury Stock 5 ,
w hich shoul d be closed into T reasu ry Stoc k A dj ust :
2 08 BON DS, C A P I T AL ST O C K , D E P R E C IA T ION
ment leaving a debit balance of $ in the latter account
,
5 .
T his d e bit balance represents the loss on the t ran sac
tion and should be closed into general Surplus .
I f the stock purchased at 1 1 0 is sold above its cost
5
,
e
g at 1 1 the first entry would be a debit to C ash
5
. .
, ,
O f $1 1 and a credit of the same amount to T reasur y
5
,
Stock leaving in the latter a credit balance of $ 1 T he
5
.
,
transaction has resulted in a realized profit of $ which
is properly transferable to Surplus after the A dj ust ,
ment A ccount of $ 1 0 has been closed out against the
5
credit balance of $ 1 shown in the T reasury S to ck ao
count .
8 . T r e a s u r y St o c k on Ba la n c e Sh e e t
T he
meth o d of showing treasury stock on the bal
ance sheet is subj ect to some difference of opinion .
Such stock is carried on the books as an asset but as , ,
it may or may not have any real asset value its real ,
nature must be ascertained when a balance Sheet is to
be prepared .
T h e purpose of the C apital Stock account is to show
the stockholders proprietary interest in the business
’
.
When a st o ckholder surrenders his capital stock either ,
by donation or sale for cash or some other asset he ,
ceases to have a proprietary I nterest I t is equally evi .
dent that the corporation c an have no proprietary in
t er e s t in itself C onsequently the proprietary interest
.
,
shown by the capital stock holdings amounts to the bal
ance of the C apital Stock account minus the balance of
the T reasury S tock account the excess representing the ,
present outstanding par value of capital st oc k I t .
s eems clear therefore that T reasury Stock account rep
, ,
T R EAS URY A ND OTHER ST O C K 2 09
res ents an adj ustment o f the capital stock originally
issued and that this adj ustment should be shown on the
balance sheet T his is done by deducting from the
.
amount of capital stock issued the par value of stock
held in the treasury extending the net amo u nt as the
,
present outstanding capital stock .
9 . Bo n u s St o c k
O n the orga nization of a corporation or when a new
issue of preferred stock or bonds is o fl e r e d to the public
’
,
common stock is sometimes given as a bonus to every
inves tor w ho buys a bond or Share of preferred stock
‘
T h e common stock is thus o ffered as an in centive to
purchase the securities which it accompanies I f such .
co m mon stock is not full paid and non assessable it is - -
clear that the bonus will not be an inducement ; therefore
bonus stoc k is usually treasury stock which has been ,
donated to the company .
I n acco u ntin g for bonus stock it should be borne in
mind that as the stock is o ffered as a gift it constitutes ,
an expense which is generally carried on the books uh
”
der the head of Bonus and treated as an organization
“
expense A ssu m ing for example that a share o f treas
.
, ,
ur y stock is o ffered as a bonus on the purchase of a
bond the j ournal ent r y to record such a sale
,
would be :
B on u s
B on d P s ay a b l e
T r s ur y
ea St okc
Another method of handl ing the bonus less fr e ,
quently met with is to co n sider it as in part a discount
,
2 10 B ON DS , C A P I T AL S T O C K, D E P RE C IA T ION
on the bond P resumably the obj ect of o ffering a share
.
o f common stock to the p urchaser of a bond is to enable
the bond issue to be sold at p ar T herefore it is obvious
.
that the bond is being O ffered at a discount I f one .
share of treasury stoc k is o ffered as an inducement for
the p urch ase O f the bond at p ar the correct entr y wo uld
,
be :
C a sh
B ond Dis co u n t
B o n ds P aya bl e
T r e s ury
a St o c k
T houghthis method is more correct in principle
than that first described it is rarely adopted T h e ar
, .
g u m e n t for handling the problem in this way is that a
stock b onus which is O ff ered as a discount on a bond
issue should be shown as such on the books and treated
accordingly .
10 . Fo r fe it e d Sto c k
W hen a subscriber to capital stock fails to make the
agreed instalment payments on the purchase of the stock
for which he has subscribed he forfeits his right to the
,
shares and in some states the amount paid in I n .
the State of N ew Y ork forfeited stock may be reissued
or subscriptions may be received therefor as in the case
of unissued stock Payments made on stock which i s
.
declared forfeited constitute a profit and as such may , ,
be transferred to a special surplus account When the .
shares are finally sold any discount on the sale is prop
,
erly an o ff set to the profit realized on the forfeiture .
T h e method of handling forfeited stock is first to
reverse the original subscription entry and credit Sur
T R EAS U RY A ND O T HE R S T OC K 2 11
plus from Forfeited S tock with the amoun t of the for
fe it e d cash payment As an example ass ume that .
,
worth of s t ock has been subscribed for and an
initial payment of $ 0 0 ha s been forfeited 5
T h e entries .
C a pi ta l St oc k S u b sc ripti o ns
Su b sc r ibe r s
To r v r
e e se th e amoun t u bs ri be d
s c fo r,
w hi ch h a s be en f or fe ite d .
A s cash was credited to S ubscribers when received the ,
next entr y would be :
C a pital S t o k Su bs r ipti o n
c c s
S ur p lu from F or fe it d
s e St ok
c
A s sume now that the block of stock is O ff ered for
subscription and is s old for in cash T h e fol .
S u bs cr ibe r s
C a pita l S toc k S u b ripti on s
sc
To r ord ub s
ec s c r ipti o n t f or f ite d
o e s toc k .
C a sh
S ur pl us f rom F or fe ite d St oc k
S ub r ibe r s
sc
T r ord p y m n t
o ec a e of s ub r ipti o n
sc s .
C apita l o k Subs r ipti o ns
St c c
C pit l S toc k
a a
To r ord i u e f s h r
ec ss o a es .
S urplus from Forfeited Stock now contain s a credit
balance of $ 2 50 which may be applied against a nv other
sales of stoc k at a di scoun t or closed into general Su r
plus .
2 12 BON DS, C A P I T AL ST O C K , D E P R E C IA T ION
REVI E W QUE ST ION S
W h at is t h e l aw in mo st s tat e s w ith r e g r d a to th e o r igina l is s ue
o f c a pit a l st o k t d is ou n t ?
c a a c
E x pl in pit l s t o k w ith ou t p v lu e
a ca a c ar a .
G iv e th e j our n l e n t r y n ce ss r y t r ec or d th e r epur ch s e nd
a e a o a a
n ce l l tio n o f
ca a
pit l st o ck
ca a .
Wh t n t r y i r e qu ir e d t o r ec or d t h e s l e o f t r e s ur y s to ck fo
a e s a a r
l e s s th n b ook v lu e ?
a a
G iv e t h e b e s t m e th od in y our o pin io n o f c ou nting f d o n te d
, ,
a c or a
s to ck p r e v iou s l y iss u e d fo ood w i l l r
g
-
.
D is tin gu ish b e twe n t r e ur y s t o ck n d u n iss u e d st o ck n d Sh ow
e as a a
h w e h l s s h oul d ppe r n
o ac c as b l n ce s h et
a a o a a a e .
Sh oul d s ur plu s r e s ul ting f rom th e s l e f a c or p or tio n s o wn
’
a o a
capit l s t o ck b e p id o u t in d ivi d en ds ?
a a
Par t III
Of As se ts Li ab ili ti e s
C HAP T ER XV I
C URRE NT AS SET S
1 . Na tu r e of C u r r e n t A ss e ts
C urrent
assets consist of cash or any other asset
whi ch in the or di nary course of business will be con
verted into cash ( see V olume I C hapter I I ) T he , .
usual current assets listed in the order of their real
iz
,
ability are : ,
1 . C ash
N ot es receivable
E A ccounts rece ivable
P
E Merchandise stock in trade - -
P Manufactur ing inventory
T he
term merchandise stock in trade usually sig
“
- -
nifie s the goods bought for sale by a mercantile house
and is so used in this book T h e term manufacturing.
“
”
inventory applies to the three classifications of raw ma
t e r ial work in process and finished g o ods
, ,
T he ac .
count ing in connection with the handling of a manu
fa ctu r ing inventory forms part of the subj ect of cost
accounting A s such it is discussed in V ol u me I I I of
.
this series and requires no further consideration here .
T h e method of ac counting for the other items listed
above has bee n covered in detail in the first two vol u mes
of this series T here remain for consideration in this
.
chapter the problems which arise in th e creation of a
2 1 5
2 16 VALUA T I ON OF A SSE T S—LIA BILI T I E S
reserve for bad debts in the assignment of accounts
, re
c e iv ab le and in the valuation of the merchandise
, in
v e n t o ry .
2 . Re s e rv e fo r Ba d De b t s
main problem in connection with accounting for
T he
—
the receivable items both open accounts and notes is —
that of estimating and recording the probable loss from
bad debts I n determining the amount to set aside as
.
a reserve against this contingency past experience is ,
the safest guide although the class of trade catered to
,
and the credit policy of the business are also d e te rmin
ing considerations While the average loss is much
. .
greater in some trades than in others the loss varies ,
greatly among concerns in the same line of business ,
much depending upon the thoroughness of the in fo r
mation and investigation made by the cre d it department
as to the risk involved in each case When accounts .
are accepted without close investigation or salesmen are
permitted to grant credit a much larger provision will
,
be required to cover the possible loss than would be
necessary when a cautious and consistent credit policy is
followed .
I t will generally be found that there is a fairly con
stant ratio between the loss from bad debts and the
—
amount of sales over a given period unless a general
panic or other disturbance throws the delicate machinery
of business credit out of gear H owever the amount .
,
of the estimated loss is a matter of individual decision
and experience as is also the basis on which it is deter
,
'
mined T h e latter may be either ( 1 ) open accoun ts at
.
close of period or total sales on credit
, .
C U RREN T A SS E T S 2 17
To base a percentage on the open accounts while ,
the most obvious method is correct in principle onl y
,
u nder certain conditions When financial statements
.
are made up only at the end of fiscal years and the
amounts outstanding at those times are fairly constant ,
the loss from failure to coll ect should prove equally con
stant B ut when the books are closed half yearly or
.
-
quarterly and the sales are seasonal—varying greatly
in volume as between one half year or quarter and an
-
—
other there may be no logical relation between the
amounts outstanding and the probable loss .
For example in th e garment m illinery sporting
, , ,
goods and other seasonal trades the greater part of the
, ,
wholesale sales takes place during a few weeks I f the .
closing o f the books coincided with the end of the half
yearly or quarterly sales campaign the ratio of loss to ,
the amount of the op en accounts would then be much
less than i f the books were closed at the opening of a
selling campaign I n the last case all prompt payers
.
would have remitted the amounts owing on the sales of
the preceding period and the accounts still open on the
books would contain more than the average number of
doubtful and bad accounts A ccor di ngly under these
.
,
circumstances the other basis would prove more reliable
,
for computing the probable loss .
T h e most general method is to figure the estimated
loss on the total sales I n all excepting retail busi
.
nesses or those selling directly to the consumer cash ,
sales are usually a negligible factor as compared with
the volume of credit sales I n the retail field however
.
, ,
especially in a case where the ratio of cash to credit sales
fluctuates from one fixed period to another the more ,
2 18 VALUA T I ON OF A SS E TS—LIA BILI T I E S
accurate base would be the total credit sales and on this
the estimated loss on the accounts of a retailer is usua ll y
computed .
3. Va l u a t io n of A c c o u n t s Re c e iv a b le
I n the case of a new concern with no past experi ence
on which to base the probable loss from bad debts a ,
fairly accurate estimate may be arrived at by making a
careful classification of the ac counts into good doubtful , ,
—
and bad basing the classification upon any available
information as to rating and standing .
I n making this classification the length of time an
account is overdue is only one criterion by which its real
izability may be j udged T h e collection methods of the
.
creditor may be at fault the debtor may for a time ,
be financially embarrassed collateral may have been de ,
posited with the creditor as a protection against loss ,
the general financial condition of a community in which
the debtor lives may be temporarily under a physical
handi cap—as after a disastrous fire earthquake bad , ,
harvest or the bankruptcy of an important local enter
,
prise .
A ll the foregoing facts need consideration before
classifying a particular account An account r e ce iv .
able which seems to be bad may ultimately be collected
and therefore no account should be ruled off the ledger
unless its status as non collectible is established beyond
-
all reasonable doubt ; e g if an execution has been r e
. .
,
turned unsatisfied o r the debtor has received a d ischarge
in bankruptcy W hen accounts are ruled o ff u su allv
.
,
no further e ff orts are made to collect them ; also em
bez z
,
le m e n t of cash received on a closed account is easier
C U R REN T A SSET S 2 19
than it would be if the acco u nt were open and thus in
v ite d attention .
4 . A c c o u n t in g fo r Ba d De b t s
As explained in V ol u me I C hapter XX I X the , ,
method of accounting for bad debts is to credit a r e
serve accoun t entitled R eserve for B ad Debts at the end
of each period with the estimated loss for that period .
T h e o ffsetting debit is made to the expense account of
Bad Debts When a customer s account proves n u
.
’
collectible it is written o ff by charging it to the reserve
,
acco u nt .
I nasmuch as the reserve is an estimate of probable
loss the acc u racy of which is subj ect to test in later pe
‘
r io d s the probability exists of the loss being under
, or
over estim ated I f u nderestimated it is apparent that
-
.
,
the asset value of the accounts receivable is inflated to
the extent of the deficiency in the estimate ; if o v e r e sti
mated profits are understated and instead of the amount
,
in the reserve account being solely a suspended credit
to an asset it includes also a true reserve of profits I f
, .
fin ancial condition is to be truly stated an under or ,
over estimate of the loss in the past must be adj usted
-
to accord with the newly determined facts of experience .
T his is e ffected if the reserv e has been underestimated
, ,
by the entry
S ur plu s
R ese rv e for Ba d D eb t s
To ch a rg e an un d r e s tim
e a te d e x pe nse of p re
v iou s pe i d s ro .
If the reserve h as been overestim ated
2 2 0 VA L UA T ION OF A SSE T S—L IA B ILI T I ES
Re se rv e fo r B a d D e b ts
S ur plu s
To c r d it n ov e r e s tim at e d e xp en s e
e a of p r vi
e
ou s p e r i od s .
A n immediate adj ustment of the full amount is bet
ter accounting practice than a gradual one e ffe cted by
a slight increase or decrease in the allowance carried to
reserve .
5I
. n com e T a x Re q u ir e m e n t s
Thesound accounting practice of providing a r e
serve for bad debts as described in the preceding para
graphs should always be followed notwithstanding the ,
fact that in certain cases t h e law may require other facts
to be brought out For example the Federal I ncome
.
,
T a x L aw as applied to the year 1 9 1 8 provides that the
, ,
amount charged as expenses and credited to the R eserve
for Bad Debts has no significance in determining the
amount of expenses deductible for income tax purposes .
T h e only deduction allowed is the amount of bad debts
actually written o ff as uncollectible .
A s an illustration assume that the charge for bad
,
debts with a corresponding credit to the reserve account
5
for 1 9 1 8 was $ 0 0 but that the amount of accounts
,
actually charged o ff was $ 40 0 I n this case the amount .
,
of the expenses of the business would be reduced from
5
$ 0 0 to $ 40 0 in the preparation of the income tax r e
turn T h e unused portion o f the R eserve for Bad
.
Debts namely $ 1 0 0 would of course be considered
, , , ,
part o f the invested capital I f the R eserve for B ad .
Debts as set up on the books is to be ignored it r e pr e ,
sents a portion of the capital of the business to the ex
C U R REN T A S SET S 2 2 1
tent that it exceeds the amo u nt of the loss as actuall y
reported to the gover nment T herefore i f the reserve
of $ 5
.
,
0 0 as set up on the books is reduced to $ 40 0 to
correspond with the accounts actually written o ff the ,
$ 1 0 0 excess is considered part of the invested capital in
calculatin g that figure for income tax p u rposes .
6 . A ss ig n m e n t of A c c o u n t s Re c e iv a b le
A growing business frequently finds itself with a
limited amount of cash and a large num ber of customers ’
accoun ts on its boo ks I n such a situation the practice
.
is sometimes adopted of assign ing the collection of t he
open accounts to a bank or other concern which a d
van ces immediately from 70 % to 8 0 7 0 of their face
value and pays the balance less comm issions and ex ,
penses when the collections are compl e ted IV h e n a
,
.
balance sheet is draw n up the amoun t of the un as
,
signed accounts receivable should appear first followed ,
by the total face value of accounts assign ed under the ,
”
caption o f A ccounts R eceivable A ssigned
“
O ffset .
ting this hypothecated asset the amount advanced b v ,
the assignee should appear on the liabilit y side under
some appropriate caption such as L oan on A ssigned
,
“
”
A ccounts .
T h e appearance of these two accounts on the bal
ance sheet makes clear the bookkeeping procedure A c .
counts R eceivable A ssigned account is charged with the
face amount o f the assigned accounts L oan on A s .
signed A ccounts acco u nt i s credited with the advance
( the o ff settin g debit being to C ash ) and debited with the
sums collected by the assignee ( offsett ing credits being
made to the customers accoun ts a ff ected )
’
.
2 2 2 VA L UA T ION OF A SSET S—LIA B I L I T I E S
I t is seen therefore that the accounting procedure
, ,
in connection with the assignment of accounts receivable
is similar to that involved in handling discounted notes
receivable Since the accounts are not sold the mer
.
,
chant must make good any loss to the assignee in the ,
same manner as he would have to make good a dis
honored note receivable discounted at a bank .
E ach account receivable assigned should be recorded
in a special register When an account is collected an
.
,
entry to that e ffect is made in the register U pon final .
settlement with the assignee all accounts in the register ,
not marked as collected must be accounted for by the
assignee either in cash or by a return of the claim
,
against the debtor .
7. M e r c h a n d is e In v e n t o r y
T hemerchandise inventory consists of the items of
stock in trade manufactured or purchased by a business
- -
for the purposes of sale I n accounting for the mer
.
ch a n dis e inventory many perplexing points arise which
,
can be satisfac torily solved only by adherence to a fixed
policy based on sound and conservative principles .
T hese points include the treatment of goods out on con
sign m e n t or the goods of others held on consignment ,
the problems of inventory pricing and depreciation and ,
the distribution of overhead and carry ing charges over
the items of the inventory .
I n taking the inventory any merchandise held for ,
sale on consignment or in trust for any purpose and
therefore not the absolute property of the business ,
should not be included in the count C onversely goods .
,
whic h are out on consignment and w h ich in conse q u ence
C U R R E N T AS SE T S 2 2 3
are held in trust for the busin ess by others form part
of the cur rent invento ry .
M e rchan dise j ust received for which no invoice has
i
come to hand and for w h ich no liability has been entered
on the boo ks obvious ly form s no part of the current
,
in ventory S imilarly sales may be recorded for goods
.
,
which have not yet be en shipped and ret u rn s may have ,
b een received for whi ch no credit has yet been given .
Unl ess ca re is taken to separate such items from the
rest of the stock in trade they are likely to be included
- -
in the in v e n t or v cou n t C are should al so be taken to
.
include therein a n y g o od s for which credit has been
given but whi ch have not yet been de livere d by vendors
or returned by cust omers .
8 . De p r e c ia tio n on Sto c k in T r a d e - -
Part of the s tock in tr ade of every mercan tile busi
- -
ness depreciates throu gh various causes even though
merchandise cann ot be considered either as a fixed or a
wast ing asset G oods may be inj udiciously bought in
.
excess of the demand and deteriora te while kept in stor
age Wares used for win dow and counter display pur
.
poses depreciate rapidly A radical change in s tyle or .
fashion or the progress of in vention m ay reduce the se ll
ing value of a particular li ne to less than cost And
in e v e r v business articles accumula te in odd siz
.
e s broken ,
nu mbers and remn ants whi ch const itute the scrap ma
,
t e r ia l of the sales department .
T he common method of d is pos ing of such depre
c iat e d stock is to o ffer it to the customer at cost or ,
less than cost as a bargain and a loss inc u rred in thi s
, ,
way is reflected in the gross profit Af ter every e ffort .
2 2 k 4 VALUA T ION OF A SSE T S—LIA BILI T I E S
has been made to dispose of the depreci ated stock b y
means of its forced sale a certain quantity will always,
remain on hand at inventory time T o carry such stock .
on the books at its cost price would be an obvious in
fl at io n of asset values T h e books should show the e f
.
fe e t of the depreciation on the marketability of the
goods T h e proper valuation basis is the market price
.
—th e current price at which goods o f similar kinds and
q ualities can be purchased T h e di ff erence between the
.
depreciated value of the goods and their original pur
chase price should be set u p in a S tock Depreciation
R eserve account and the resulting loss closed out to
Profit and L oss .
A n y deterioration the e ffect of which is to make the
stock less salable is an expense chargeable against the
present period and not chargeable against the period in
,
which the sale is made T herefore when the reserve is
.
,
set up the entry would be :
,
P rofi t and Los s
St o k D p r
c e e c ia t i n o R ese rv e
and when sales at the reduced prices have taken place ,
periodical entries should be made for the amount of the
reduction
St o c k D e p r e c ia ti on R e e rv
s e
M e r c h a n d is e
9 . Pr ic in g of M e r c h a n d is e In v e n t o r y
When considering how merchandise should be car
ried on the books two theories are advanced :( 1 ) the
,
showin g should be based on cost or current market
price—whichever is the lower figure ; ( 2 ) the showing
C U R REN T A SSE T S 2 2 5
should always be at cost regardless of fluctuations in
market value .
T h e most general practice supported by world wide
,
-
business usage is to carry the stock in trade at the low
,
- -
est figure consi stent with truth From the point of view .
-
of conservatism the goods are worth to the business ex
a c t ly what they would cost were they to be replaced
and no more Should the merchandise be destroyed by
.
fire or the business be sold as a going concern no higher ,
value could be placed upon the inventory than the cost
of its replacement i e its current market price T here
, . .
, .
fore to carry the item on the books at its cost price
,
when the current market price is lower is to inflate the ,
value of the assets to the extent of the difference b e
tween cost and market .
I n the case of a business dealing in varied articles
the purchase price of which fluctuates little if at all it ,
would seem unnecessary to pay attention to slight
changes in stock values S uch a business usually oper
.
ates o u a fixed percentage of profit and buys only for ,
current needs A n y considerable fall in the value of
.
the stock on hand would be more likely to be due to
depreciation or obsolesc ence than to market values .
I n the case of a business dea l ing in a staple com
m o d ity such as cotton copper or any product the price
, ,
of which fluctuates because of changing market condi
tions th e situation is altogether di ff erent U nder these
, .
circumstances to carry the stock on the books at cost
,
when the market price is lower might greatly exaggerate
the net worth of the concern T h e transactions of such
.
a business are to a large extent speculative in character ,
and to conceal a serious loss by failing to state inventory
2 2 6 VALUA T ION OF A SSE T S—LIA BI LI T I E S
values at their proper figure is obviously m isleading and
in some cases may be done with fraudulent intent .
T h e contention raised against valuing stock in trade - -
at a figure lower than cost is that a loss is thereby taken
up on the books which may never be realized T o an .
t icipate a profit by valuing the merchandise at a price
higher than cost when the market price rises is con ,
tr ar y to the principles of sound and conservative ac
counting T herefore it is contended tha t no loss should
be anticipated until reali z
.
,
ed when the goods are sold ,
and hence the merchandise should be carried at cost .
T h e arguments for and against the di ff erent meth
ods of carrying the inventory may be settled by a com
promise When the market value is much less than
.
cost the depreciated value can be shown on the books
,
and financial statements by setting up a reserve under
a suitable title such as R eserve for Stock D eprecia
“
”
tion . T h e reserve is accumulated out of profits by
crediting this account and charging Profit and L oss ac
count at the end of the period with the di fference b e
tween the market and cost prices of th e inventory T he .
advantage of this method is that while the inventory,
is retained on the books at its original figure a portion ,
of the profits are earmarked as a reserve and held to
cover any possible capital loss through a permanent de
crease in the value of the inventor y A permanent .
decrease is noted as follows
St o ck D e pr e c ia tio n Re s e rv e
M e r ch a n d is e
T hisreserve is handled in the same way as that for de
preciation on stock in trade already discussed
- -
.
C U R R E N T A S SE T S 2 2 7
10 . O v e r h e a d A p p lic a b le t o Sto c k in T r a d e
- -
S o far the consideration of the merchandise inv e n
,
tory has covered only one phase of the problem of its
correct pr icin g T h e matters of overhead and depre
.
cia t io n also a ffect the price at w h ich it is carried on the
books T o the invoice price of the merchandise should
.
be added any additional charges incurred in its delivery
to and its subsequent storage in store or warehouse
, , .
Such costs include freight cartage insurance during
, ,
transit and storage warehouse charges and the like
, ,
.
T h e general practice is to record these items in separate
accounts which are ultimately closed out to Purchases
accoun t .
A t inventory time the problem arises of apportion
ing these costs over the units of stock remaining u nsold .
I n the maj ority of cases the cost of freight and cartage
can be loaded on th e original invoice price and the unit ,
price of the goods covered by the invoice is thereby in
creased C harges for warehousing insurance and the
.
, ,
like being applicable to all go o ds must be charged on ,
some equitable basis to each unit sold A percentage .
rate on value will usually be sufficiently accurate and will
at th e same time simplify the problem of distribution .
T h e precise method however is unimportant
, , T he es .
s e n t ia l thing is a consistent policy whereby the fu ll costs
of the merchandise inventory are taken up on the books .
11 . In s u r a n c e of M e r c h a n d is e In v e n t o r y
A n important matter relating as much to ma nagerial
po licy as to accounting is the carrying of adequate in
surance to cover the full value of the stock in trade - -
.
T h e value of the fixed assets is a definite amount not
2 2 8 VALUAT ION OF A SSE T S—LIA BILI T I E S
subj ect to rapid fluctuations and these assets in c on se
,
u e n c e can be protected to their full value once and for
q
all when acqu ired T h e amount of stock in trade how
.
- -
ever rises and falls in many businesses with the seasons
,
or with market conditions I t is part of an a ccountant s
.
’
duties to safeguard the interests of the business by see
ing that the fire insurance carried on the stock in trade - -
is sufficient to cover the value of the asset while at the ,
same time avoiding the expense of over insurance -
.
T his can be accomplished by comparing the policies
of insurance with the record thereof and examining each
policy to ascertain the following :
1 . T hat
the amount of insurance carried during
each month is su fficient to cover the average
merchandise stock .
2 T hat the stock of merchandise is described in
.
‘
precisely the same words in each policy and ,
that the location of the stock is also prop
erly stated in each policy
3
.
T hat the description of the merchandise covers
.
fairly and adequately the merchandise in the
inventory .
4 T hat the coinsurance clause ( if any ) is ide nt i
.
cal in all policies covering the same property
5
.
T hat special privilege clauses are attached to
. ,
and made part of each policy , .
6 T hat if a chattel mortgage exists against the
.
merchandise each policy has the mortgage
,
clause duly attached .
7 T hat in all other respects the insured is ob
.
serving the terms of the contract of ins a r
ance as stated in the policies .
C U RRE N T A SS E T S 2 2 9
REVI E W QUE ST ION S
G iv x m pl e s f urr e nt
e e a ts o c a s se .
Wh t in y our o pin io n i th c orr e t b s i f fi gu r in g r s e rv e
a s e c a s or a e
f orb d d eb t s ?
a
G iv th e n t r y r q u ir e d w h e n
e e oll tio n i m d n n
e ou nt
a c ec s a e o a a cc
pr v iou l y h r ge d ff t R
e s c rv f B d D b t
a o o e se e or a e s .
N m e e v r l po in ts th t r eq u ir s p i l o n id r t io n in v e ri
a s e a a e ec a c s e a
fy in g t h v lu f n in v e n t ory
e a e o a .
H ow h ould n in v n t ory be pr i d — t o t or m rk et v lu ?
s a e ce a c s a a e
G iv e v n p o in t s w h i h s h oul d b e o n id r d in e x m inin g in
se e c c s e e a
s ur n e pol ici c ov rin g s to ck n h nd
a c es e o a .
C HA P T E R X VI I
F I XE D AND WA S T I N G A S S E T S
F I X ED A SSET S
1 . Na t u r e of Fix e d A s s e t s
T hefixed or capital assets include all property of
a permanent or fixed character used in the conduct of
a business T hey are so termed because they represent
.
the capital investment which is essential to the under
taking and which cannot be disposed of in its entirety
without causing the dissolution of the business T he .
property generally consists of land the buildings ,
thereon and the machinery furniture fixtures and
, , , ,
other equipment A lso to be included among the fixed
.
assets are any permanent investments such as working
ca p ital loaned to an a ffiliated company ; the stocks of
another concern bought for purposes of control ; and
Si nking fund investments which are held for a specific
purpose and can be used only for that purpose .
T h e method of carrying the fixed assets on the books
presents nothing n ew in principle and but brief con
sideration need be given to the application of these prin
c ip le s .T h e chief problems in connection with account
ing for fix e d assets r e late to the manner o f determining
and recording t h e depreciation on items of plant .
T hese matters have already been adequately covered in
C hapters X I I and X I I I T here remain for considera
3
.
2 0
F I X E D AS S ET S 2 3
1
tion here a few points concerning the valuation of the
fixed and wasting assets and the methods of record ing
changes in their valuations on the books where such
changes are brought a bout by causes other than depre
ciat io n .
2 . Fl u c t u a t io n s in La n d V a lu e
L and used for business purposes unlike other fix ed ,
assets is not sub j ect to wear and tear nor does its value
, ,
as a rul e fluctuate rapidly I n the maj ority of cases .
the tendency is for it Slowly to appreciate concurrently
with the development of a city or district and the growth
of a community A n assumed appr e ciation Should
.
,
however not as a rule be taken up on the books for
, ,
the reason that ord inarily no appreciation can be con
s id e r e d as such until rea liz
ed I n the rare cases where .
the appreciation can be definitely considered as a real
iz ab le asset it may with propriety be shown T hi s .
would be permissible where an increase of assessment
value over cost indi cates that the appreciation of land
is a very real asset A s such appreciation is not r e
.
fl e cte d in increased profits but may even result in di m in
ish e d profits due to an i ncrease in taxation and other ex
penses it would seem prop er to increase the net worth
,
of the business by the amount of the appreciation .
T his would be e ff ected by the entry
A pp r o f L nd
e cia t i n o a
L n d A ppr e i t io n Sur plu ( or R
a c a s e
rv e )
se
To t k a
p th e pp r i t d v lu e
u e a f th e ec a e a o
l nd
a pp r i
as d by a a se
P rudent financial cons iderations would requir e that the
2 3 2 VALUA T ION OF A SSE TS—LIA BILI T I ES
estimate of the increased value be made by an ind e pend
ent appraisal company .
L and does not as a rule depreciate in value where
stable business enterprises are carried on I n the rare .
cases where its value decreases it would seem proper to
carry it at its original cost so long as it proved adequate ,
for the purpose for which it was bought I ts account .
represents the cost tied up in it and the amount on
which profits must be earned S o long as the bus iness .
is operated at a profit the land is worth its original pur ,
chase price .
For business reasons land may sometimes be pur
chased at a price higher than the market value of simi
lar surrounding land T h e conservative valuation of .
assets would then indicate that the excess paid might be
charged to operation as follows :
L nda D e p r e c ia t io n
L n d D pr i tio n R rv
a e ec a ese e
To r du th c o s t o f t h e
e ce e a s se t t o i ts
m rk e t v lu e
a a .
Pr ofi t an d Los s
L an d De p r o
e ci a t i n
To ch a rg e to c urr en t o p r e a ti n s o th e di
m in i sh e d v lu e a of th e a ss et .
3 . La n d In v e s t m e n t s
L and may be purchased either for use or as an in
vestment T h e obj ect for which it is bought a ffects to
.
a slight extent the method of its accounting I f bought .
with the obj ect of erecting buildings or using existing
structures for manufacturing purposes expenditures on ,
grading draining leveling and similar improvements
, , ,
F I X E D AS S ET S 3
3
may with propriet y be added to the purchase price and
included in the value of the land I f the land is bought
.
for in vestm ent the carrying charges and the cost of
,
im prov ements may also be capitalized ; but instead of ,
ad ding the se charges to the capital value o f land ( an d
thus to s ur plus ) they should be shown in a separate
,
L and I mprovements or L and Development account .
A t the same time a reserv e shoul d be set up out of profits
equaling the carr ying charges and expenditures on the
land whi ch have been capitaliz ed .
T h e reaso n for thi s di fference in accounting treat
ment is that land in use may genera ll y be assumed to
be worth its purchase price plus the expendi t ures r e
quired to adapt it to a particular purpose ; whereas ,
when land is bought as an invest ment it is problematical
whether the capitaliz ed value of the cost of the improve
ments and other expen ditur es will be realized in its sale
price I f the cap italized charges are not reali zed then
.
,
surplus will have b een fictitiou sly incre as ed to the ex
tent o f the loss su ff ered on th e sale By o ffsetting the
.
development cha rges with a reserve of the same amou nt ,
the risk of di stributing the surplus in dividends is
avoided .
4 . A c c o u n tin g fo r La n d
I f th e p u rchase pri ce of real estate includes any
buildings on the land the cost of the land shoul d be
,
separated from that of the b u il din gs and each item
should be carr ied in its own accoun t T h e term real .
“
”
estate is too in clusive to use as an account hea ding in ,
view of the fac t that the rate at which di fferent assets
dep r e ciate varies in each ca se A s noted above l an d
.
,
2 3 4i VALUA T ION OF A SSE T S—L IA BILI T I E S
seldom de p reciates at least to the extent that the ex
,
pense must be provided for ; but buildings even before ,
they are first occupied begin a very steady process of ,
declining value C onsequently each kind of real estate
.
,
property should be stated separately .
T h e value of land Should be set up on the book s at
its full purchase price T his includes all legal fees and
.
any taxes or assessments for improvements owing at
the date of its purchase A S a rule all land holdings .
,
though purchased at di fferent tim e s are held in one ao
count if the land owned is in one place I f the land
-
.
consists of a number of widely separated lots and the
taxes and other assessments on the di fferent holdings
vary separat e accounts for the various parcels of land
,
are to be preferred .
When land is purchased for resale purposes and is
held as a current asset— as by a real estate company
it constitutes the raw material of the business and Should
be so accounted for A ll development and carr ying
.
costs should be cap italized during the development pe
r io d Wh e n the deve lopment is completed subsequent
.
,
carrying charges may be capitalized in which case a r e ,
serve against possible loss on the selling price Should
be set up When a lot is sold this reserve should be
.
,
adj usted ; if any part of the reserve is recouped in the
sales price of the lot the amount thereof may be trans
,
ferred to Surplus .
5 . Bu ild in g s
Buildings should be recorded at their full cost I n .
the case of an old building this includes purchase price , ,
leg al fe e s and expenditures on renovations rep airs and
, , ,
F I X E D A SS E T S 2 3
5
renewals ; in the case of a new building the full cost of ,
its construction When the construction work is done
.
by an outside concern the price paid to the contractor
,
and the fees of the architect are generally included in
the cost of the work When the construction is car
.
ried out by th e business itself the costs include material
, ,
labor and a proper proportion of overhead to cover the
,
facilities and the supervision a fforded by the factory o r
g an i a t iozn .
A uthorities diff er as to whether or not it is correct
to capitalize the cost of tearing down and removing old
buildings or of indemnifying existing tenants for loss
or inconvenience suffered through their dispossession .
A s such expenses in no way add to the value of the new
building it would seem the better practice to charge
,
them to e xpense unless it can be proved that the expense
of wrecking the old building is more than covered bv the
increased value of the new structure I n a congested
city where the destruction of an out o f—
.
, date though not -
outworn building is more than compensated by the con
v e nie n c e s and greatly increased floor area of the new
premises the cost of removing the old buil d ing is usually
,
added to the capital value of the new c onstruction .
6. Re p a ir s and Im p r o v e m e n t s t o Bu ild in g s
A s a lready stated expenditures for the repairing
,
and renovating of an old building when purchased for ,
use may be properly considered a cap ital charge T h e
, .
necessity of making the repairs may be assumed to have
bee n taken into consideration when the purchase price
was fixed A fter the building is occupi ed the repairs
.
,
and renewals re q uired to maintai n it in ad e quate con
2 3
6 VA L UA T ION OF A SSET S—L IA BILI T I ES
dition for use are obviousl y expense charges When .
any renovations or changes in structure are carried out
which entail a large and unusual expenditure the pro ,
p r ie t y of capitalizing all or any part of such e x p e n d i
tures should be considered T h e general principle ap
.
plicable to the solution o f this probl e m as discussed in,
C hapter IV is that no expenditure can be properly
,
treated as a capital outlay if it does not increase the
earning capacity of a business A S renovations and
.
structural changes are made for the sake of convenience
and e fficiency and thus indirectly increase the earning
capacity of a plant it would seem proper to treat them
,
as cap ital outlay Such improvements however are
.
, ,
frequently made when extensive repairs become meces
sary in which case their cost might be little more than
,
the necessary outlay on the accrued repairs .
T here are two methods of insuring the drawing of
a correct di stinction between expenditures for repairs
and renewals and those for capital improvements T h e .
most general method is to estimate the annual e x pe n di
ture required to keep the building in good condition and
to bring this amount p eriodically on the books as a credit
to R eserve for R epairs account and a debit to R epairs ,
which is charged to Profit and L oss on operation A s .
repairs are actually made their cost is not charged to
,
operation but to the reserve created for the purpose .
D uring the early years of the life of the building the
reserve accumulates to be drawn upon later as repairs
,
and improvements are carried out T he advantages of.
“
this method are that the reserve account shows over a
term of years whether the amount estimated as re
quired for repairs has been adequate while at the same ,
F I X E D A SS E T S 2 3
7
time it Spreads the charge for maj or repairs equitably
over a long period of time and insures their steady ap
plication against revenue U nder present tax condi
.
tions however reserves for repairs should be avoided
, ,
because only actual expenditures for r e pairs are allowed
by the government as income tax deductions .
A n alternative method is to include the repairs cost
with the depreciation charge T o set up separate re
.
serves for repairs and depreciation and to draw a clear
distinction between the amounts properly chargeable
thereto is a difficult matter T h e problem is simplified
.
by combining the estimated annual cost of the repairs
with th e depreciation charge into a combined charge
against operation T h e method of computing such a
.
composite rate is discussed on p age 1 78 .
C onditions under which work i s carried on and the
character of the buildings differ greatly T herefore .
,
the peculiar problems of each bus iness should be sepa
r a t e ly considered and from these should be determined
what Shall constitute its normal repair policy When .
the policy is finally outlined it should be steadily ad
,
hered to until conditions make its revision nec e ssary .
7. M a c h in e r y and Eq u ip m e n t
T he problem involved in accounting for the machin
ery and equipment of a p lant is that of their deprecia
tion While the same general principles of depreciation
.
are applicable to all items of equipment it is apparent ,
that not only will different kinds of machines and ma
chine tools vary in the ir rate of wear and tear but that
s imilar kinds of machines may also depreciate at dif
fe rent rates if the conditions under which the y are o p er
2 3 8 VA L UA T ION o r A SSE T S—L IA BILI T I ES
ated are dis s imilar Some of the questions involved
.
,
such as the probable life of a gi ven piece of equipment
operated under certain conditions are matters belong ,
ing more to the province of the engineer than of the ao
co u n t a n t T h e accountant however should know of
.
, ,
their existence G iven the nec essary engineering data
.
,
it falls to him to calculate the correct charge in each case
and record on the books the asset values which are grad
u ally consumed in machine operations T h e problems .
involved have been a lread y taken u p in C hap ters X I I
and X I I I .
WA ST I N G ASSET S
8 . De fi n it io n an d Tr e a tm e n t
term wasting assets refers to the propert y of
T he
an enterprise which is subj ect to depletion such as a ,
mine a quarry or an oil well Such property instead
, , .
,
of depreciating until finally it wears out ( to be replaced
by a new asset ) is gradually depleted until the supply
,
is exhausted after which it cannot be replaced T h e
, .
same principles apply to carrying the fixed assets on the
”
books of a wasting enterprise as of any other ; but
“
if the material resources of the undertaking are ex
p e ct e d to give out within a measurable period of time ,
several considerations modify the usual distinctions that
are made between revenue and cap ital expenditures .
I f the enterprise is limited in character i e formed , . .
,
to exploit one piece of property only it is clear that the ,
conservative policy of mai n taining the capital val ue of
the concern at its original amount is not applicable I f .
a tract of timber land for example is expected at the , ,
W A ST I NG A SS E T S 2 3
9
current rate of cutt ing to be depleted in ten y ears and
the buil dings an d power machinery are adequate for the
needs of its life term then it would seem unnecessary
,
to charge production with the depreciation and thus the
cost of replacing the fixed assets U nder these condi .
tions profits may legitimately be distributed in fu ll with
out regard to th e factors of depreciation and depletion .
T h e assumption in this case is that the larger di vidends
whi ch accrue to shareholders in consequence of this
policy in part represent the return of their original
,
investment .
I f however it is intended to carry on the enterprise
, ,
elsewhere as soon as the material resource s of one place
are exhausted then the capital invested shoul d be pre
,
served intact and the dividends distributed should r e pre
sent only profits .
I n this connection it may be noted that the law dif
fer e n tia tes between capital subj ect to ordinary depre
c ia t io n and that subj ect to depletion I n the first case .
the capital of a corporation cannot legally be distributed
as dividends by ignoring the factor of depreciation I n .
the second case it is recognized that some portion of the
dividends may represent a p art of the original cap ital
.
of the undertak ing .
9 . A c co u n t in g fo r W a s tin g A ss e ts
When the policy of the business is to exhaust its
wast ing assets with the inte ntion of ultimately wi ndin g
up the enterprise no special provisio n n eed be made
,
for the depletion of the asset value and the accoun tin g ,
problem involved is that of liquidation T hi s matter is .
di scus sed in C ha p ter X X V .
2 40 VALUA T ION OF A SSE TS—LIA BI LI T IE S
When the enterprise is of a permanent character ,
it is necessary to accumulate out of profits an amount
equal to the original capital investment in the business .
T his may be accomplished in various ways T h e most .
conservative meth od is to create a reserve account as
described in C hapter VI I I and to charge to current ,
Profit and L oss an amount equal to the depletion T h e ,
amount of the depletion charge is proportioned to the
estimated shrinkage of the wasting assets .
T o illustrate the purchase price of a tract of tim
,
ber land and the amount of land exhausted by cutting
operations are matters of record T h e ratio of the tim .
ber cut to the original amount on the land i s the per
cent of the original purchase price to be charged against
operations I f then the original asset value of the
.
, ,
land is and one tenth of the area is cut -
annually th e depletion charge would be
, and
the j ournal entry here shown would be required to
record it
P rofit an d L os s
D p l et io n R s e rv
e e e
To ch rg
a urr n t ope r
e c e o
a ti n s w i th th e
ca
pit l d p l e ti o n
a e .
T he e ffect of these periodical charges to Profit and
L oss IS to cre ate a res e rve which at the time of the com ,
p l e t e exhaustion of the wasting assets will be equal to ,
the original capital investment .
Many accountants believe that a reserve under these
conditions is unnecessary and misleading T hey main .
tain that the asset acco u nt itself should be credi ted with
the depletion .
W A ST I N G A SS E T S 2 41
R EVI E W QUE ST ION S
Gi v e e x m pl a es of fix d s ets
e a s .
W hen m ay a ppr e c i ti o n in fix d
a e a sse ts b e t ak e n up on th e
b ook s ?
Wh a t x p n s m y b e dd d t th e b ook v lu o f l nd p
e e se a a e o a e a ur
c h e d n d u n d r w h t o n d itio n s ?
as a e a c
Wh t e x p n
a m y b
e ses d d d t t h e b ook v lu e f bu il dings
a e a e o a o
p ur h cse d ? a
G iv x m pl
e e a f w st in g s s et s
es o a a .
D iff r n ti t b t w n d pr i t io n n d d e p l t io n
e e a e e ee e ec a a e .
G iv e th e j our n l en tr y t o s et u p de pl e tio n in n i ro n m ine
a a .
C HA P T E R X VI I I
L I A B ILIT IE S
1 . De fi n it io n and Na t u r e
L iabilities may be broadly classified under the three
groups of ( 1 ) current ( 2 ) fixed and ( ) contingent , , 3 ,
C urrent liabilities consist of ( a ) the amounts due to
trade creditors under notes payable or on open accounts ,
( b ) short term loans and ( c ) accrued expenses to date
-
, ,
such as rent taxes wages etc T h e fixed liabilities
, , ,
.
consist of long term loans of various kinds often se
-
cured by mortgages o n property an d e qu ipm e n t C o n '
.
tingent liabilities comprise all claims against the busi
ness which while not legally enforcible at present may
, ,
p ossibly though n o t probably become enforcible in the
, ,
future .
T h e only di fference between a fixed and a current
liability is that the maturity dates of the fixed liab ili
'
ties fall much later th an those of the current items .
T herefore the fixed items tend to become current as
,
their time of payment draws near .
Fixed liabilities are usually incurred for the p urpose
of raising capital to be used in extending the market
of a business or for additions to its plant and equip
ment C apital obtained for such extensions is as a
.
,
rule borrowed upon a promise to pay at a definite fu
,
ture time with real or personal property mortgaged as
,
collateral security Such promises may take the form
.
2 42
LIA BI L I T I E S 3
2 4
o f bonds real estate mortgages loans on collateral or
, , ,
short term notes T h e subj ect of bonds and bond is
-
.
sues has been taken up in C hapt er s I X and X and the
,
problems in connection with the accounting for accrued
and deferred liabilities in C hapters I I and I I I T hose .
relating to the remaining kinds of liabilities are dis
cussed in this and the two following chapters I n gen .
eral it may be stated that the chief points to consider
,
in accounting for the liabilities are the clearn ess and .
fullness of the informati on giv en A ll such informa .
tion Should be recorded with due regard to future pres
e n t a tion and classification on the balance Sheet .
2 . C u rr e n t Lia b ilit ie s
A s the difference between the amo unts of the cur
rent assets and the current liabilities represents work
ing capital a comparison of the two sets of figures is
,
always a matter of significance to the creditors of a
business or to those from whom a request for credit is
made T herefore the drawing of a correct distinction
.
,
between current and fixed liabilities is important T h e .
ordinary co m mercial practice is to include among the
c urrent items all notes accounts payable and other o b
, ,
ligations which mature within from three months to a
year A retail or wholesale business would generally
.
consider only those obligations current which fall due
within a comparatively brief period A manufacturing .
concern would look further ahead and rank as current
liabilit ies all items falling due within Six months or a
year .
N ot all notes and accounts payab le are current items .
N otes given to stockholders or ofiicer s of a company ,
2 44 VALUA T ION OF A SSE T S—LIA BI L I T I E S
or to banks or sold through brokers ma y be p roperl y
,
classified as fixed when there is no particular urgency
as to their time of payment ; and the same observation
applies to amounts due on open account to stockholders
or any outside parties holding an interest in a concern .
Before closing the accounts payable ledger at the
end of a financial period the order and receiving books
,
Should be inspected so as to insure taking up the lia
bility for all goods received at or before inventory tak -
ing and included therein T rade discounts as else .
,
where stated should not appear upon the books of a c
,
count as such discounts represent the reduction of
,
fictitious prices to their actual values A s regards the .
deduction of cash discounts practice in this respect is ,
not uniform being governed by the custom in a par
,
ticu l ar case Where it is the practice to take advantage
.
of every cash discount the deduction is usually made
,
upon the invoice and before it is entered When the .
cash balance does not permit the taking up of discounts ,
the liability will of course be entered in full
, , .
I f open accounts or notes payable carry interest the ,
amount of the interest due at the date of closing the
books should be taken up as e xp lained in the discus
, ,
sion of liabilities accrued ( C hapter I I I ) O ther cur .
rent liabilities which are discussed elsewhere in this and
,
the first volume are consigned goods sold by the con
,
signee salaries and wages accrued and dividends de
, ,
c la r e d but not yet paid .
3. Re a l Es t a t e M o r t g a g e s
I n the case of most large corporations the bonds ,
issued for the purpose of obtaining capital consist of a
LIA BI LI T I E S 5
2 4
series of numbered bonds secured by one mortgage
placed upon the corporation s property for the security ’
of all bondholders I n contras t to this copartnership
.
of interest in one security is the ordi nary bond and ,
“
mortgage the bond being the promise to pay and the
,
mortgage the security for the amount of money bor
rowed A S the credit rating of small concerns is u m
.
known to the general public they rarely issue the serial ,
bonds because of the di ffi culty of marketing them I n .
stead the owners o f such a business obtain a loan on
,
the concern s single bond with a mortgage on the real
’
estate as collateral the mortgage being executed in
,
favor of the person or concern loaning the money .
A s it is desirable to kn ow the li ability due on the
mortgage as to both principal and interest at all times ,
two liability accounts Mortgage Payable and I nterest
, ,
on Mortgage P ayab le ar e set up and charged with pay
,
‘
ments of principal and interest respectively as these are
made T h e o ffsetting debit to I nterest on Mortgage
.
Payable is to the general expense account I nterest as ,
a lready explained in the discussion of accruals in C hap
ter I I When the interest liability is expunged by its
.
payment the expense has already been taken up on the
,
books .
4 . Co l la t e r a l Lo a n s
L oans which are secured by the deposit of securities
or other assets as collateral are recorded in the same way
as any other liability the title of the account signifying
,
that the loan is secured by collateral of some kind N o .
bookkeeping for the security deposited as collateral is
required other than a memorandum entry in the Stock
2 46 VALUAT ION OF A SS E TS—LIA BI LI T I E S
or Bond I nvestment account giving the number of the ,
securities and the date and place of deposit Such se .
cu r it ie s are still owned by the borrowing concern sub
j e c t to the discharge of the liability Securities should .
be stated as hypothecated on the balance sheet .
I f the loan is dishonored at maturity and the securi
ties are sold in satisfaction of the claim entries are r e ,
quired to show the price realized from them the rep ay ,
ment of the loan and the loss or profit on the tr an sac
,
tion I f the sale of the securities realizes more than
.
the loan but less than the value at which the securities
are carried the loan is wiped out C ash account is then
, .
charged with the surplus realized on the sale the invest ,
ment account is credited with the proceeds of the sale ,
and the loss on the sale written off to Profit and L oss .
I f the sale realizes less than the loan the loss is in ,
creased and a liability still remains on the books .
T o illustrate assume that bonds of the face value of
,
are hypothecated for that the loan is
dishonored an d that the sale of the bonds less expenses
,
realizes T h e j ournal entries required are
C a sh
L o n or A d v n ce s n B o n d s
a a o
To r e ord th e l i b il ity in urr d n d th e
c a c e a
mou n t r e ceiv d n fi r s t mort g ge
a e o a
b o n d s No s .
p l d s ol l t e r l ac e a c a a .
Lo an or A dv a n ce s on B o nd s
C a sh
P r fit
o an d L o ss n I n v e s t m nt
o e
F i r s t M or tg ge Bo n d s
a
T o r e c ord th e n ca l l t io n
ce a of lo an by
th e s l oll r l
’
a e of b n d pl o d s a ce as c a te a
a n d th e l o s s t h e r e o n .
LI ABILI T I E S 2 4d
I f the sale of the collateral secu rity less expenses
realizes less than the loan say the loss is pro ,
po rt io n a te ly increased and the entr y required to
, wipe
out the liability would be :
Lo n or A dv n s n Bo n d
a a ce o s
P rofi t or L o n I n v e s tm n t
ss o e
F ir t M or tg g Bo n d
s a e s
C s h ( or L o n P y b l
a a a a e
)
5C
. o n tin g e n t Lia b ilitie s
A cont ingent liabili ty is a claim or debt for which
a business may be held liable if certain things come to
pass ; or a claim which the b u s iness ref u ses to ack n o w l
edge but which may become an actual liability upon
legal adj udication W hile there is always the possi
.
b il ity that a contingent liability may become an actual
liability the conditions are usually considered to be so
,
remote or un ce rta in that the taking up on the books of
the possible loss as an ac tual loss is unnecessary .
T h e contingent liab ilities which most commonly de
v e lo
p in to actual liabi lities are notes receivable dis
counted accomm odatio n indorsements guarantees of
, ,
various kinds damage suits or contested claims and u n
, ,
paid or partially p aid stock held T h e liability on the .
latter would fall upon shareholders owning the stock of
a corporation upon its insolvency .
T h e method of acco u nting for notes or dr afts dis
co u nted or sold when they are dishonored is covered in
V olume I C hapter XX VI I T h e ma nner of reco rding
, .
other contingent liabilities is il lustrated by the method
of handling accommodation in dorsements exp lained in
the followin g section .
2 48 VALUA T ION OF A SSE T S—LIA BI L I T I E S
6 . A c c o m m o d a t io n In d o r s e m e n t
An accommodation indorsement represents the ac
c e pt a n c e of a note or a bill by one party who receiv es
no value therefor for the use or benefit of another party
, .
T h e indorser is liable on the instrum ent only in case of
its protest Such a contingent liability is usually Shown
.
on the books as in the illustrative entry below
A ommo d tion I n dor se m nt ( o n tr )
cc a e c a
R s e rv fo I n dor e r s L i b il ity
e e r s
’
a ( con
tr a )
A ssuming that the note is dishonored and that its
holder recovers its face value together with the protest
fee from the indorser the entries on the latter s books ,
’
would be
R e se rv e for I n d or s r s L i
e
’
a bil ity
P ro te s t Fe e
C a sh
P ro fit an d L o ss
A cco mmod a ti o n I n d or se m en t
C orporations are usually very chary about lending
their names on promissory notes for the accommodation
of the makers and the charter and b y laws of many cor
,
-
p o r a t io n s forbid the practice as do also many partner ,
ship agreements .
7. O t h e r C o n t in g e n t Lia b il it ie s
O ther contingent liabilities such as guarantees of ,
product sold or work performed possible losses from ,
pending laws u its stock not fully paid and so on Should
, , ,
all be handled in a similar way as above that is by , ,
LI AB I LI T I E S 2 49
showing the liab ility in a suitable reserve acc ount o ff
set by a suspense expense account “ h en such l iab ili .
I
ties are likely to involve cash payments of any size as ,
where there is the possibility of an adverse decision and
heavy costs in a lawsuit it is usual to create a fund so ,
that cash may be available for the settlement of the
legal charges and claims .
R EVI EW QU E ST ION S
Gi ve r ee l se f l i b il iti
th c as s o a es .
\Vh n e fix e d l i b il iti u u l l y r ted ?
a re a es s a c ea
G iv t n x m pl
e e e f urr n t l i b i l iti
a es o c e a es .
Wh t a ou nt
a cc r q u ir d t h ow t ll t im s t h orr t
s are e e o s a a e e c ec
t tu s
s a f lo n s n r e l e s t t ?
o a o a a e
G iv e t h n t r y r e q u i r e d t s h ow th e s l f s e cur itie p r e vi
e e o a e o s
l pl d ged f
o us y e n ot p y bl e
or a e a a .
D e r ibe
sc o n tin ge nt l i bil ity
a c a .
N m s e v r l c o n ting n t l i bil itie s nd s t te h ow e ch s h oul d
a e e a e a a a a
a ppe r o n a b l n ce sh e et
a a a .
C H AP T E R XI X
I N T A N G I B LE A S S E T S
1 . Na t u r e of In t a n g ib le A s se t s
intangible assets of a business comprise those
T he
such as good will—which cannot be converted into
-
m o n e v except by the sale of the business as a going con
cern ; and those—such as trade secrets and patents
which cannot be bought on the open market Because .
of the difficulty of realization the value of such assets ,
is indeterminate or intangible N evertheless they often .
,
constitute some of the most valuable asset s o f a con
'
cern the loss of which would as a rule se r iou slv im
, , ,
pair the business prosperity E numerated in the order .
in which they will be taken u p here the y comprise : ,
1 G ood will -
T rade marks
3
2 .
-
Patents
.
4 T rade secrets
5
.
C opyrights
.
6 R oyalties
.
7 Franchises
.
Because the value of this class of assets cannot be
so readily determined as that of the fixed and current
assets they are often carried at fictitious and purposely
,
inflated values T h e correct method o f accounting for
.
the intangible assets is to carry on the books only thos e
which hav e a real value which is open to verification
5
.
2 0
I N T ANGI B L E AS SE T S 2 5 1
2 . G oo d -
W ill
Good wi l l repre sents the exp ectation of doing busi
-
ness with and receivin g the established patronage of a
, ,
p articu lar community or trade ; it is an estima te of the
capita lized value of future earnings in excess of the r e
su lts which mi ght normally be expected when a new
business is created I n estimat ing its value a numbe r
.
of thing s must be taken into consideration .
Th e location of a business has sometimes an impor
tant bear ing on the value of the good will A con -
.
gested corner one year may through the diversion of ,
tra ffic cause d by the opening of a new rail road become ,
much less frequented a few yea rs later I n the ca se .
of a retail enterprise such a change might seriously
,
diminish its profits and cons e q uently the value of the
A gain the memb ers of a firm may be men who are
,
well k nown and respected by those who do busin ess with
them B eca use of their lengthy experience in the trade
.
,
they may enj oy the patronage that springs from per
sonal liking and reputa tion I f their bus in ess changes .
h a nds and it is k nown that th e v have severed their con
n ectio n with it its earn in g capacity may be seriously
,
a ffected For this reason when an old establi shed busi
.
,
-
ness is taken over by a new management the firm name ,
is rarely if ever changed the new proprietor preferring
, , ,
to lose hi s identity rather tha n sacrifice the good will -
att ached to the firm name F inally a busin ess may .
,
enj oy a flouris hing trade and be sold at a favorable
price w h ich includes the ful l value of the good will I f -
.
the former o wner of the concern is not restricted in his
futu re bus iness operations he may enter in to competi ,
2 5
2 VALUA T ION OF A SSET S—L IA BI L I T IE S
tion with the old business and attract much of the good
will which was included in its purchase price .
3 . M e th o d of De t e r m in a t io n of Go o d -
W ill
A s in its origin good will is an asset of a wholly -
indeterminate nature it is not considered good account
,
ing practice to set it up on the books until its realizable
value has been determined by the sale of a business as
a going concern With one exception to be discussed
.
,
later commercial usage permits the capitalization of
good —
,
will only when its value takes tangible form in the
price actually paid for it .
T here are two well known methods of determining-
the value of good will O ne method commonly used i s
-
.
to capitalize the estimated earnings for a certain number
of years— in large consolidations the period varies from
two to ten years For example if a concern showed
.
,
average net profits of an agreement might be
reached on the sale of the business that the good will
, ,
-
should be sold for a price equal to a three years pur
’
chase o f the average net profits T h e purchaser could .
then properly retain this amount on his books as an as
set o f established value .
A nother method is to capitalize that port ion of the
profits which is in excess of the usual return on money
invested in a Similar kind of business I n the above .
example the average net profits are A ssum
ing that the company s capitalization amounts to
’
0 0 0 the average net profits would be 1 0 % on the capi
t a liz
,
at io n T hen if 6 % is taken as the normal profit in
.
,
the trade this profit would amount to
,
leaving
an excess of which would be considered as the
I N T AN G I B L E A SSET S 2 3
5
normal return of the asset good will T h e value p laced -
.
upon the good will woul d therefore be :
-
06 .
4. Ba s is of V a lu atio n of Goo d -
W ill
H a v ing determ ined the num ber of years profits ’
upon the basis of which the sell ing price of the good
wi ll is to be calculated consideration must next be given
,
to the method of computing the profits I n this con .
n e c t io n it is necessary to bear in m ind cert a in important
guidi ng rules whi ch are generally accepted as the cor
rect method of appraisal and as equitable to both part ies
interested in the valuation Briefly enumerated the .
,
rules are as foll ows :
1 . A ll extraordin ary profits or losses not due to ,
the ordinary opera tion of the business ,
should be eliminated .
2 . I nterest paid on b o rrowed money should not
be included
3
.
. A dequate reserves for depreciation should be
provided for .
4 . T h e charges to operating expense on account
of repair s shoul d be adequate C are should .
be taken to se e that the charges to the repair
accounts do not show a sudden fall ing off
toward the close of the period under review
5
.
. C are shoul d be taken to see that no sales e f
fe ct e d for a subsequent period are taken up
in the accounts of the period un der review ,
with the view of i nflating profits Ship .
"
ments made to branches or on consignm ent
account sho u ld not be regarded as sa les .
2 5
4 VA L UA T ION OF A SS E T S—LIA BI LI T I E S
T he inventories should be checked over care
fully they should be certified by the persons
,
taking them and should be valued at cost or,
market whichever is the lower ; proper a l
,
lowance should be made for old or obsolete
material .
A mple provision should be made for all liab ili
ties for expenses incurred during the period
’
u n d er r e v ie w and outstanding at the close
thereof .
5 Goo d W ill Va lu e of A d v e r t is in g
3
-
.
T he exceptional case previously mentioned in
when good will may with propriety be set up on the
-
books before its value has been fixed by its sale and
purchase refers to the good will created by advertising
,
-
.
A large corporation with an established reputation and
a product in universal demand usually aims to cover
the country with its sales by means of a wide spread -
advertising campaign the appropriation for which may ,
run into seven figures I n such a case there is no ex .
p e c t a t io n of immediately reaping the fruit of the pub
licity . T h e obj ect is to create a good name for the
product the effect of which will be noticed in an in
,
creasing volume o f sales for months and perhaps years
to come .
T o establish a demand for an unknown product in
this way is one of the quickest methods of building up
good will T h e trade once acquired it can other things
-
.
, ,
being equal be retained with but a small expenditure
,
on advertising as compared with the cost of securing
the business in the first instance T h e di fference be .
I N T ANGI BLE A SSE T S 2 5
5
tween the cost of retaining the trade and that of bu ild
ing it up may be regarded as good will to be set up on -
the books and W ritten o ff over a period to be determined
by the circumstances of the case Where the appro .
p r ia t io n is handled carefully and the results derived ,
from advertising are methodically tabulated the effect ,
of a large advertising expenditure can b e clearly fol
lowed I t is then considered good accoun ting practice
.
to bring good will on the books by crediting advertising
-
expense with its value calculated in the above way and ,
setting up this am ount as anasset which however should
then be written o ff as rapidly as possible—within say
, ,
, ,
three years A similar principle is here involved as in
.
other cases where expendi tures incurred in part for the
benefit of future operations are capitalized and charged
o ff against the profits of the years which benefit there
from .
6 . De p r e c ia tio n of Go o d -
W ill
A ccountants of the more conservative school r e com
mend that good will be depreciated over a term of years
-
by ann ual charges against profits Such profits have .
been paid for or capitalize d in advance and therefore , ,
it is contended they should be used as earned to pay
back their purchase price before dividends are paid .
While this recommendation is followed by many pru
dent business men it is by no means universally a d
,
hered to in practice Good will account it is con.
-
tended represents earning capacity and has been valued
,
on the basis of the very profits which are to be used to
depreciate it For this reason many accountants con
.
t end that there is no logical reason for writing o ff th e
2 5
6 VALUA T ION OF A SS E T S —
LIAB ILI T I E S
asset and that the e ffect of so doing assuming that the ,
original prosperity of the business is maintained is to ,
create a secret reserve A dditional strength is given to
.
this contention by the fact that when profits are more
than the average the good will is proportionately valu
,
-
able and a very real asset .
7 . A c c o u n t in g fo r G o o d -
W ill
To sum up the preceding discussion good will ,
-
should be considered as an asset only after it has been
acquired and only for its original cost I t should never .
be treated arbitrarily I t Should not represent the ex
.
pense of building up a business as it sometimes does , ,
since such expenditures are in no sense an asset but a
deferred charge to be written o ff to future operations .
I t should be noted that good will is not permitt e d as -
an expense deduction by the g overnment in the compu
t at io n o f income tax Fro m a credit standpoint g ood
.
,
will has no value and the account may easily contain
losses which a concern wishes to hide from the public .
I n fact the G ood will account as found in many bal
,
-
ance sheets is retained for the sole purpose of inflating
,
surplus and thereb y concealing a deficit .
G ood will may be set up on the books at the t ime
-
of the sale of the entire business or when taking in a ,
new partner or in cases where excess profits are earned
,
on a small capitalization or where an unusual amount ,
has been spent in advertising A s the sole purpose of .
bringing the asset upon the books is to increase the
capital the entry required is a debit to G ood will o ff
,
-
set by a like amount credited to Surplus or C apital .
I n calculating the amount to be depreciated the ,
I N T AN G I B L E A SSETS 2 5
7
method of computin g an ann ui ty is somet imes employed .
G ood will is in this case assumed to have a de finite lif e
-
and to represent the value of an annuity which will
produce a n amo u nt equal to the excess of profits that
the bus iness is expected to earn because of an estab
li sh e d reputation superior location or a monopoly of
, ,
some k ind H ere there are two facts upon which the
.
solution of the problem may be bas e d :( 1 ) definite life
of good will and ( 2 ) amount of excess profits With
-
,
.
these figures as a starting point the value of an annuity ,
is computed which will ext inguish the value of the good
wi ll A t the termination of the li fe of the good will
.
-
the a nnuity has accu m ul ated an amoun t equal to the
excess profits which were expected to be earned .
I t may here be noted that when good wi ll is pur -
chased as one o f the assets of a going concern the busi ,
ness sold is usua lly th at of a sole proprietor or a part
n e r sh ip which is to be trans formed into a corporation
,
.
I n such a case it is customary to pay the vendor for the
value of the go od w ill out of the capital stock of the
-
new corporation .
8 . P a t e n ts
A patent is a governmental grant whereby an in
v e n t or or the p u rchaser of an invention enj oys the ex
elusive right to make and sell a particul ar invention for
'
—
a cer ta in number of years usually seventeen A s a .
patent represents a monopoly grant for a limited peri od
of time and certain de finite expenditures are made in
its development or acquirement the problem of its han ,
d ling on the books is simple T heoretically all that is
.
,
required is to spread the full cost of the patent over the
2 5
8 VA L UA T ION OF A SSE T S—L IA BI LI T I E S
years of its monopoly making the charge to either the
,
cost of the goods produced or to selling expense Prae .
tically h owever the ownership of a patent usually cre
, ,
ates a good will which offsets its depreciation in that
-
by the time the patent rights expire their owner ship has
built up such a lucrative business that the asset r epr e
sented by the cost of purchasing or developing the pat
ent in the first instance is replaced by an equally valu
able good will asset Furthermore it is rarely the case
-
.
,
’
that a concern s profits are limited to those derived from
the original patent T h e tendency is for one invention
.
to beget another and the first patent is often so im
proved or amended under later patents that it takes on
a new lease of life .
9 . De p r e c ia t io n on Pa t e n t s
I n estimating the probable depreciation on patents
the fact Should not be overlooked that the progress of
invention may at any time extinguish the value of a
lucrative patent right I ts active life wi ll therefore
.
, ,
often be less than its legal life C onservative practice .
in general recommends that the cost of a patent be writ
ten o ff over the period of its expected active life An .
alternative method adaptable to some conditions of man
u fa ctu r e is to charge the cost of the p atent to the prod
u e t per unit of production Whatever the method of .
depreciation adopted the charges to revenue on account
,
of the patent should never be greater than its actual
cost .
I f a patent covers an article the life of which is ex
e ct e d to be of brief duration such as a novelty which
p ,
pleases the public fancy for the moment the cost of the ,
I N T AN GI BLE A SS E T S 2 5
9
patent should be writt en o ff durin g the fir st year or tw o
by chargin g it to the cost of manufacture .
10 . A c c o u n tin g fo r Pa t e n ts
I n accoun ting for patents the customary proc edur e
i s to capitalize all expenditures connected with the de
v e lo m e n t acquirement and retention of the m o n o po lv
p , ,
rights O ften the cost o f development includes the ex
.
e n di tu r e s during years of experim ental work much of
p ,
which may seem for the time being to have been fruit
less and therefore to be charged o ff as a loss Such .
would be the correct procedure unl ess existing patents
were carried on the books at a conservative figure in ,
which case it would seem proper to add to their cost the
cost of the experimental work I f there is no existing
.
patent asset such expenditur es coul d not properly be
,
cap ita lize d .
T h e method of recording depreciation on patents is
the same as that for depreciation on other fixed assets .
Depreciation on Patents expense account is charged
with the current amount an o ff setting credit being
,
made generally to Depreciation R eserve on Patents
acco u nt or in some cases directly to the Patent account .
I n support o f the practice of writing o ff the value of
the asset accoun t it is contended that the life of the
,
patent is a de finite term and therefore the value of the
asset should be written down so as to correspond with
the u nexpired p eriod yet to run O n the other ha nd
.
,
where numerous patents are held and it is required for
administrative purposes to ascerta in the total e x pe n di
tures to date on any particular patent this information
,
is more co nveniently presented by carrying the o ff setting
2 60 VALUA T I ON OF A SSE T S—LIA BI L I T I E S
estimation of depreciation in the valuation account ,
E ither of the above methods of Showing the value of the
patent may be used with equal pr opr ietv .
T h e fact may here be noted that some accountants
recommend the merging of the three assets good will ,
-
trade marks and patents into one capital account espe
-
, , ,
c ia lly when these assets have been included in the v a lu a
tion of the purchase price of the concern T h e three .
assets are often treated as part of the permanent in
—
vested capital of the business to be retained at its
original figure on the books so long as the prosperity of
the concern is evenly maintained .
11 . Tr a d e M a r k s
-
A trade mark is a symbol of ownership such as a
-
distinctive label im print or design used to distinguish
, ,
a particular brand of pr o duct from all other brands .
I t is used for advertising and selling purposes by print
’
ing it on the wrapper or package of a concern s goods
as well as by using it on most of the concern s a d v er ’
t is in g literature Th e symbol is intended to guarantee
.
the quality of the goods by a ffording the consumer a
ready means of recognizing the make or brand of the
articles o ffered for sale and thus a trade mark r epr e
,
-
sents an e ffort to give tangible effect to good will -
.
W hen a business carries on a profitable trade which
has been built up by maintaining a high standard of
quality for which its trade mark stands the symbol of
-
this quality has a very real though intangible value I ts .
actual worth to a business may be difficult to estimate
but it is proper to set it up on the books at least at its
cost value A s a trade mark is rarely sold unless the
.
-
IN T AN G I B L E A SSE T S 2 61
business itself is sold this cost usually includes that of
,
its design development and registration and any ex
, ,
penses which may have been incurred in defending it
against the inroads of fraudulent imitators .
12 . T r a d e Se c r e t s
A nalogous in some respects to patents are trade
secrets T hese u su allv represent a formula or receipt
.
for the ingredients or the method of combining the in
re d ie nt s used in the manu facture of a special product
g .
Such a formula may be and often is as valuable as a
patent and its ownership like that of a patent may
, , ,
carry with it a monopoly in the manufacture of a par
t icu lar product .
T h e proper method of handling trade secrets on the
books i s to cap it alize all expenditures incurred in their
acquirement or devel opment A s trade secrets are .
a fforded no legal protection and the value of their pos
session lies largely in the secrecy with which the process
of manufacture can be carried on it is customary to write ,
off the cost of their purchase price if they have been ,
acquired in this way as rapidly as is practicable A
, .
trade secret which is merely the fruit of a fortunate dis
c o v e ry has like good will no asset value until it is sold
,
-
, .
1 3. C o p y r ig h t s
A copyright is a government grant for the exclu
sive publication of a certain work of literature music , ,
or pictorial art T h e accounting treatment of copy
.
rights is Sim ilar to that of patents for the reason that ,
they also constitute a monopoly granted for a pre
scribed and definite period T h e term extends over .
2 62 VALUA T ION OF A SSE T S—L I A BI LI T I E S
2 8 years with the privilege of renewal for a further
,
2 8 years if the application i s made one year prior to the
termination of the original copyright .
T h e legal cost of securing a copyright is in sign ifi
cant and is usually written o ff against the first issue of
,
t h e copyrighted production T h e value of a copyright
.
m ay be large or small depending upon the demand for
the work which it protects and the price paid to the
author for the right of reproduction I f a copyright .
invariably retained its original value over the years of
its life all that would be required for its correct account
,
ing would be gradually to charge o ff this value to the
production cost of the copyrighted article O nly a small .
minority however prove of much co m mercial worth and
, ,
thi s worth which at one time may seem considerable may
within a few years suffer serious depreciation T h e .
probable demand for works of artistic and educational
value I S a difficult matter to estimate T herefore the .
,
values at which the copyrights are carried on the books
Should be subj ect to periodic and expert appraisals .
T h e amounts written o ff the cost of the copyrights and
charged to either profits or production costs should be
bas e d on this valuation regardless o f the length of the
term that the copyright still has to run .
14 . Ro y a l t ie s
are payments made for the right of manu
R o v altie s
fa ct u r ing a patented article or producing a copyrighted
article or for the right of extracting a raw product fro m
,
the ground such as the operation of a mine T h e royalty
,
.
which is paid for the privilege of manufacture or repro
duction Should be treated as an expense to be charged
I N T A NGI BLE ASS E TS 2 6 3
to the cost of the article produced A royal ty which is
.
paid for the right to exploit a piece of land may under
certa in co nditions be capitaliz
ed as an asset Mines for .
,
example are frequently lea sed under terms which stipu
,
late a royal ty to be paid on the tonnage extracted with ,
a minimum charge if the tonnage raised is below a s t ip u
lated amount I f the tonn age extracted d u ring the early
.
years of development is less than the stipulated mini
mum the royalty paid in excess of actual production
may be capitaliz
,
ed to be charged to the cost of produc
tion when maxim u m pr o ductive capacity is reached .
A franchise is a legal contract whereby a state or ,
one of its divisions permits a corporation or a publi c
,
utility co mpany to perform some kind of public service
.
for whi ch p urpose it is granted the use of public
property Ma nifestly the value of th e franchise will be
.
,
wholl y dependent upon the term s of the contract and the
length of the monopoly grant T his may be perpetual
. ,
a s where no time limit is set or it may be for a definite
,
term of years .
IV ith o u t considering the terms of the contract or
their e ffect upon its asset value it may be stated as a
,
general accountin g pr inciple that a franchis e may be
taken up on the boo ks at its full cost T his includes : .
1 . L egal expenditures .
2 . R eimbursements to property owners who se real
estate o w nings are depreciated by the grant
of the franchi se
3
.
. T h e payments made to the state county or , ,
other political unit which gives the franchis e .
2 64 VA L UA T I ON OF A SS E T S —IA L B I LI T I E S
A ny p ayments made yearly or at recurring interval s
whereby the cost of the franchise is paid out of operating
expenses should be charged as such
, .
A s the amounts t o be written o ff for the de p recia
tion of the franchise are dependent upon its length
and terms it is im p racticable to formulate any definite
,
principles for guidance A s a general rule the grant .
ing of the franchise carries with it certain legal require
ments as to the amount to be taken out of earnings for
the purpose of amortizing the asset When a company .
i s controlled by a co m mission the rulings of that com ,
mission must be followed For example in N ew Y ork .
,
the rulings of the Public S ervice C o m mission prohibit
public service companies under its supervision charging
to the Franchises account expenses of a legal character
or those incurred in securing consent of property
owners O nly the amount actually paid to the state or
.
to one of its political subdivisions as consideration for
the grant is a proper charge to Franchises account .
R EVI E W QU E ST ION S
Gi v e v e n x m pl s f in t n gib l
e s e a e ts e o a e as s .
Formul t d e fi n itio n f good w il l
a e a o -
D r ib e t w m th od f d t rm in in g th e v lu f g oo d w ill
e sc o e s o e e a e o -
.
W h t is t h U n it d S t t s in om e t x r gul tio n w it h r g r d t
a e e a e c a e a e a o
d pr e i tio n f good w il l ?
e c a o -
W h t i th U n ite d St t in c om t x r gul tio n w ith r e g r d t
a s e a es e a e a a o
d p r e i t i o n f p te n t ?
e c a o a s
Wh t ia t r d m rk ? A f r n h is ?
s a a e -
a a c e
Wh t is th N w Y ork S t t e P u b l i S rv i C omm is s io n rul in g
a e e a c e ce
r g rd in g h r g t Fr n ch i
e a c a ou n t ?
es o a s e a cc
O f w h t pe rm n n t v lu e is c o py r igh t ? G i v e ou nt n t ’
a a e na a a ac c a s
o pin ion .
C HAP T E R XX
F IRE L O S S AD JU S T M E N T S
1 . Na t ur e of Pr o b le m
accounting problems which are apt to arise in
T he
connection with the adj ustment and settlement of a
fire loss relate more to the proof of the extent of the loss
to be presented to the insurance company than to the
bookkeeping proper Most of the difficulties which
.
cause delay in maki ng the adj ustment are due to the
inabili ty of the insured to produce satisfactory evidence
of the value of the assets destroyed T he standard .
policy adopted by most in surance companies requires the
pr o duction of the ori gi nal invoices when the entries on
the books of account are uns atisfactory T herefore if .
,
the books have been improp erly kept and if the sup
porting vouchers have been destroyed the adj ustment,
may be long drawn out and expensive and in any case
will be delayed until the insured can procure satisfactor y
evidence of the amount of the loss .
Such evidence of values woul d ordinarily be stores
and plant subsidiar y ledgers supported by 1 ) con
trolling accounts on the general ledger and ( 2 ) sup ,
porting data o f all charges to these accoun ts as given in
a voucher system of account keeping Where fu rn i
-
.
ture fixtures ma chinery and other equipment have been
, , ,
wholly destroyed the subsidiary plant ledger in which
,
the depreciation charges are recorded is a particularl y
advantageous record .
2 66 VALUA T ION OF A SS E T S—LIA BI LI T I E S
2 . Fir e In s u r a n c e Po lic y
T hefire insurance policy is a legal contract whereby
the insurance company agrees to pay or replace in ,
whole or in part the damage or loss incurred T h e pre
,
.
cise liability of the company is limited by the terms of the
contract and the amount of the policy T h e clauses of .
the policy cover the pa r ties the property the risk, , ,
amount term and premium to be paid I f a quick a d
, , .
j ustment is to follow a loss the policy should state with
,
the utmost clearness and preciseness the p articular
property to which it applies Where several buildings
.
are insured for di ff erent amoun ts or when policies ar e
,
taken out to cover new equipment as it is purchased it ,
may be a di fficult matter to determine which building
or which equipment is covered by a particular policy ,
especially when machinery or plant has been moved from
building to building T hese d ifficulties are likely to
.
arise where the plant of a concern is spread overa large
area and is divided into numerous sep arate buildings .
T o overcome the di fficulty it may be advisable to draw
up charts and map s of each building Showing the machin
e r y and equipment therein and to indicate on the in s u r
,
ance policy the particular p ieces o f property covered by
the instrument .
T h e policy terminates at noon on the last day named
ther e in I f a fire breaks out in the morning of the last
.
day and even though the greater p art of the damage
,
takes place in the afternoon the loss is still covered by
,
the policy as the fire started before the policy expired .
T h e policy may be ca nc e led imm ediately by the insured
giving notice to the company in which case the cost o f
,
th e expired in suran ce is u s u a lly higher than at the
I
F RE LO SS AD JU ST M E N T S 2 67
rate spec ified for the ful l term More frequently the .
policy is ca nceled by the insurance company it self b e
cause of neglect on the part of the insur e d to provide
the safeguards stipulated such as the installation of a
,
sprinkler syste m or provis ion for watching the build
,
ing l flo r e o v e r either the use of dangerous substances
.
, ,
or concea lment or misrepresentation in taking out the
pol icy may be the reason for withdrawal of pro tection .
A fter th e ins u rance company has given notice of can
ce lla t ion,five days must elap se before the protec tion
aff orded by the poli cy cea ses .
3. Se tt le m e n t of Lo s s e s
W hen a fire oc curs the ins u red is required give to
written notice of it to the in surance company imme
di ately and to do everythin g in his power to protect the
propert y from further damage in the meantime Sub .
sequently an in ventory must be made out in deta il to
cover the damage cla imed and the proof of loss must
,
be submitted within sixt y days T h e claim must give .
all possible facts and opinions of the in s u red as to the
t ime and cause of the fire ; it must be supported b y a
sworn affidavit and by specifications of the property
destroyed with the exact l ocation of the various items at
,
the time of their destruction ; A t the option of the in
surance company the insured may be required to pro
,
duce books and records and submit to an oral exam ina
tion under oath so that the validity of the claim mav be
tes ted and established .
T h e determination of values des t royed is not gov
erned by defini te proc ed u re and rules T h e insurance .
company in accordance with its usual contract may set
2 68 VALUA T ION OF A SSET S—LIA BI L I T I E S
tle in one of two ways :( 1 ) by paying over the actual
cash value of the property destroyed at the time of the
fire or ( 2 ) by paying over the amount which it would
,
cost to replace the property T h e governing price .
“
usually is cost price with heav y allowance for de p recia
,
tion .
I f the parties cannot agree as to the value involved ,
the insurer or the insured may each appoin t an appraiser
who selects a third person called an umpire T h e ap .
praisers after determining the damage caused and the
,
value of the loss usually submit a written report which
,
is held as binding upon both parties T h e umpire is .
only called upon to decide matters about which the ap
praisers cannot agree .
A fter the amount of the loss has been settled by ,
’
agreement or by appraisal the insuranc e company s ,
liability thereunder is determ i ned U nless the property .
is i nsured to its full value ( which for reasons to be ex
plained presently is rarely the case ) the clauses of the
contract may limit or qualify the liability of the com
pany in various ways L ittle attention as a rule is
.
given to the bearing of these clauses on the contract .
”
T h e coinsurance clause i s one of the most common and
“
important of these clauses .
4 . C o in s u r a n c e C la u s e
C oinsurance
or the average clause as it is some
, ,
times called is one o f the most important features in
,
connection with fire insurance I n the case of insu r .
ance covering property all losses should be based on
,
indemnity only and to insure equity in making the rate
,
the factor of coinsurance must be considered .
F R I E LO SS A DJU ST M E N TS 2 69
W hile commonly called coinsurance the word is ,
rather misleading but having become part of the com
,
mon speech it probably will not be di splaced A cc
, .
insurer would imply one who insures someth ing with
another that is assumes part of the risk of insurance ;
, ,
whereas th e phrase as comm only used means that the
, ,
in surer has agreed to carry insurance to a certain amount
of the value of the property and failing to carry that
,
amount he loses a certain percentage of the amo u nt for
which he is insured T herefore when the insured fails
.
,
to carry a sufficient amount o f insurance he becomes a
coinsurer because he really insures himself for a part
of the amount .
A s an example if a piece of property worth
,
is insured under the 8 0 % coinsurance clause the in su r ,
ance required is in amount I f the insured ow y .
carries and a loss occurs three fourths of the loss
,
-
only will be paid because the actual insurance carried
i s only three fourths of the amount that Should
-
be carried under the coinsurance clause
A n actual case was of a property worth
insured for A fire occurred and the loss was
T h e policy carried the 8 0 % coinsurance clause .
8 0 % of is hence the insurance
carried was one fourth of what should have been carried
-
and the loss paid was one four th of -
or
5O bj
. e ct of C o in s u r a n c e C la u s e
The obj ect of the coinsurance clause is to make the
p remium to be paid proportionate as much to the value
of the property as to the risk involved Few fire losses .
are total ; the great maj ority are only partial losses I n .
VALUA T ION OF A SS E T S—LIA BI LI T I E S
a well constructed building in which few if any com
-
bu st ib le materials are handled and which is properly
protected by suitable precautions a fire may never be ,
able to spread to the extent of causing more than 2 0 %
5
to 0 % of damage to the value of its contents while ,
the build ing itself may be practically fire proof -
.
I f property worth is insured for only
because this is the extent of any likely loss and ,
Similar property of like v a lue where mortgage loans
have to be protected is forced to ins u re for 8 0 % or
it can readily be seen that without the prin
c iple of coinsurance there would be no way of establish
ing an e quitable relationship among di fferent insurers .
A s one of the primary obj ects of insurance is to
e q ualize the r ate of insurance on similar classes of
pr o pert y the principle of a fixed relation between the
,
property insured and its value must be made part of the
polic y T here is no special magic about 8 0 % or 7 %
. 5
coinsurance Policies are required by a mortgagee or
.
re q uired by the banks when loaning money on real estate
collateral and the insurance demanded in such cases
,
is always sufficient to cover every possible chance of loss .
8 0 % represents this unless the risk i s exceptional in ,
which case ful l insurance is demanded and the full
loss is paid .
6 . A p p o r t io n m e n t of Lia b ilit y and a C o in s u r a n c e C la u se
I nsurance above a certain amount or of more than
average risk is invariably distributed over two or more
companies the companies themselves often deciding
,
u pon the method of distribution When the risk is so.
distributed the question arises as to the amount each
,
I E LO SS A D J U ST M E N T S
F R 2 71
compan y shall be c a lled upon to pay un der the terms
of the coinsurance clause T o illustrate th e method of .
solvin g the problem assume that the value of the prop
,
e r ty is the loss and that thr ee po l i
cies have been ta ken out as follows
C om p a ny A
C om p any B
C om p an
y C
liability of each company is determined by divid
T he
ing the amount covered by its policy by 8 0 % of the total
value of the property then multiply ing the result by
,
the amo u nt of the loss T h e calculations follow .
C om pan y A of
80 % of
C ornpan y B o f
80 % of
C om pa ny C of
80 % of
The loss to the insured on account of the operation
of the 8 0 % coinsurance clause is shown below
C om p ny a
Appor tio nm n t I n ur n
e Lo P s a ce ss ay s
C om p n y A
a
C om p n y B
a
C om p n y C
a
Lo ss ur d n
to in s e o a cc ou nt of o pe r o
a ti n o f 80 % co
in s u r nce c l u s e
a a
2 72 VALUA T ION OF A SSE T S—LIA BILIT I ES
7. In v e n t o r y V a lu a t io n
When the stock of merchandise is destroyed and per
e tu al inventory records are not available to compute its
p
value the value is usually determined by taking the sales
,
total S ince the last inventory and deducting therefrom
the average gross profit of one or more preceding year s
or fiscal periods T he procedure the source of the fig.
,
ures and the method of presentation are explained in the
,
following statements
A SC E RT AI N M E N T OF P R F T R T O I A IO
I n v ent or y J n u r y
,
a a 1, 19 1 9
P ur h s c J n u ry
a es , .
a a 1 , 1 9 1 9 , to J nu ry
a a 1, 1 9 2 0
I n v e nt or y J n u r y
, a a 1, 1 9 2 0
Ba l an ce c o st of m e r ch andi s e s old d ur in g y r ea
Sa l e s pe r Sa l e s Bo ok
C os t a s ab ov e
G ro ss P rofi t s
2 0% of C o st V lu ea of or of Sa l es
V lu e
a of
A SC E RT AI N M E N T O F ST O C K O N HAN D
D a te of Fir e A pr i l 1, 19 2 0
I n v e nt or y J n u r y 1 1 9 2 0 (
,
a a , as a bov e )
P ur ch se s p a b ook J nu r y
, er s a a 1 to A pr i l 1, 1 9 2 0
F R I E LO SS ADJ U ST M E N T S 3
2 7
Sal es , pe r b ooks J n ua ry
a 1 to A pr il I,
19 2 0
Le ss P rofi ts ,
as e s ti m a te d
a bo v e
C o st o f Go od s So l d
Ne t V l ue
a St oc k on H an d, A pr il 1, 19 2 0
8 . A c c o u n tin g fo r Fir e Lo ss
The entries requir ed to record the fire loss and a d
j ust the asset values o n the books are comparatively
”
s imple A special asset account ca lled Fire Lo ss or
.
”
“
Fire A dj ustment is set up on the ledger and charged
with the extent of the damage O ffse tting credits are .
made to the asset ac counts a ffected by the fir e An ill us .
tr a t iv e j ournal entry is :
Fi r e L o s s A d j u s tm e n t
M h in r yac e
R w M t ri l
a a e a s
M n u f tur d G od s
a ac e o
T o r e rd t h e mou n t f l o s d e t fi e
co a o s u o r
nd
a oll t ib l from t h Bl nk I ns r
c ec e e a a
n e
a c C om p ny w h e n t h e lo s s is
a
p ro v d e .
When the loss i s adj usted and payment is made the ,
entry as sumin g that the liability of the company is
,
foun d to be three quarters of the a b ove loss would be
-
C as h
S ur p lu s
F i r L o ss A d j u s tm nt
e e
T o r ord t h e r e ce ipt f t h in ur n
ec o e s a ce
cl a im n d lo s in ur r d by t h
a s fi c e e re .
2 74 VALUAT ION OF A SS E T S—LIA BILIT I E S
T he
loss is charged to S u rplus so that the cu rrent
profit and loss figures are not a ff ected thereb y .
9 . De p r e c ia t io n Fa c t o r
T he factor of depreciation often complicates both the
adj ustment and the bookkeeping entries required to
record the loss T h e company is onl y liable for the de
.
p r e c ia t e d value of the fixed assets and if adequate ,
records are not available to Show the shrinkage in value
or if such values as are Shown on the books are less than
the actual values destroyed the appraisers generally ,
fail to agree and the matter is submitted to the umpire .
T o illustrate the accounting requirements where depre
c iat io n records are not available and the values placed
upon the assets destroyed have to be taken from in co m
p l e te data assume
, the following facts
A fire destroyed the store and stock of a retail busi
ness When the safe was opened the books revealed the
.
following facts concerning the merchandise :purchases
amounted to sales amounted to fur
n itu re and fixtures were entered upon the records at
and the store building was carried at
T h e average gross profit agreed to by the ad j usters was
40 % of sales T h e insurance companies agreed to pay
5
.
7 % of the book value of the furniture and fixtures ,
9 0 % of the value of the store building and the entire ,
loss on the merchandise stock T h e j ournal entries fol .
low
I nv e nt or y ( n ew )
M e r ch a n d is e P ur ch a s e s
To r ord t h v lu e o f th e in v en tory
ec e a at
t h t im e f th e fi e
e o s f ollow
r a s
FI RE LO SS A DJ U ST M E N T S 5
2 7
Sa l e s
C o st o f s l
a es
I n v ento r
y
Fir e L oss
I n v e nt or y ( n e w )
T o c h r ge in ur n a c om p n y w ith
s a ce a
om pl ete l o s f in v n t or y o f go d s
c s o e o
o n h nd w hich lo ss om p ny w ill
a ,
c a
p y in f ull
a .
Fir e L o ss
Su p lus
r
Fu rnitur e n d Fix t ur e s a
T l e ut t h e l o s n fu n itur n d
o c os o s o r e a
fi x tur es 75% to be r e ov e r e d n d th e
, c a
b l n ce ch r ge d g in s t S ur plu s
a a a a a .
Fi r e L o ss
To l
c o se ou t th e lo s s on s t or e b u il d
in g —9 0 % to b e r ov r e d n d t h
ec e a e
b al a n c e ch a r ge d g in s t Surp lu s
a a .
T he posting of the above entries to Fire L oss account
sets up a claim again st the insurance company for $ 61
5
,
12 as below :
,
FI RE L o ss
19 19 M r h di I e c an se nv e n
t ory ( w) ne
Fur it ur
n d F ix tur
e an es
St or e B i u lding
2 76 VALUA T ION OF A SSE T S—LIA BI LI T I E S
W hen the claim is paid the above account is closed , ,
the o ff setting debit being to C ash for the amount r e
c e iv e d .T h e two debits to S urplus
r e p resent the ca p ital loss caused b y the fire .
R EVI E W QUE ST ION S
W h at u s u ll y o n s id r e d goo d e v ide n ce o f th e v lu e o f prop
is a c e a
et t y d e s t ro ye d b y fi e ? r
H ow e fi e in s ur n c d is o u te s re g r ding th e v lu e o f pro pe rt y
ar r a e a a
u s u l l y s tt l ed ?
a e
D e s r ib c o in s ur n ce
c e a .
H ow is th e l i b il ity f e ch ins ur n ce c om p ny d ete rm ine d w h en
a o a a a
t h e r is k i d is t r ib u te d ?
s
I n d i te by x m pl e h w profi t r t io i s r t in e d
ca e a o a s a ce a .
G iv th e n t r y r q u i r d t s h ow th e r c ov e ry f rom th e in u
e e e e o e s r
a n e c om p ny fo 8 0 % o f th e v lu e o f pro pe r ty d e st roye d by
c a r a
fir e .
C H AP T E R XX I
THE B AL AN C E S HE E T
1 . De fi
n i tio n
A ba lance sheet is a statement showin g the fina ncial
condition of a bus iness at a specific date vizits assets ,
.
,
and liabilities the capital employed as well as any r e
, ,
s e rves s u rplus o r deficiency there may be A state
, , .
ment of assets and liabili ties would contain the same
elements as a balance sheet but an attempt has been ,
”
made to restrict the u se of the term balance sheet to “
such a statement made up from facts recorded in double
entry books of account an d to use the term statement
,
“
”
of as sets and liabil ities in co nn ection w ith a statement
of such facts made up from other sour ces .
2 . Im p o r t a n ce of Ba la n ce Sh e e t
O f all statements the balance sheet is the most im
port ant as a means of presentin g the financial condition
of a business not onl y to the proprietors but also to out
siders who for various reasons are in terested in its
fin ancial status I f the busin ess is that of a corpora
.
tion every stockholder is entitled to receive a copy of
,
the balan ce sheet so drawn up as to make its reading in
tell i gible to the la yman E very appli cant for a bank
.
loan or other credit m u st prove hi s right to the loan and
mus t show caus e why he dese r ves it A balance sheet .
,
support e d by a profit and loss statement when necessary ,
is the m odern accounting means to this end .
2 79
2 80 F I NAN C IAL ST A T E M E N T S
3. Fo r m of Ba l a n c e Sh e e t
A balance sheet is not an account nor is it the state ,
ment of an account I t is simply a statement of assets
.
,
li abilities and net worth arranged in whatever form
,
best suits the purpose in View Wh en arranged in .
statement form with the assets appearing first followed
,
by the liabilities and net worth it is called the report ,
form W hen arranged with the assets on the left Side
.
and the liabilities and net worth on the right Side it is ,
called the account form A balance Sheet therefore.
, ,
cann ot be said to have either a debit or a credit side .
T his flexibility has led to the sho wing on most E nglish
balance sheets of the liabilities and net worth on the left
side and the assets on the right side T h e American .
practice which is the reverse of the E nglish method and
,
which in some respects seems the more logical method of
presentation is based on the practice of the continent
,
of E urope I t is pr o fitle s s to discuss the origin of the
.
di fference in methods and their respective merits .
O pinions vary concerning the matter and no satisfactory
reason can be advanced as to why one method is to be
preferred to the other S o long as the balance sheet
.
presents the assets liabilities and net worth in a form
, ,
which gives the information required for a particul ar
purpose it fulfils its mission
, .
T h e question as to form thus reduces itself to the
respective merits of the report or statement form or the
account form A S a general rule to which exceptions
.
,
may be made it may be stated that when the number of
,
items are few it is advisable to use the statement form ;
,
whereas when the items are numerous it is unquestion
,
ably better to present them in accoun t form T h e in .
THE B ALAN C E S HEE T 2 81
formation presented on the balance Sheet is then much
easier to read as liabilities can more readily be com
,
pared with assets and conclusions drawn therefrom .
4. A rr a n ge m e n t o f C o n te n t —A s s e ts
I n considering the arrangement of the groups of
items on the balance Sheet much depends upon the pur
,
p ose it is to Serve O ne of the most common purposes
.
,
as already indicated is the submission of a balance sheet
,
as a basis for a request for credit When for example .
, ,
the compilation is to be submitted to a credit man a ,
financial rating concern or a bank cashier the liquid or
, ,
curr ent assets are usually of more interest than the
fixed assets and therefore the current assets Should ap
pear first o n the left side o ffset by the current liabilities
,
on the right Side A credit man would ordinarily dis
.
regard the fixe d assets in arriving at his conclusions r e
garding an application for credit H e would examine .
,
however the amounts of all current assets and current
,
liabilities and also the di ff erence between their total
amounts in order to ascertain the working capital avail
able for the satisfaction of creditor s claims ’
.
T h e listing of the fixed assets first is to be preferred
only when the chief interest in the balance sheet is
centered in the amount of the capital invested in prop
e r t ie s and the growth of such investment Such would .
usually be the case with railways steel corporations and , ,
other concerns where the ratio of the fixed assets to the
floating assets is large and where the stability and mag
nitu d e of the enterprise is in itself a guarantee of its
credit rating I n the maj ority of cases however chief
.
, ,
interest c enters in th e li quidity of the assets of a con
2 82 F I NAN C I AL ST A T E M E N T S
cern The ability to p ay dividends to extend the sales
.
,
market by carrying large stocks of merchandise and t h e ,
possession of su fficient liqui d assets to meet a ll credit
obligations without impairing working capital—these
are the points of chief interest to the maj ority of out
siders For these reasons the current assets usually
.
appear at the head of the statement .
I t Should be understood however that the question , ,
as to whether the fixed assets shall be shown first fol
lowe d by the current or whether the current Shall head
,
the list followed by the fixed is not particularly im
portant T h e important point is to adopt one plan and
.
follow it consistently for both assets and liabilities .
When c u rrent items are stated first the assets Should ,
be listed in four main groups as follows :
1 . C urrent assets in the order of their availability
to a going business .
2 . T angible fixed assets in the order of their
money values the largest amoun ts appearing
,
first
3
.
. I ntangible assets in the order of their amounts .
4 . Deferred charges in the order of their amounts .
5A. r r a n ge m e n t of Lia b ilit ie s
general arrangement of the liability items ma y
T he
be state d as follows :
1 C urrent liabilities in the order o f their liquida
.
tion with the most pressing items first
, .
2 Fixed liabilities according to importance and
.
amount or in the order of their permanency
3
.
,
Deferred credits in the order of their amo u nts
. .
4 N et worth in proper det ail
. ,
T HE B ALAN C E S HE E T 2 8 3
C apital consist ing of prop rietorship or capita l
, ,
s tock plus surpl u s represents the inves t ment in the busi
,
ness or th e ex ce ss of asse ts over liabil ities T h e bus i
, .
ness partnership or corporation doe s not owe thi s
, ,
amount in the sa me sens e that it clearly owes c re ditors
for liabili ties T h e proprietors or stoc k holder s own the
.
busin ess and therefore the bus iness ca nnot be said to owe
them for their investment C apita l is not a liab ility but
.
an acco un ta bility For balance sheet pur poses how
.
,
ever th e cap ital is usu ally shown foll o wi ng the liabi lities
,
so that their combined to ta l may e qual the total of the
as sets T hus ha ve be en evolved the titles of L iabili ties
.
“
and C apita l and L iabilities C apita l S t ock and N et
” “
, ,
Worth as applying to the section of the bala nce shee t
,
where the ca p ita l and liabilities are sho wn I n the cas e .
of a corporation the capita l will consist of the outstand
,
ing ca pita l s t ock plus the S urplus or minus the Deficit .
C apital st o ck may cons ist of preferred s t ock and com
mon st ock and sub div isions of each clas s and the out ,
standing amo u nt may not ab sorb the entire authorized
capita l A ll of the s e facts should be st ated c le arlv on
.
the balance sheet U sually the authorized amoun t is
.
shown ; then a deduction i s made for the uni ssued stoc k
and th e outstandin g amoun t is ext ended a s a net item
enterin g into the to ta l of that side of the balance sheet .
7. Sh o w in g of De fi c it
I f a deficit ex ists that is if the aggrega t e of liabili
, ,
ties an d ca pital stock is greate r than the total as sets ,
then to the extent of the excess there is an impairment
o f cap ital I t follows logical l y that the amount of the
.
, ,
2 84 F I NAN C IAL ST A T EM E N T S
deficit may be shown as a deduction from the amount of
the capital stock on the balance Sheet and for emphasis , ,
the deficit may be stated in red ink T h e above method .
of showing a deficit will p ermit of a balance ; that is the ,
liabilities plus the capital stock less the deficit will equal
the total assets S ome accountants Show the deficit on
.
”
the asset side o f the balance sheet to permit of a bal
“
an cin g to an e qual total but as indicated above the r e
, ,
sult can be accomplished under the plan suggested here
and a more logical statemen t is presented Deficit is .
never entitled to a place among assets I f the deficit is .
larger in amount than the capital stock the excess of lia ,
b ilit ie s over assets Should still be Shown in red ink as a
”
deduction on the liability sid e of the balance sheet
“
.
8 . Sh o w in g of Re s e rv e s
A ll reserves for depreciation or extinguishment of
fixed assets and all reserves covering the Shrinkage in
value of current assets are as already explained valna
, ,
tion accounts and should preferably be Shown on the
balance sheet as deductions from their correlative assets .
Such reserves are not liabilities nor are they part of ,
surplus T heir creation is necessary to Show the true
.
amount of the assets to which they apply and which
Should be reduced accordingly .
T h e reserves which are not set aside to meet shrink
ages in asset values but which eventually revert to sur
plus have been c onsidered in C hapter VI I T hese r e .
serves should be stated as a sepa rate section of surplus .
9 . C o n d e n s a t io n of It e m s
A s the primary reason for a balance heet is to
S
T HE B ALAN C E SHEE T 2 8 5
exhibit asse ts and liabilities under groups and headings
which summarize the information obtained from the
books of account the question arises as to how far the
,
condensation may be properly carried T his depends .
largely upon the use to which the balance Sheet is to be
put T h e obj ects in all cases are truth and clarity
. .
Detailed information which may be necessary for the
guidance of the management of the business or for
internal use may be meaningless and confusing to out
siders T herefore the information on a balance sh e et
.
,
to be submitted to stockholders and the public may well
be condensed under a few main headings the meaning
of which is clear to most business men .
C ondensation however may be made a convenient
, ,
method of misrepresenting facts by their concealment ;
for this there is o f cour se no j ustification A s a gen
, ,
.
eral rul e the fewer the number of group s and the items
within a group consistent with truthful statement the
, ,
better When the balance sheet is condensed in this
.
way and ad ditional information as to assets or liabilities
is required for internal use this information can best ,
be rendered by means of supporting statem ents and
schedules E xamples are given in a following chapter
. .
10 . Illu s t r a t iv e Fo r m of Ba l a n c e Sh e e t
A Skeleton form of balance Sheet as discussed in the
preceding section is presented below T h e fo r m r e pr e .
sents the limit to which condensation should usually be
carried A n y one or all the group s may be supported
.
by schedules whe n these are desirable for internal use
or for the information of persons interested in the de
tail o f a particular group .
2 86 F I NAN C IAL ST AT EM E N T S
C ON D EN SE D FOR M or B ALAN C E S HEE T
A s s e ts
C urr e nt A ss e t s
C a sh
No t es R v l
e ce i ab e
A cc ou nt s R iv b l
e ce a e
T ta o l
L e ss —R rv for B
e se e ad De b ts
I v
n e nt ori es
r l
R a w M a te ia
G ood in P ro s c e ss
F i i h d G ood
n s e s 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0
o l C urr
T ta e nt A sse t s
F ix d A t
e s se s
I nv t m t
es en s
Pl t
an d E qu ipm t
an en
L d an
B u ild i g n s
M h i ry
ac ne
T ool d E q u ipm t
s an en
Furnitur d F ix t ur
e an es
o l
T ta
L —R
e ss ese rv for
e De pr e c ia
P at e nt s
o l F ix d A
T ta e sse t s
De f rr d Ch r g
e e a es
U n xp ir d I ur
e e ns anc e
P r p i d I nt r t
e a e es
o l
T ta De f rr d
e e Ch a ge s r
T H E BAL AN C E S HEE T 2 87
L ia b il itie s an d C apital
F ix d Li b il iti
e a es
M ort g g P y bl
a es a a e
Long T rm N ot
-
e es Pa y bla e
o l F ix d L i b iliti
T ta e a es 0 0 0 0 0 0 0 0 0
D f rr d C r d it
e e e e s
Un rn d I om
ea e nc e
p l
C a it a
P r f rr d St o
e e e c k
A uth oriz d e
Unis u d s e
C ommo S to n c k
A uthorizd e
U ni u d ss e
u
O t st an i n g d f
0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0
T ta o l C apit a l
T he
Federal R eserve Board re commends the follow
—
ing an excellent example o f the account form con ,
taining headings wh ich g ive complete information and
Show some details of interest usuall y omitted .
2 88 FI NAN C I AL ST A T E M E N T S
F D E E RAL RE S E RVE BOA RD
A s s e ts
1a . C as h on h and —r c u re n c y a n d co in 0 0 0 0 0 0 0 0
1h . C as h in b a n k
N R
3N
ote s a n d A c c ou n t s e ce iv ab l e
otes r e c e iv ab l e o f cu s t o m e s r h an d ( n ot p a st due )
5N
. on .
. ote s r e ce iv a b l e d is cou n te d or s ol d w ith in d o r s e me n t or
gu a r a n t y
A
o o o o o o o o o o o o o o o
7 . cc ou n t s r e ce iv ab l e , c u s t om e r s ( n ot p as t d ue )
9 N ot e s r i e c e v ab l e , c u s to m e r p a st d ue ( ca sh v a lu e
A
. s,
11 . cc ou n s t r e ce iv ab le , cu s to m e r s, p as t due ( c as h v alu e
1 3r P ov i s ion s f o r b a d d e b ts
5
. .
1 . P r ov is ion s for d isc ou n ts , f r e ig h t s , al l o w s
’
.
In v ento ri es
1 7 R aw m ate i al
. r on h and
p
—y
19 . Goo d s in r o ce ss
2 1 . Un co p
m le te d c o n tr a ct s
L es s P a m e n ts on ac c ou n t th e r f eo
2 3 . Fin is h e d go od s on h an d
O th e r Qu ic k A ss e ts ( d es c b e fu ll ) ri y
T ot al Qu ic k A s s e ts ( e x clu d in g all in v e stm e n ts )
S e cur itie s :
2 5S ri i . e cu t es r e a d il y ma rk e t a b le a nd s al ab le w ith ou t im
p iria ng th e b u s in e s s .
2 7 N o te sg iv e n b y o ffi c e s , stoc h ol d e s , or e m l o e e s r k r p y
A
.
2 9 . r
c c o u n ts d u e f om o fii ce r s , s to c h ol d e s , o r e m lo k r p y ee s .
T ota l C u r r e nt A ss e ts
3
Fixe d A s se ts
p
3
3B
1 . L an d u s ed fo r l an t
3
u il d in gs u se d fo r p l a n t
5
.
y
3
. M a ch i n e r 0 0 0 0 0 0
p pm
3 r
7 T o ol s
. and l an t e qu i e nt
9 r. P atte n s an d d a w i n gs
3 r
41 O fii c e fu r n itu r e and fixt u r e s
y)
.
4 . O th e fixed a s se t s , if a ny r
( d es c ib e fu ll
4 5R r
. ese v es for d e pr e c iat ion 0 0 0 0 0 0 0 0
T ot al Fixe d A ss e ts
De fe r r ed Ch a ge s r
47 P re . p id x p
a e e n s es , in te r es t, in s u r an ce , tax es , e tc .
Oth e r As se ts ( 49 )
Total A s se ts.
THE B ALAN C E SHEE T 2 89
F O RM OF B ALAN C E SH E ET
L ia b il itie s
B ills N ote s , an d A cc ou n ts P a y bl a e
:
,
Un sec ur e d B ill d N o te s
A p
s an
2 . c ce m d f
t an ce s m h di a e or er c an se or r aw m ateri al
p h dur c a se
4 . N i f m h di
o te s g v en w or erc an se or ra m at e r ial pr
u eh .
6 . N i
o t es g b k f m ybr
ve n to an s or on e o r ow e d
8 . N ld th r
o te s h b
so k ou g ro er s
N i f m hi y ddi i pl
3
10 . o te s g ven or ac ne r , a t o n s to an t, e tc . .
12 N d ote s k h ld r ffi r
ue to s t oc o e s, o ce s , or e m pl y
o ee s
A
. .
Un s e c u r ed c c o u n ts :
14 A c c o u n ts p bl fo r p rh ( n ot y et du e )
A
. ay a e u c as es
16 c co u n ts pyb l e fo r p rh ( p as t due )
A
. a a u c a s es
18 . c co u n t s p y bl
a a e to s oc t k h ld o e r s , o fii ce r s , o r e m pl yo e es
Se c u rde L i abili t ies
2 0a . N o te s r e ce iv ab le d is co u n te d or s ol d w it h in d o r se
m e n t or gu a a n t ( co n t r a ) r y
Cu s to m e s r
ac c o u n t s
’
d is c o u n te d or a s s ig n ed ( c on
tr a )
2 00 . O b lig a t io n s s e cu r e d b y li e n s on in v e n to r ies
2 0d . i
Ob l ga t io n s se cu rd e by se cu ri i
t es de p os ite d as c ol
l a te al r
2 2 . A r
cc u ed l i ab il it ie s ( in te r es t , t ax e s , w ag e s, etc .
)
O th e r Cu r re nt Liab il it ies r
( d e s c ib e f ul l ) y
T o ta l Cu r r e nt L iab li t ie s i
3
Fixe d L i ab ili tie s
2 4 . r
M o t g age on pl an t ( d u e d a te )
2 6 . r
M o t g ag e on ot h e rr e al e s ta te ( d u e d at e )
y pm
3
2 8 . C h a tt e l m o rt g a g e on m a c h in e r or eq u i ent ( d u e d ate ) .
0 . B on d e d d eb t ( d u e d ate )
3 2 . O th e r fix e d li ab il t ii es ( d e s c ibe r f lly )
u
Ne t W o rth
To tal Liab ilitie s 3
3 rp r
3
4 . If a co o a t io n
( a ) P r e fe r r e d s to c ( le s s s to c in t e a suk k r ry )
( b ) Co mm o n s to c ( le ss s to c in tr e asur ) k k y
p
( c ) Sur l u s a nd un d ivid e d ofits pr
3
3
.
B oo k v alu e of good
-
w il l
( e ) De ficit
3I f p
3
6 . an i n d ivi d u al or a r t n e rs h ip
( a ) C a it al p
(b) U
n di s t ib u te d r pr o fits or d fi it
e c
To tal 3
2 90 F I NAN C IAL ST A T E M EN T S
11 . C o m p a r a t iv e Ba l a n c e Sh e e t s
’
I n the writer s opinion a balance sheet has not fully
served its purpose unless it shows a comparison item ,
for item with the last preceding balance sheet T hus
3
, .
,
a balance sheet as of D ecember 1 1 9 1 9 should be com
3
, ,
pared with one as o f December 1 1 9 1 8 Many ac
“
, .
c o u n t an t s invariably present balance sheets in compara
tive form for three years I n large corporations where
.
monthly balance sheets are issued to the executives it ,
is very often the practice to Show the amounts for each
item at the various dates in columns from left to right
as follows
A mounts at end of month for period under r e
View .
Am ounts at end of previous month .
Am ounts at end of month one year previous
to month in first column .
T he form is sometimes varied to include a balance sheet
as at the first of the current year or a col u mn indicatin g
increases and decreases in each item from the end of the
previous month or since the first of the year Any of .
the above variations will produce an effective statement
which will be acceptable to most executives especially ,
if it is accompanied by a comparative earning statement .
12 . Sp e c ia l Po in t s
liabilities for notes receivable di s
C ontingent
counted may be disclosed o n a balance sheet in the form
of a foot note or as o ff setting contra entries T h e form
-
.
is not important but it is important that information r e
T HE B ALAN C E S HEE T 2 91
gardi ng contingent liab ilities should n ot be omi tt ed
from the balance sheet .
A nother item often erroneo u sly omi tted from
balance sheets is the accountabili ty for un paid cumula
tive dividends on preferred stock T hese di vidends do
.
not constitute a liability until declared by the directors ,
but the fact that they must be p aid before any dividend
on the common stock i s often of paramoun t importance ,
especially to common stockholders .
C redit balances in the accounts receivable ledgers
should be shown on a balance sheet under acco u nts pay
able and conversely debit balances in the accoun ts pay
, ,
able ledgers should be indicated as acco u nts receivable ,
but the items should be properly described to di fferen
t ia t e them from other accounts usually liquidated in
cash T h e above rule needs no explanation but the
.
error i s often made of showing the net balances of the
ledgers as the total of accounts receivable and accoun ts
payable in spite of the fact that such opposin g bal
,
a n c e s in the accounts of customers and creditors usually
indicate allowances and claims which are to be settled
in merchandise or be applied against future tr ans ac
tions .
A ccounts and notes due from or payable to , ,
proprietors or corporation o fficials should always be
stated as separate and distinct items on the balance
sheet and should never be merged W ith other accounts
and notes receivable or payable I n many cases such
.
an item is merely a different form of cap ital investment
although it may not be so treated T h e reader of the
.
balance sheet shoul d have the benefit of that informa
tion for obvious reasons .
2 92 F I NAN C IAL ST A T EM E N TS
1 3
. Tie Up Be t w e e n Ba l a n c e Sh e e t
-
an d In c o m e St a t e
ment
A definite reference from the balance sheet to the
income statement or vice versa is absolutely essential .
T his reference is u sually provided through the transfer
of net profits from the income statement to the Surplus
account on the balance sheet but it may also be s e ,
complished by adding the surplus at the beginning of
the period to the net profits on the income statement and
thus establishing on the income statement the total of
the Surplus account as stated on the balance sheet .
I n the first case the Surplus acco u nt on the balance
sheet would appear as follows
Ba l a n ce o f S ur p lu s at b e ginn ing of yea r
A dd —N et P rofi t s pe r I n c om e S t a te m e n t
T tao l S urp lu s —B l a a n ce a t e n d o f yea r
T he last line on the income statement would then be
labeled N et Profits for year ( carried to Balance
“
Sheet ) .
I n the case of showing the tie u p on the income state -
ment the surplus on the balance sheet would be stated
,
as Surplus per I ncome S tatement W hile the foot of
”
,
the income statement would show the following
Ne t P rofi ts for y e a r
A dd —B l a a n ce o f S ur p lu s at b e ginn ing of y e a r
o l Sur plu s
T ta at e n d of ye a r { c rr ied
a t o B al
a n ce Sh e e t )
T his
reference from one statement to the other which
”
we call tie u p should not be omitted as it indicates
“
-
completeness is in accordance with the book entries
,
T HE B ALAN C E S HEE T 29 3
trans ferring the balance of net profits to the Surplus
acco u nt and establishes a direct conn ection between the
,
balance sheet and income statement .
R eference to V olume V of B usiness A ccounting
wil l give the reader several examples of balance sheets ‘
and profit and loss statements which have been ar
ranged to show their mutual dependence O bviously .
all changes in surplus due to di vidends and adj ust
ments applicable to previous years must be indicated in
addition to that caused by the current profit or loss .
When a balance sheet is intended for general distribu
tion and it is not des ired to reveal the operating result
”
for the current year the tie u p should be shown on ,
“
-
the profit and loss statement not the balance sheet , .
R EVI E W QUE ST ION S
1 . Wh e n sh oul d fix e d a s s e ts a p pe a r fir st a mo n g th e a s s et s o n a b al
a n ce sheet ?
2 . Wh a t m th o d f l i tin g s se t n d l i b il itie s on
e o s a s a a a b a l an ce s he et
is u u lly p r e fe rr d by b nk ?
3W
s a e a a
. ha t is th e g n r l ru l r g rd in g t h s h ow in g
e e a e e a e of r e s rv e
e s on a
b a l a nce s h e et ?
4 . What it e ms on a c or por ow its pit l ( in t h
a te ba l a n c e s h ee t s h ca a e
c o un t in
g e n e f c pit l ) W h t i t m s h ow its e o n om ic
“ ”
ac s s o a a a e s c
l ? ( R fe r t V olum e I C h t r I I I
ca
p i t a e p o ) , a e .
H ow m y d e fi it b e s h ow n n or por te b l n e s h eet ?
a a c o a c a a a c
H ow if t ll h ould po s ib l e j u dgm n t g in s t th e b u ine ss in
, a a , s a s e a a s
p n d in l it i t io n be in d ica te d o n b l n s h e e t ? W h t ki n d a
e
g g a a a a ce
o f l i b il i ty i
a it ? s
Wh t u e fu l pur po s
a s e s e rv e d by om p r tiv e b l n e s h e t s ?
es ar c a a a a c e
Wh t r e l ti o n i t h r b t w e n t h p rofi t or lo s
a a s e e e n n in om
e e s o a c e
t t e m n t n d t h e ur p lu
s a e a h ow n n c or por b l
s t n s sh e t ? o a a e a a ce s e
C HA P T ER XX I I
PR O F I T A N D L O S S S T A T E M E N T
1 . De fi n it io n an d Pu r p o s e
A profit and loss statement is a logically arranged
analysis of the net profit resulting from the carrying on
of a business for a given period of t ime .
A s the purpose of the profit and loss statement is
to supplement the balance sheet the two statements ,
should always be rendered when it is desired to make a
full and comprehensive report of the result of financial
operations showing not only the profit or loss of a given
,
period of t ime but also the source or activities to which
such profit or loss is due T his purpose is effected by
.
drawing up the two statements in such a way as to set
forth
1 . T he profit or loss resulting from operations ,
i e the increase or decrease of the working
. .
,
capital used in manufacturing and selling or
in buying and selling g o ods or in sel ling
service .
2 . T h e expense of operation i e the amount by ,
. .
,
which the capital is decreased or given up in
exchange for such services as the business
requires
3
.
. C apital expenses i e deductions from income
, . .
,
and profit whi ch are not part of the regular
ex p ense of operation .
2 94
PR O FI T A ND LOSS S TAT EM E NT
. 2 9 5
4
. P rofit and loss charges and credits i e losses , . .
,
or gains of capital made during an account
ing period otherwise than through regular
—
operations for example the sale of a fixed ,
asset for more or less than its book value or ,
the depreciation or a ppreciation of invest
ments which are held for other than trading
purposes
5
.
. Surplus or capital adj ustments made necessary
by the operations of former periods .
T he
accounting treatment of item 4 in the above
tabulation has been discussed in C hapter X VI I and
5
,
item in C hapter VI I T h e remaining items need .
brief consideration so far as concerns their make u p on -
the profit and loss statement .
2 . Pr o t fi or Lo s s Re s u lt in g fr o m O p e r a t io n s
T he profit or loss resulting from operations consti
t u t e s the gross profit or loss T h e figures are obtained
.
by deducting from the net sales the cost of the goods
sold I n a mercantile busi ness the cost of the goods
.
sold will be the net purchase price of the merchandise
plus freight delivery insurance and carrying charges
, , ,
.
T hese items are usually shown on the statement In .
the case of a manufacturing business the cost of the
goods sold is their cost of manufacture plus carrying
charges I f it is requir ed to show the elements of manu
.
factu r ing cost in detail the information may be pre
,
sented on a separate schedule headed C ost o f G oods “
Sold—Manufactur ing Section .
T o take advantage of discounts on purchases some ,
businesses must borrow money while other businesses ,
2 96 F I NAN C IAL ST AT E M E N T S
in the same line have s u fficient money of their own .
L ikewise the amount of discounts on sales depends
,
upon the policies of the business management the need ,
for money and the class of trade served T h e discount
, .
allowed to customers is sometimes much larger than
usual because the business requires the money for a
,
working fund especially if it cannot borrow enough
,
from banks T o arrive at results from regular opera
.
tions on a consistent basis the items of interest and dis ,
count must therefore be shown on the profit and loss
, ,
statement after the net profits from the regular con
duct of the business have been reached .
3. Ex p e n s e s of O p e r a t io n
T his
class of expenses includes all those which have
to do with the regular operations of the business which ,
apply strictly to the current fiscal period and which are ,
common to concerns in that line regardless of their fin an ,
c ia l condition ; e g all selling expenses delivery ex
. .
, ,
penses general administrative expenses depreciation
, ,
when a periodical charge is made for that purpose etc , .
T h e di fference between the gross profit from the regular
sources of revenue and the operating expenses is the
, ,
earning capacity of a business and should be known as ,
”
the net profit from operations
“
.
4 . C a p it a l Ex p e n s e s
T his
class of expenses comprehends all which have
to do directly with the securing of available cash funds ;
e g .interest on borrowed moneys whether on bonds or
.
,
notes interest on overdue accounts payable and dis
, ,
counts allowed to customers for pa y ing their bills on or
P RO FI T A ND LO SS S T A T E M EN T 2 97 .
before a ce rtain date Any moneys received on de
.
posits notes receivable or overdue accoun ts receivable
, ,
are o ffsets to the interest paid and discounts allowed .
T h e net result of interest and discount items may be a
debit or a credit balance depending very largely upon,
the financial condition of the business its requirements ,
for ready cash the cleverness of the financial manage
,
ment and the class of trade dealt with
, .
L oss on bad accounts must also be included with
capital expenses l V ith most busin esses thi s loss is a
.
recurring item which must be taken into consideration
before the net profit can be truly shown for a given
period I t varies from year to year such variations de
.
,
pending largely o u the class of trade eagerness to sell , ,
the ability of the credit man and on other conditions ,
which cannot be foreseen .
W he fi a profit and loss statement is compiled the ,
prospective loss on bad accounts during the subsequent
month or fiscal period as the case may be should be esti
, ,
mated and shown underneath the items of interest and
discount T o arrive at the net profit for the period if
.
the net result of the interest and discounts is a debit ,
the estimated loss on bad accounts should be added to it
and the su m of the two amoun ts deducted from the net
profit from operations ; if the net balance of the interest
and discount items is a credit then the difference b e ,
tween that credit and the loss on bad accounts should be
added to or deducted from the net profit on operations ,
as the case may be E xtraneous items of income and
.
exp ense may also be shown on the profit and loss sta te
ment as additions to and deductions from the net profit
, ,
on operations .
2 98 F I NAN C IAL S TA TE M E N T S
5F . o rm of Pr e se n t a t io n
T heprofit and loss statement like the balance sheet , ,
may be presented in either the account form or the re
port ( statement ) form O f the two m e thods the one
.
,
most commonly employed is the report or run ning form
because in this wa y the final figure at the bottom of the
statement shows t h e net profit very clearly T h e .
method of presentation previously described relates to
the statement form When the account form is used
.
,
the sales or main items of income are placed on the one
side and the direct costs of the items of income in the
,
same order on the other side T h e balance of the two .
sides is then brought down as gross profit or loss .
A gainst this are set up the groups of selling and a d
ministrative expenses T h e di ff erence between the two
.
sides is again brought down and co n stitu t eg the net
o perating profit or loss to which are added other items
,
of income A fter the expenses of financing the business
.
are set up against the net O perating profit the balance ,
remaining represents the net profit available for d is tr i
b u t ion or the net loss T h e amounts declared as divi
.
d e n d s or carried to reserves or surplus are t h en shown
opposite the net profit in this way b alancing the two
,
sides of the statement .
6 . Illu s t r a t iv e Fo r m of St a t e m e n t
skeleton form of presentation given below is the
T he
one suggested by A L owes D ickinson in A ccounting
.
”
Practice and Procedure I t should be understood that
.
the form of presentation and method of showing the
profit and loss items may be varied to suit the use to
which the statement is to be put and the information it is
PR OFIT A ND L O SS ST A T E M EN T 2 99
des ired to set forth A n agency or commission busi .
ness a bank or transportation company would show in
,
the upper part of the statement its earnings from opera
— —
tions instead of from sales from which earnings the
expenses of management would be deducted to deter
mine the net profit from operations From this point .
onward the form for all profit and loss statements would
be practically the same .
M ANU FA C T URI N G A ND M E R C HAN D I S I NG FO RM O F
P RO FI T A ND L O SS ST ATEM E N T
G ro l
Sa
—R tur
ss es
L e ss e ns , A ll ow ance s, a nd Disc ou nt
Ne t E a r nings from S l a es
De du ct -
C o t of G ood
s s S old
G ro ss P rofi t
De du t c
C o t of S ll i g
s e n
A dmini tr t iv E xp s a e e nse
Ne t P rofit from O p r tion
e a s
O the r I om nc e
D du t :
e c
I t r t Bo d
n e es on n s
O th r F i x d C h r g
e e a es
Surplu for y r s ea
E x t r ord i ry P ro fit
a
( D t il d )
na s e a e
S urplu b rou gh t forw rd from pr
s a ec e d ing y r
ea
De du t—Ex t r ordin ry
c a a Ch a ge s r
o l Surplu
T ta s Av a il a b e l
Div id nd n e s o St o
c k s
S urpl us ca rri d forw rd
e a
3 00 F I NAN C I AL ST AT E M E N T S
7 . Fe d e r a l Re s e r v e Bo a r d Fo r m
co mmittee of the Federal R e se r ve B oard in
T he ,
the interest of uniformity in accounting has drawn up ,
a skeleton profit and loss statement form for the use of
manufacturers and merchants with the suggestion that ,
such a statement should cover the operations of the past
three years T his form gives a little more detail than
.
the one presented above but in principle the method of “
showing is the same T h e form is reproduced herewith . .
F D E E RAL E RVE BOAR D FOR M O F C O M P ARA T IVE
RE S
ST A T E M E N T O F P RO FI T A ND L O SS
Y r Y r ea ea
E nd d E nd d e e
19 19
G ro S l
L s —O utw rd Fr
ss a es
e s a e igh t, A llow a nces,
d R t ur n
an e s
Ne t Sal e s
I v ory
n e nt b e ginning of y r ea
P ur h c as e s, Ne t
L —I nv
es s e nt ory e nd of y r ea
C o stof Sa l es
G ro ss P rofit on Sa l es
ll
Se ing E xp e n se s ( ite miz e d to c orr e
spo nd w ith l d g r e e a cc ou t
n s
kp e t)
T tao l S ll i g Exp n
e n e se
Ge n r l E xp
e a ( it m iz d
e n se s e e to c orr e
p d s with l d g r
on e e a cc ou nt s
k pt ) e
T ta o l Ge ne r l a E xp e n se
P RO FI T A ND LO SS S T A T E M EN T 3
01
c orr es p o d with l d g r
n e e ac
O th e r I nc om e
I r
nte es t o n No tes R v l
e ce i ab e, e t c . .
I r
n te est on o d d D bt
B n e e
I r
nt e es t o n Not P y bles a a e
Ad
—
Ne t I ncome Pr ofit and Lo ss
m i al C re di ts t o P ro fit and
De duct —p S e ci a l r
Ch a ges t o P rofi t an d
Lo ss
P ro fit andL for p ri od
o ss e
S urplu s be ginnin g of p r iod e
Di vid e nds P ai d
S urpl us a t e nd of p r iod
e 8
8 . Su p p o r tin g Sc h e d u l e s
A s the main obj ect of the financial statement is to
present a condensed and as it were a bird s e v e view of , ,
’
-
the r e sult of operations it is unnecessary to p rese nt all ,
302 F I NAN C IAL ST A T E M E N TS
that detail which explains how the figures of the main
items which appear on the statement are made up T his .
detail when required is presented in separate schedules .
T h e first supporting schedule of the statement of a
manufacturing concern is usually that of the cost of
goods sold O ther schedules may also cover selling and
.
administrative expenses and may comprise lists o f ac
counts receivable and trade creditors I n short an .
,
analysis may be made of the figures o f any item which
appears on either of the two principal statements if such ,
analysis is of interest to the individual concern E x .
amples of suc h sch edules are given in the following
chapters .
R EVI E W QUE ST ION S
W hat is arofi t n d l o s s st t em nt ?
p a a e
W hat l s s ifi c tio n mu t b e d is tin ct l y m aint ined in a profi t
c a a s s a
a n d lo s s s t t e m e n t ?
a
H ow sh oul d in te r e s t e r n ed b sh ow n o n a p rofi t and l o s s s tate
a e
m ent ?
G iv e e x am pl e s o f c pit l e x pe n se s
a a .
H ow sh ould s l e s r e tur n s b e h ow n on profi t and l o s s st t e
a s a a
m e nt ?
W h t im por t n t s u gge t io n d o e th e Fe d r l Reser v e Boa r d
a a s s e a
m k e in egard to profi t an d lo s s s t te m ents ?
a r a
C HAP T E R XX I I I
S T A T E M E N T S O F A M AN UF A C T UR I N G
BUS INE S S
1 . Co n s ti tu e n t Pa r t s of Re po r t
followin g group of statements cons t itutes a
T he
complete annual report o f a manufac turing concern ,
where th e assets or liabilities are not required to be
shown in detail on schedul es supporting E xhibit A ( the
balan ce sheet ) T h e report co nsists of the followin g :
3
.
1 Balance sheet D ecember 1 1 9 1 9
.
, , .
S tatement of adj us tments o f surplus as o f D e
3
2 .
ce m b e r
3Profit and loss statement for year ended De
1, 19 18 .
3
.
c e m b er 1, 1 9 19 .
S tatement of cost of goods sold d ri g year
ended D cember 3
4 . u n
e 1, 1 9 19 .
2 . Ar r ang e m e n t of Re p o r t
T heconcern is a corporation and the ne t worth in,
d ic at e s that the stock is worth $ 1 2 9 per share .
O n the asset side of the balance sheet th e fixed as sets
appear first follo wed by the floating as sets in the order
,
of their avai labil ity T h e defe r r e d charges to Profit
.
and L oss shoul d always appear last O n the other side .
the liabilities are arranged to conform to the order of
the assets N et w o rth should be sho wn last
33
.
0
3
04 FI NAN C IAL ST A T E M E N TS
—
E xhibit A Schedule shows entries made during 1
the year under review which must not be shown in the
current Profit and L oss account as they apply to a pre ,
vions y ear T h e first item represents an error made as
3
.
of December 1 1 9 1 8 but not discovered until after the
, ,
boo ks were closed T h e remaining entries woul d not .
have been necessary if the books had been properly
cl o sed as of December 1 1 9 1 8 T h e bookkeeper 3 , .
omitted to set up the items paid in advance and the items
accrued as of that dat e ; conse quently these errors
corrected the next year through S ur p lus account .
Fo r m of Re p o r t
A TW OO D M ANU FA C T U R I NG C O M PANY
EXHIBIT A
BALAN C E S HE E T
De ce m b e r 3
1 19 19 ,
A s s e ts
R l Ett
r —o t )
ea s a e
L nda ac e s c s
B u ild i g ( o t)
n s c s
L —R rv for D pr i tion ( 4%
e ss e se e e ec a
p er um ) a nn
M h i ry
ac ne d E q u ipm tan en
F ix d M h i ry
e ac ne
Sh f t i g H
a n g r ,P l an e s, u
ly t e s, e c .
M ov b l F t ory E q u ip
a e ac
m nt e
St b la E q u ipm t
e en
Offi Equ ipm t
ce en
L —R rv f o r D pr i tio n
e ss e se e e ec a
( 10 % p nnum ) er a
Dr wing
3
a d P tt r
s i U
an(i v a e ns n se n e nt or i d
e at
o t)
c s
ST A T E M EN T S—M ANU FAC T URI NG B U SI N ES S 35
0
Righ t ( o t )
P a t e nt s c s
L —R rv for E xti gui h m
e ss e se e n s e nt pe r
Sin ing k Fun d for Ex tingu i h m s e nt of B o d n s
3
C a sh
In Ban k s
A cc ou t d Not R iv b l
n s an es e ce a e
T r d D b t or
a e e s
L R
e ss rv for
-
e s e e
Dou b t ful A ou t cc n s
Per on l s a A ccou nt s R e ce i v bl
a e
Not R es e ce iv b l a e
I v ori
n e nt es
F i i h d P rodu t ( o t )
n s e c s c s
G ood in P ro s ( o t) ce s s c s
R w M t ri l ( o t )
a a e a s c s
Fu l d F tory Suppli
e an ac es ( c o st )
De f rr d C h r g t P rofit d L o
e e a es o an ss
I t r t P r p id N o t O u t t d i
n e es e a on es s an ng
I ur P r mium P r p id
ns a n ce e s e a
St b l S upp li
a en H nd es o a
L ia bilitie s a nd Ne t Wo r th
M or tg o nd O u t t d i g B
D t d J u ry 2 19 1 9—
a ge s s an n
a e d J nu ry
an a , ue a a 2 , 1 92 8
A ou t d Not P y b l
cc n s an es a a e
Tr d C r d it or
a e e s
C u t om r A ou t h ow i g r di t
’
s e s cc n s s n c e
b l n a a ce s
N o t P y b l ( di ou t d t b k )
es a a e sc n e a an s
I te m s A cc ru d e b u t No t D u e
I r
nte e s t o n or tg g Bo d
M a e n s
Ta x es
( es tim t d for 1 9 19 )
a e
L abo r
306 F I NAN C IAL ST AT E M E N TS
p l
C a it a St o c k ( a u th or iz
ed iss u e sh a e s r at
$ 100 )
I u d d Fully P id ( 60 0 h r at p
ss e an a s a es ar )
S urplu :
mb r 3
s
B l D
a a n ce , 1 19 1 8 d
e ce e as a
E xh ib it A —
, ,
ju t d ( s e S h dul
se e c e e
1)
Ne t P ro fit for y r d d D mb r
3
ea en e e ce e
1, 1 9 19 ( E xhib it B )
se e
L —S m i nnu l
e ss e a a Di i vd d en
d l r d J uly 1 0
ec a e , 1 9 19 17
Ne t Wor h t
A TW OO D M ANU FA C T U RI NG C O M P A NY
EXHIBIT A —S C HE D ULE l
ST A T E M EN T or A DJ UST M E N T S o r SU RPLU S
D ur in g Y r E ndea e d D e ce m b e r 3 1, 1 9 1 9
Ba l n D mb r 3
a ce , 1 1 9 18 ec e e
A dd—C r dit A dj u tm nt :
,
of D mb r 3
e s e s
E rror i I v t ory of R w M t r i l
n n en 1 19 1 8 a a e a s, a s e ce e , ,
xt d d
I t r t P r p id N ot O ut t di g of D mb r 3
$ 10 e en e as
n e es e a 1 on es s an n as e ce e ,
I ns ur an c e P r mium U xp ir d
e s ne e , as of De ce mb r e 3 1, 1 9 18
Dedu t
L b or A ru d b t N t D D mb r 3
c
a cc e1 1 9 18 u o u e, e ce e
B d A ou t
,
Lo ss on h rg d aff i 1 9 1 9 w hi h
cc n s c a e o n , c
h ould h v
s b provid d for by m
a e ofeen e e a ns a
r rv th m h b do D mb r
3
e se e, e sa e as as ee n ne on e ce e
1 1 9 19 Th i
,
t ry t dj u t th omi io
. s en o a s e ss n
Ba l a nc e , De ce mb r e 31 , 1 9 1 8, as a dj u t d s e ( se e x
E h ib i t A)
STA T E M E N T S —M ANU FAC T URI NG B U SI NE SS 37
0
A TW OO D M ANU FA C T U R I NG C O M PAN Y
EX HIBI T B
PR O FI T A ND LO SS ST AT E M E N T
Y e r E n d ed
a De c e m be r 3 1 1 9 19
C o t of G ood
s s S old ( s ee x
E hib it B —S h dul
c e e 1)
Gro P rofit from S l ( 2 0 % of S l
ss a es a es —5
% of C o t )
2 s
D du t :
e c
S lli ng E xp n
e e se s
A dv rti ing e s
S l m S l ri
’
a es en s a a es
S l m E xp
’
a es en s e nse s
A g t C ommi io en s
’
ss ns
C r d it M S l ry
’
e an s a a
M r t il R fr
e can e e e e nce s
S t o gr p h ren S ll i g D p r t
a e s e n e a
St ab l e xp E e ns e s
M is ce ll n ou
a e s
o l S l li g E xp
T ta (5 4% of e n e n se s G ro ss
P ro fit ) s
G r l A dm i i t r tiv Exp
e ne a n s a e e ns e s
Offi S l ri
’
c er s a a es
Offi H lp ce e
Offi S uppl i
ce es
Po t g T l pho
s a e,d T l e e ne , an e e
gr m a s
A ud iti g Ch rg n a es
Mi ll ou
s ce a ne s
D pr i t io n of O ffi
e ec a E q u ip ce
m t en
T tao l Gn e e ra l E xp e n se s ( 16% of G ro ss
P ro fit ) s
Ne t P rofit s from O p r tion e a s
308 F I NAN C IAL ST A T E M E N T S
De du t—N t I nt r
c e e est r
C h a ge s a nd Lo ss on B ad A cc ount :
s
I t r t n Bo d
n e es o n s (1 y r)
ea
I nt r t N ot
e es on es Disc o nt d
u e
Di ou t
sc S l n s on a es
L —Di ou t P ur h
e ss sc n s on c a se s
N t Ie r t Ch r g
nte e s a es
Lo ss B d A ou
on a cc nt s
N t P rofi t (
e E xh ib it A ) ( 5
%
se e , on Sa l es )
A TW OO D M AN U FA C T U R I NG C O M P AN Y
EXHIB IT B —S HE D ULEC 1
S T A T E M EN T S HO W I NG C O S T O F GOO DS SOL D
D ur ing Y e r E n ded
a De ce m b e r 3 1 19 19
U d
R aw M ate ials r se
P rodu tiv L b or
c e a
o l Dir t Ch r g t M uf cturing Duri
T ta ec a es o an a ng 1 9 19
M nuf t ur i g E p n
a ac : n x e se s
S up r i t d
e d N
n en P rodu t iv L b or
e n ce an on -
c e a
P ow r H t e d L igh t
, ea , an
F tory S uppl i
ac es
R p ir t M h i ry d E q u ipm t
e a s o ac ne an en
I ur ns n R w M t ri l
a nc e o d M h i ry a a e a an ac ne
M i t of R l E t t :
a n e n a nc e ea s a e
T x a es
I ur ns ance
R p ir e a s
D pr i t io n
e ec a
L e ss I nc om e fro m R e nt ing
W orkm en s
’
C o tt ga es
De pr e cia ti n o of M ach ine ry a nd E quipm e nt
ST A T E M E N T S—M AN U FA C T U RI NG U SI NE SS
B 3
09
A nn ula Ch a ge sr for x
E tin g i s hme nt u of P ate nt
R ight s
D r wi g r r d Ofi
‘
a n s a nd P atte ns C ha ge
o l
T ta I r
nd i ect r
C h a ges to M an uf t uring dur ing 19 19
ac
o l C h r g t M n uf t uring dur i g 1 9 19
A dd—C o t of Good in P ro D c mb r 3
T ta a es o a ac n
mb r 3
s 1 1 9 18 s ce ss , e e e
L —C o t of G ood in P ro
,
e ss s D 1 s cess , ece e ,
—C o of F i i h d G ood
A dd st H an d Dece mb r
3
n s e s on , e
1, 19 1 9
L —C o t of F i i h d G ood H an d Dec e mb r
3
e ss s n s e s on , e
1, 1 9 19
C os t of G ood s S old d r ing u 1 9 19 ( see Exhibit B)
R EVI E W QUE ST ION S
W h at st a t e m e n ts u s u l l y form th e b i o f n nn u l r e port fo
a as s a a a r
m nu f
a a ac t u r in g b u in ? s ess
H ow if t , a a ll s h oul d t h e t te m n ts be in t rr l te d ?
, es s a e e e a
Wh at is t h e o bj e tio n to om bini ng L n d n d Bu il dings int o on e
c c a a
a s s et m? it e
W h y is it dvi b l t h ow th e dj u tm n ts f s ur plu n o t d in
a sa e o s a s e o s e
E x hibit A S h d ul e 1 ? , c e
I n t h e p rofi t n d l o t te m n t E x h ib it B w h t o t h r p rc e n t
a ss s a e , ,
a e e
gae l c ul t
cai o ns woul d beao f i n te r es t ?
C HA P T E R X X IV
S T A T E M E N T S O F A M ER C A N T I L E
BU S INE S S
1 . Co n s t it u e n t P a r t s of Re p o r t
following group of statements constitutes a
T he
complete annual report of a mercantile p artnership ,
including schedules I t consists o f.
1 . B alance sheet .
2 . L ist of balances due from customers so ar ,
range d as to indicate the condition thereof
3
.
. Statement showing amount and cost of in su r
ance in force and the unexpired premiums
, .
Statement of adj usting entries made in 1 9 1 9
a ffecting the net worth of the partners as at
the close of the previous year .
P rofit and loss statement .
Summ arized analysis of sales returns cost of , ,
goods sold and gross profits
, .
2 . A rr a n g e m e n t of Re p o r t
floating assets are gi ven first in t h e order of
T he ,
availability then the fixed assets in the order of per
,
m an en cy and importance ; tangible assets before the in
tangible T h e deferred charges to Profit and L oss are
.
s hown last regardless of which assets appear first T h e
, .
floating liabilities appear first followed by the fixed , .
N et worth always ap p ears last
3
.
10
ST A T E M E N T S—M E RCAN T I LE U S IN E SS
B
T he
adj us tin g ent ri es made in 1 9 1 9 as in dicated on
3
,
E xhibit A — S chedul e would not have been necessary ,
if the boo k keeper had prop erly closed the books o n De
c e m be r 1 1 9 18 3H e erroneously o m itted to enter cer
, .
tain bills and a c crued items applicable to 1 9 1 8 before the
boo ks were closed A s a result the partners net worth ’
3
.
as o f D ecember 1 1 9 1 8 had to be a dj usted ( corrected ) , ,
du ring the subsequent year I t would have been in .
co rrec t to pass the a d j ustments t hrough Profit and L oss .
3. Fo r m of Re p o r t
M A T T H EW S A ND BU RN S
EX HIBI T A
B ALAN C E S HEE T
D e ce m b r 3
1 19 19
e ,
A s s e ts
C u tom r ’
( se e Sc h ed ul 1)
L —R
s e s e
e ss e se rv for e B ad A c
co u nts
A oucc n ts Pa y bla e sh ow i n
g D e b it B al
A dv an ce s to E mploy ee s an d Ag e nts . .
N o t R iv b l
es ece a e
I v tori :
n en es
M r h ndi
e c an H d se o an ( co s t )
M r h n di
e c C n ign d
a se o s e ( co st )
R l Et t
ea s a e
L d ( plot 60 2 5
an 0 ) ’
x
’
( co s t )
B uildi ng ( o t ) c s
3 12 F I NAN C IAL ST A T E M E N T S
F ix tur
—R
es
L es s rv for
e se e De pr e c iat i o n ( 10 %
pe r a nnum )
De f rr d Ch r g t P rofit d Lo
e e a es o an ss
I ur U xp ir d ( S h dul
ns a nc e ne e se e c e e 2 )
A dv rti i g C ut nd Suppli
e s n s a es
N w C t lo gu
e a a e
Sh ipp i g R oom S uppli n es
O ffi S uppl i
ce es
I nt r t P r p id
e es e a
L ia bilitie s an d Ne t Wo r th
A oun t P y b l
cc s a a e
Tr d C r d it or
a e e s
C u t om r C r d it B l n
’
s e s e a a ces
Not P y b l
es a a e
Di ou t d t B k
sc n e a an s
I u d t Cr ditor
ss e o e s
A ru d I t m
cc e e s
T x a es
I t r t n M ortg g P y b l
n e es o a es a a e
M or t g g P y bl
a es a a e
F ir t s
S o d ec n
N t W or th
e
J m B M tth w
a es a e s
of C p it l A ount
.
B l De ce m
3
a a nce a a cc ,
b dj u t d (
3
1 19 1 8
er , , as a s e se e S ch e d
ul e )
O ne h a -
lf Ne t P rofit for 1 9 19 ( se e
x E hib it B)
W illi m a G B ur ns
p l A ou nt
.
B l of De ce m
3
a a nce C a it a cc ,
dj u t d (
3
be r 1, 1 9 18, as a s e se e Sch e d
u le )
O ne h a -
lf Ne t P rofi t for 1 9 19 ( se e
x
E h ibit B )
ST A T E M E N T S —M E RCAN TILE BU S IN E SS 33 1
M A T T HE W S A ND B U R N S
E X H I B I T A—S HE D ULE 1 C
C U ST O M E RS A C C OUN T S R E C E IVA BLE
’
De ce m b e r 3
1 19 19 ,
O r 3 0 Ov r 60 ve e
t r n ot o v e r no ov e O ver
Nm a e 60 d y 90 d y a s a s 9 0 day s
H W Ad m C
. . a s o.
G H B. di t C
. e ne c o .
B row n R t i l i g C e a n o .
J S B u tl r C
. . e o .
C m ro n S t or
a e es
Co ne M N il c e
D rry
e So ns
D o n ld o T r di g C
a s n a n o .
Du G ood
nn, C e o .
E v r itte Fi h r s e
F r um B row
a n n
G ood V lu C a e o .
H m il t o n 8:
a C o .
H J H or r C ne o
I gr h m M r C
. . .
n a a e c . o .
J u ior M fg C
n . o .
" llo gg
e " llo gg e
L mb T r d i g C
a a n o .
Lo g n S h or t
M i a neB uy i g C n o .
N orth St or C e o .
O pp h im r en C e e o .
Pr i St or
nc e es
Fr i k S l C
c a es o .
R igh t T r tm t C ea en o
S ur T hi g C
e n o
Tu k r
.
c Pl t r
e a e
U io S upply C
n n o
V r o Whit
.
e n n e
Tot l ( Sa E xhib it A ) ee
3 14 FI NAN C IAL ST A T E M E N T S
M A T T HE W S A ND BU RN S
E X H I B I T A—SC HE D U LE 2
STA T E M E N T S HO W I N G A M OUN T A ND C O ST OF
I N SU RAN C E I N FOR C E A ND T HE U NEX ,
P I RE D P RE M IU M S
A s f D e c e m be 3 1 1 9 19 o r ,
Date of
i y E xp ir
P ol c es
A mou n t
of of De c 3
1
p ny Ri k iy r
.
Co m a s 1 9 19 192 0 P ol c P e m iu m 1 9 19
o
Sc tt is h U ion n B ld g M ar 2 7 M ar 2 7
L o do A ur n
. . .
n n ss a ce 00
H r t ford F i r
a e
A t H r t ford
e na -
a
A m r i of P hil
e c an
M h i E ri
ec an c -
e
P h o nix H r t ford
e -
a A ug 1 . A ug 1 .
L L G lo b e
H om of N w r k
. .
e e a .
M anuf tur r ac e s M d se . J uly 1 J ul y 1
W or t r F irce s e e
N tio l of N J
a na . .
R oy l a
U io of P h il
n n .
Co ti u t
nne c c
G rm i
e an a
R oy l a
A mount of I ur n ns a ce in for ce De ce mb r
e 3 1,
C o t of
s ab ov e I ns ur anc e
U n xp ir d P r mium
e e e s, De ce mb r e 3 1, 1 9 1 9 ( se e x
E h ib it A)
M A T T HE W S A ND B U R N S
E XH I B IT A —S C HE D ULE 3
ST A T E M E N T O F A D JU S T M E N T S I N 1 9 1 9 A FFE C T I NG
T H E NE T W O RT H O F T H E BU S I NE S S
A s o f D ece m b e r 31 19 18 ,
D b it A d ju tm t
e s en s
T x for 19 18 p id in 1919
a es a
ST A T E M E N T S—M E R CAN T I LE B U S I N ESS 35
1
B ill s ppl i ca b e l r d in 1 9 19
mb r 3
a to 19 18 e nt e e
Sa l ri
a es A r d of D
cc u e as ece 1 1 9 18
e , , b ut p ida
an d c h a r g d J u ry 2 19 1 9
e an a ,
De du t —C r di t A dj u t m t
3
c e s en s
I ur P r mi m U xpir d
ns ance e u s ne e as of De ce mb r e 1, 1 9 1 8
Ne t De b it A dj u stm t e n s, t o be ch a rg d e r
t o P a tn e r ’
s I v m
n e st e nt
A cc ou nt s in e q u l moa a u nt s
r r C p it l A ou t D m b r 3
P a tn e s
’
1 1 9 18
a a cc n s. ec e e ,
J m B M tt h w b oo k
D du t—
a es p a e s, a s er s
O n h l f of b ov N t A dj u t
.
e c e-
a a e e s
m t en s
Ba l an ce as a dj u t ds e Dec e mb r e 3 1, 19 18 ( see Ex
bib it A)
Willi m G B ur oo k
D du t—
a p ns, as er b s
A dj u
.
O n h lf of
e c e -
a a b ov N e et st
m t en s
Ba ln a ce as a dj u t d D s e ecem be r3
1 1 9 18
, ( se e x
E h ib it
A)
M A T T H E W S AND BU R N S
EXHI B IT B
P R F T A ND O I LO SS ST AT E M E N T
Ye r E n ded
a D ece m b e r 3 1, 1 9 1 9
Gross P ro fit n S l o a es ( see Sche dul e 1)
D du t
e c
S l ling E xp n
e e se s
S l m S l ri
’
a es en s a a es
S l m E xp n
’
a es en s e se s
C omm i io n ss s
A dv rti i g e s n
Fr S mpl ee a es
F r igh t nd C rt g
e a a a e O t u w rd a
316 F I NAN C IAL ST ATE M E N TS
C r dit
e M an s Sa
’
l rya
C a se s a nd Sh i pp ing S uppl i es
Me r c an t i el Ag e ncie s
o l
T ta l
Se l in g E xp e n se s
G r l
e ne a A d mi n s i t r t iv
a e E xp e ns e s
S l ri
a a es
M ain te n ance of R l E ea s t a te
I r
nte e s t o n M or t g g a es
T x a es
I ur
ns a nce
R p ir
e a s
De pr o of F ixt ur
e cia t i n es
I n ur
s St o k
ance o n c
O fli ceS uppl i es
T l ph o
e e T l gr m
ne , e e a s, an d P o s t a ge
C o l l t io C h r g
ec n a es
H ti g
ea nd L igh ti g
an n
Supp r e s
I n id nt l
c e a s
T tao l G e ne r l a E xp e nse s
Ne t P rofit s from O p r tio
e a ns
De du ct
Ne t Ba l ance of I nt r e e st a nd Disc ou nt I te m s
I r
n t e e st o n N ot es
Disc ou nt s o n No te s
L —Di oun t s
e ss sc on P ur ch a s e s
Lo ss on B ad A cc ount s
y r nd d D m b r 3
Ne t P rofit, 1 19 1 9
ea e e e ce e , , a pportio l
n ab e be
tw P rt r
e en follow : a ne s as s
J m B M tth w ( Exh ibit A )
a es a e s se e
Willi m G Burn ( E xhibit A )
.
a . s se e
ST A TE M EN T S—M E R C AN T I LE B U S I N ES S 3
17
M A T T H EW S A ND BUR N S
E X H IB I T —S HE D UL
B C E l
S U M M ARI " E D ANA LY S I S O F G RO SS SALE S R E T URN S , ,
NET S A L E S C O ST O F SA L E S A ND G RO SS P RO F I T S
, ,
Y r E n d d D e mb r 3 1 1 9 19
ea e ce e ,
G ro ss Co t of G ro s ss
3
S l R t urn d S l S l P ro fit
5 5
a es e e a es a es
G ro S l
ss a es
T o t l G ood R t urn d
a s e e
Tot l N t S l
a e a es
T t l C o t of S l
'
o a s a es
T o t l G ro
a P ro fit
ss( s see x
E hib it B )
N et
profit from operations should always be shown
before adding or deducting as the case may be interest , ,
on borrowed capital discounts allowed dis co u nts taken
, ,
( the s e refer to cash di scoun ts only ) loss on bad ac ,
co u nts etc , .
T h e writer is opposed to the plan advocated b v some ,
accoun tants of showing on the profit and loss state
,
ment the figures used in arriving at the cost of goods
so ld I t conf uses the lay mind and a financial report
.
,
should be clear enough to be understood by one not
familiar with accounts I t is advisable to show such fig .
ures either on a separate sheet to be known as E xhibit ,
318 F I NAN C I A L ST AT E M E N T S
B— Schedule 1 or as a footnote on the profit and loss
,
statement I n this and the previous report the cost of
goods sold is worked out on E xhibit B—S chedule 1
.
R EVI E W QUE ST ION S
W h at m en t n e d d f
s t at e m n u f tur ing b u s in e ss is n ot e
e e or a a ac r
q u ir ed in m e r c n til c o n e r n ?
a a e c
W h y is it d es ir b l e t sh ow th e d e b it b l n e s f
a o c ou n t s p y a a c o
“
ac a
bl e
a
”
n dd itio n t th e
as a a ou n t r e iv b l e ?
o ac c s ce a
H ow h oul d o n ign d m e r h n di se b h ow n n th e b l n ce
s c s e c a e s o a a
h t f th
s ee o o n ign or ? O f th e c o n ign ?
e c s s ee
W h t is t h o bj ct f s h ow in g n o te p y b l e to c r e d itor s s e p
a e e o s a a a
rat el y f rom t h o s e d is c ou n t e d t b nk ? a a s
W ha t pur po s s e s e rv e d by th e s h e d ul e f in s ur n e E x h ibit
e ar c o a c
A —S h ed ul e 2 ?
,
c
C HAP T ER X XV
S T A T E M E N T O F A FF AIR S A ND
D E F I C IE N C Y S T A T E M E N T
1 . St a t e m e n t C o v e r in g Liq u id a tio n an d Ba n kr u p t cy Pr o
in g s
T he sta tement of affairs and the deficiency st ate
ment or deficiency account are usually employed in
, ,
conn ection with the acco unting of concerns which are
in liquidation as a result o f in solvency or bankru ptcy .
T h e bookkeeper or auditor is but seldom called upon
to make these s tatements A bookkeeper usua lly severs
.
his conn ection with a business before it becomes bank
rupt and has little or no occasion to concern him self
with its subsequent affairs N either is the public a c
.
c o u n t an t usually called upon to prepare such statements .
because the valuation of assets with which these state
ments are so largely concerned is a matt er to be attended
to by the appraisers and the referee .
T h e forms of the statement of a ffairs and the de
ficie n cy statement are brought in here because the b ook
keeper or ac countant should be able to prepare them i f
ca lled up on to do so and shoul d be capable of passing
,
upon them in case they are submitted to him for a nal ysis
or verification .
2 . A p p o in tm e n t an d Du tie s of T r u s t e e s in Ba n kr u p t c y
When an individual partn ership or business cor
, ,
or atio n h as been adj udged a bankr upt the credi tors at
p
3
,
19
3 2 0 F I NAN C IAL ST A T E M E N T S
*
their first meeting after the adj udication should ap
point one or more trustees as may be required I n case , .
they do not exercise this privilege the court will appoint , .
T h e first meeting referred to above must be held not
less than ten nor more than thirty days after the adj udi
cation at the county seat of the co u nty in which the
,
bankrupt had his principal pla ce of business .
T h e trust e e in bankruptcy must account for all
moneys belonging to the bankrupt concern which may
be r e ceived by him ; collect and reduce to money the
property of the bankrupt ; deposit all moneys received
by him as such trustee in a bank designated by the
court ; disburse the funds only by check ; lay before the
final meeting of the creditors detailed statements of the
administration of the estate ; make final reports and file
final accounts with the referee fifteen days before the
d ay fixed for the final meetin g of the cre di tors and pay ,
dividends within ten days after they are declared by the
referee H e must also report to the court in writing
.
, ,
the condition of the estate and the amount of money on
hand together with such other details as may be r e
,
quired by the court within the first two months after his
,
appointment and every two months thereafter unless ,
otherwise ordered by the court 1 .
’
I t is customary for the trustee to compile or have ,
co mpiled a statement of a ffairs and a deficiency state
,
ment as illustrated hereafter as soon as possible after
, ,
his appointment From these two statements the court
.
,
the trustee and any other persons at interest may gain
, ,
T h e d a te of e n t r y r
of a d e c e e in a b an r u t ck p y pr o ce e d in g th a t th e d e fe n d an t
is a b a n r u t k p
kr pt y
.
”
Th e t e r m co u r t as u se d h e r e m e a n s th e co u r t of b an u c in w h ic h th e
r i
p o ce e d n g s a r e p i
e n d n g, a n d m ay in cl u d e t h e r e fe r e e .
ST A T E M E N T O F AFFAI RS 3
2 1
a fair idea o f the probable results from liquidation I t .
is not compulsory on the trustee to have such statements
compiled but it is usually done as a matter of good prae
,
tice .
T h e only statement actuall y required by the court
must be furni shed by the bankrupt himself within ten
days after the ad j udication if an involuntary bankrupt ,
and with the petition if a voluntary bankr upt T his .
consists of a schedul e of his property showing the
amount and kind of property th e loc ation thereof and , ,
its money value in detail ; a list of creditors with their
ad d resses the amount due each of them the considera
, ,
tion thereof the securit y held by them if any ; and a
, ,
claim for such exemptions as the bankrupt may be e n
titled to T hi s report must be rendered in tripli cate
. .
3. Re fe r e e s in Ba n kr u p t c y
R eferees are appointed by the court of bankruptcy ,
for a period of two years T hey are direct fe pr e se n t a
.
t iv e s of the court by whi ch they are appointed T hey .
declare dividends and prepare and deliver to the trus
tees the dividend sheets showing the dividends declared
and to whom they are pa y able ; they examin e all
schedules of property and li sts of creditors filed b y the
bankrupts and cause such as are incomplete or defe o
,
t ive to be amended ; they f u rn ish such information con
cernin g the estates in proc ess of ad ministr ation before
them as mav be requeste d by the parties in in terest ; and
,
they prepare and file the schedules of propert y and lists
of creditors required to be filed by the b ank rupts or ,
cause the same to be done when the bankrupts fail r e , ,
fus e o r neglect to do so
,
.
3 2 2 F I NANC IAL ST AT EM E N T S
Ba n k r up t A ffa ir s
’
4 . In v e s t ig a t io n of s
A ll real and personal property must be appraised
by three disinterested appraisers who shall be appointed ,
by and report to the court T heir figures in respect
, ,
.
to the estimated realizable value of the assets should be
used in compiling the statement of a ffairs T he referee .
and trustees should co operate in an e ff ort to obtain -
a complete statement o f all liabilities including all con ,
tingent ones I n this e ffort they are permitted b y law
.
‘
to require the bankrupt to appear before them and
answer all questions the y may elect to ask concerning his
a ffairs T h e public accountant i s sometimes called in
.
by the trustees to compile a report showing the condi
tion o f the assets and liabilities as at the date the trus
tees take charge of the business or the date of adj udica ,
tion as the case may be Such a report would not di ffer
, .
in form from a regular audit report so far as the bal ,
ance sheet is conc erned T h e auditor would present .
book values and not the appraisers values ’
.
5T . r u s te e s
’
A c co u n t s and Re p o r t s
Where it is deemed for the best interests of the
creditors the court will order the business conducted by
,
the trustees as long as is advantageous N o special .
knowledge is required to keep or examine the accounts
of trustees T h e transactions pertaining to the liquida
.
tion of the business must be kept separate from those r e
garding the expenses of administering the business .
T h e statements presented to the referee by the trus
tees must show in summarized form all cash receipts and
disbursements properly classified during the period
, ,
covered b y the report I t is a good plan to show in .
ST AT E M E N T OF A FFAI RS 33 2
two additional columns the total of such receip ts and
disbursements from the beginning of the trusteeship to
date Another schedule should show the original condi
.
tion of the liabilities the amounts by which they have
,
been reduced and their present condition
, .
T h e referee may also desire a schedule showing the
appraised value of the assets the amoun t realize d on ,
each to date the balance to be realized and any com
, ,
ments by the trustees as to the probable proportion yet
to be realized I f the busines s is being conducted by
‘
the trustees they must also present a report showin g the
,
results from the conduct of the business .
Pr io r it y of De b ts
Debts of the bankrupt which have priority are
1 . A ll taxes legally due ; the necessary cost of
preserving the estate after filing the petition .
2 . T h e filing fees paid by creditors in involuntary
cases .
°
9 C ost of a d ministering the trusteeship .
4 . Wages due workmen clerks or servants which
, ,
have been earned within three months prior
to the date of commencement of proceedings
( not to exceed $ 0 0 to any one3claimant )
5
.
. Debts owing to any person who is entitled to
priority by the laws of the U nited S tates ;
mortgages on real and personal properties ,
and mortgage bonds .
6 . L iabilities in the form of written instruments
( such as notes etc ) secured
, by. the assign
ment of certain assets specified in the in stru
ment and j udgments and costs A mort
,
.
32 4 F I NAN C IAL ST ATE M E N TS
gage or other secured liability carries with
, ,
it all accrued interest .
debts which have priority may be divided into
T he
t wo classes ( )
1 those of preferred creditors and ( )
2 ,
those of secured creditors T h e former must be satis
.
fie d before any other liabilities are liquidated T h e lat .
ter must be proved and allowed by the court and then ,
the property pledged as security must be converted into
money according to the terms of the written instrument ,
or of the arrangement entered into between the creditor
’
and the court I f the creditor s claim is not fully satis
.
fie d from the property pledged for its security the bal ,
ance due him ranks the same as the ordinary unsecured
’
creditor s claim and he is paid dividends accordingly
, .
7. St a t e m e n t of A ff a ir s
T his
form of statement consists of a regular balance
sheet to which are added two columns o n e on either side , ,
for showing on the asset side the probable realizable
v alues of the assets and on the liability side the liabilities
,
that must be paid out of the moneys realized from all
assets except those mortgaged or pledged as collateral
security T h e di ffer e nce between these two columns
.
—
is called the d e ficie n cy the excess of liabilities unse
cured over the estimated amount available for their
liquidation .
I n the arrangement of a statement of affairs the as
sets should appear in the order of their availability ; the
liabilities in the order of priority the preferred
creditors first the secured creditors next the p artially
, ,
secured creditors next and then the unsecured creditors
, ,
properly classified A ll liabilities represented by mort
.
ST A T E M E N T O F A FFAI RS 35
2
gages payable or mortgage bonds outstanding should
be deducted from the appraise d value of the assets
pledged ( see liability N o 2 in the statement of af .
fairs as shown in I f the amount of the lien ex
cee d s the appraised value o f the property covered by
the lien then only such a part of the lien should be used
,
as a deduction from the appraised value of the asset to
which it applies as will exactly equal that appraised
,
value T h e balance of the lien should be extended on
.
the liability side b ecause it represents the estimated por
tion of the liability that is unsecured ( see liabi lity N o 4 ) .
A ll liabilities secured by the assignment of assets should
be deducted from the appraised value of those particular
assets and if that appraised value exceeds the amount
,
of the liability the balance should be extended on the
,
assets side as part of the realizable assets for li quidating
the un secured liabilities ( see liability N o .
T h e unsecured creditors are not listed in any par
t icu lar order because they are on an equal footing so far
as the ir claims are concerned B onds that are not a .
specific lien on property described on their face have no
priority over ordinary trade creditors Some real estate .
companies issue bonds stating these bonds are a lien on “
all the assets o f this company T his means nothing .
so far as security 18 concerned and in case of a failure ,
the bondholders rank with other unsecured creditors .
8 . De fi c ie n c y St a t e m e n t
deficiency statement is usually called a deficiency
T he
account but such a term is incorrect if the data are pre
,
sented in statement form as illustrated , .
T h e deficienc y statement merel y shows how the
32 6 F I NAN C IAL ST AT E M E N T S
amount of deficiency as shown in the statement of a ffairs
is arrived at I t is started with the net worth ( capital
.
stock plus surplus or minus deficit )
, For a business .
to be insolv ent the liabilities must exceed the value of
,
the assets .
( V alue referred to here means the value
of the assets to a going business ) T herefore unless .
,
the shrinkage in assets wipes out all the surplus and
the capital stock the business is still solvent
, .
T h e items in the statement of affairs which require
analysis to ascertain their composition should be sup
ported by schedules showing the necessary details ; e g . .
,
accounts receivable should be support ed by a schedule
showing the name and balance of each individual per
sonal account ; the item of securities own ed should be
supported by a schedule showing the name of each se cu r
ity number of bonds or shares par value cost and a p
, , , ,
praised value ; and the item of real estate should be
supported by a schedule giving a description of each
tract or piece of property its cost to date and its a p
, ,
praised value T h e same applies to liabilities
. .
I t is also advisable to attach to the report an ex
planation of the cause of any extraordinary shrinkages ,
and the probable cause or causes of the failure I n this .
particular case the largest shrinkage is in the item of real
estate ( see asset N o which is carried at arbitrary
.
values instead of at cost these values having been placed
,
entirely too high in order to inflate the surplus .
T h e statement of a ffairs and deficiency statement
which follow di ffer in form from the examples given in
other volumes of this set T h e forms in V ol u me I
.
,
C hapter X I I are in the writer s opinion more explicit
’
, , , ,
but those given here are more co mm o n lv used .
S TA T EM E NT o r AFFA I RS 327
Fo r m of St a t e m e n t of A fi a ir s
C H RI S T O P H E R R EA L T Y C OR P O RA T ION
Ex m A a rT
S T A T E M E N T O F A FFAI RS
S e pt m be r 3
0 1 9 19 e ,
m d
E s ti at e
r zl
e a li a b e
v u
al e s , as
A s s e ts A p p A p
er r ais
S er
p
L dg r
e e e rs lua es
O n H an d
( 9) A cc ou nts R ece i v bl
a e
R t ( Dou b t ful )
en s
S u dry P r o
n l A ou t ( G ood )
e s na cc n s
S u dry P r o
n l A ou t ( Doub t f l )
e s na cc n s u
Co ns t ru t io M t ri l
c n ( o t) a e a s c s
E q u ipm t ( t)
en co s
R lEtt
ea s a e
V t Lo t P rt ly I mprov d
ac an s, a e
( b oo k v lu ) a e
V lu d t
a e a S
H ou C mpl t d
se s od in e e an
P ro ( o t)
c e ss c s
V lu d t
a e a
Ofi B ildi g
ce u P rop rti n s on e es
( o t) c s
V lu d t
a e a
B l a a nce d Lo t S old und r
ue o n s e
C o tr t ( titl
n acn t p d) es o as se
o l V l u tio
T ta a a n
D d u t—
e M ort g g
c Li a e e ns on
U n ld P rop rti
so d L e e s an o ts
So ld u d r C o t r tn e n ac
( 7) Se curiti H d es on an
M ort g g R iv b l
a es ec e a e
S t o k of S u b idi ry C omp
c s i s a an e s ( c o st )
( 8) S c ur iti
e ign d es C oll t r l
a ss e as a e a to No t es
P y bl : a a e
M ort g g R iv b la es ece a e
3 2 8 F I NAN C IAL ST A T E M E N T S
Vlu d t
L i b i l it y N 3
a e a
D du t—e c a o .
S to k of S ub id i ry C omp ni
c s s a a es ( co st )
( C o id r d ns of v lu ) e e as no a e
ury S to k ( 1 0 0 h r t p
.
(9) Tr e as c s a es a ar )
( 10 ) D fi i n y (
e c e E x h ibit B )
c se e
L ia bil itie s
P r f rr d C r d itor
e e e e s
T x a D es d U p id ue an n a
W g D d U p id
a es ue an n a
C r d itor S ur d b y M or t g g
e s ec e a es
F ir t M or tg g
s a es
S o d M or t g g
ec n l 76 68 4 0 0 a es
I nt r t A ru d
, .
e es cc e
( D du t d from
e t N c e 5d a ss e s os . an
C r d it or
e N o t P y b l Fully S ur d
s on es a a e ec e
( D du t d from
e t No c e a sse .
C r d it or
e N ot P y b l P r ti lly S
s on es a a e a a e
ur dc e
( A b ov mou t r pr t e a ot ur d n e e se n s a n e se c e
by o d mortg g giv for $ 5
a se c 0 n a e en ,
000 i lud d i , mou t of mor tg g
nc e n a n a e
li e ns d du t d from t e c e a sse
N 6 It io .tim t d t h t t h
. mor t s es a e a e
g g i a t good for mor t h n
e s no e a
O rd i ry U na ur d C r d itor nse c e e s
G old D b t ur Bo d e en e n s
C oupo D b n tur Bo d
n e e e n s
I t lm t D b ntur Bo d
ns a en e e e n s
T r d C r d it or
a e e s
A
ge nts
o
C nt inge nt L i b il iti in th form of gu r a es e a
nt
a n b o nd
ee s i u d by o ub id i ry s ss e a s s a
omp y
c d i mprov m n t
an
gu r n t d
,
an e e s a a ee
t l t pur h
o o r c a se s
N t W or th
e
C p it l S t o k O u t t nd ing ( p )
a a c s a ar
S urplu s
ST A T E M E N T O F A FFAI R S 3 2 9
10 . Fo r m of De fi c ie n c y St a t e m e n t
H RI ST O P HE R R EAL T Y C O RP ORA T ION
C
EXHIB IT B
D E FI C IE N C Y S T A T E M E N T
Se pt e m b e r 3
0 19 19 ,
A mou of A ppr i tio L o t U old of S p t mb r
3
nt ec a n on s ns as e e e
0 , 19 1 9
De du of P rofit nd L o A ou t of S p
De b it B a l
t mb r 3
ct a n ce a ss cc n as e
e 0 1 9 19 b i g
e ,x of E xp , ov r P ro fit
e n e ce s s e ns e s e s
from b gi i g of b u i e nn n F b ru ry 10 19 10 s ne s s e a ,
B l n
a a of Surplu A ou t p b ook S p t mb r 3
ce s cc 0 19 19 n as er s, e e e 8
C p it l St o k O ut t d i g
, , .
a a c h r t p )
s an n s a es a ar
N t W or t h
e
Sh r i k g i
n a A t b i g d ifi
e n sse s,b tw th i r o t or
e n e r e nc e e e en e c s
b o k v lu
o th a m y b
e, asd th tim t d v lu
e c a se a e, an e es a e a e
for th purpo of l iqu id tio
e h ow n i
se d t il a n, as s n e a on
E xhib it A
A ou t R iv b l ( N 2 )
(N 3
cc n s e ce a e o .
C o t ru t io
ns c n ) o
E qu ipm nt
.
e ( N 4) o
(N 5
.
R lEtt ea s a e ) o .
S ur it i
ec (Nes 7 8) os
ury S to k
.
Tr e as ( N 9) c o
L o th rou gh Sh r i k g i B ook V lu of L o t
.
ss n a e n a e s
ov r d b y mor tg g of
c e e giv t a e en o
ur th p ym t of o t of
se c e e a ( en a n e se e
l i b il ity N 4)
a o .
P o ib l L o
ss eth rou gh C o t i g t L i b il it i
ss t n n en a es no
h ow
s b oo k ( l i b il it y No 6 )
n on s a
E xhib it A )
.
D fi ci n y ( s
e e c ee
EVI EW QU E ST ION S R
H ow d o e s st te m n t f ff ir s d iff r f rom b l n e s h e t ?
a a e o a a e a a a c e
W h t is th e fu n ct io n f d fi ie n y t t m n t ?
a o a e c c s a e e
H ow r d it or s l s ifi d u n d r t h b nkru pt y l w ?
a re c e c as e e e a c a
H ow mu h n th d ol l r c n th u n ur d r d it or r o n
“
o e a ca e sec e c e s ea s
la x
b y e pect f ro m t h t t em n t o f f
f ir s s h ow n in t hi c h p t r ? e s a e a a s a e
C HA P T E R XXV I
M ET H OD S O F C O MB I N A T I ON S
1 . Gr o w t h and De v e lo p m e n t
A discussion of account ing practice as it is related
to corporate combinati o ns or consolidations may with ,
advantage be preceded by an outline of the causes which
lead to c onsolidations and of the possible kinds of combi
nations which may legally be made .
A s an industry ex pands in di viduals or corporations
,
engaged in the manufacture and sale of the same product
increasingly feel the encroachment of competition among
themselves A s this competition is usually found to be
.
wasteful and expensive the natur al thought arises that
,
its elimination between two or more companies will re
sult in s aving to a ll ; hence the combination the primary ,
ob j ect of which is to control a number of sources of sup
ply o f the same article for the purpose of regulating
prices .
T h e formation of a partnership by two men com pe t
ing in the same business is an example of a business
combination in its simplest form When one or more .
individuals or p artners combine their business assets and
talents i n t h e more flexible organization known a s the
corporation the combination is of a more advanced type
, .
T h e accountant of to day however hardly considers the
-
, ,
term combination in a business or financial sense as ap
plying to anything short of a combination of corpora
tions .
M E T HO DS O F C O M B I NA T I ON S 3
3 1
A g r e e m e n ts
’
d G e n t le m e n
“
2 . Po o ls an s
U ntil almost the end of the last century in the ma ,
j o r it y of the states it was illegal for one corporation to
acquire stock in another corporation w ith the obj ect of
controlling its operations and activities T his legal dis .
ability led to many subterfuges and expedi ents to defeat
the intent of the law C o m munity associations and c o.
operative methods were the first recorded attem pt at a
combination of corpor ations through the medium of a
mutual understanding . T h e next step know n as a ,
”
“
po ol was a popular form of association as early as
5
,
1 8 7 and was based on what was termed a gentlemen s
“ ’
”
agreement T h e obj ect of the pool was usually to
stabiliz
.
e prices by di viding selling territories or restrict
ing output A central selling organization was some
.
times organized by a num ber of manufacturers A s the .
success of the plan d epended enti r ely on the gentle
”
men s agreement between hitherto competing com
’
panics the pool was unsatisfactory as the stress of hard
, ,
times usually proved too much for the combinatio n ,
which often di ssolved when co operation was most -
needed .
3D . e v e lo p m e n t o f
.
T r u s ts
To lega l ize the pool and provide a more stable form
“
of administration than that a ff orded by the gentle
”
men s agreement the form of organization known as
’
a trust came into being T his method of combination .
was first e ffected through the formation of a managing
board of tr ustees S everal comp et ing companies de
.
posi ted their capital stocks with the trustee s an d r e
c e iv e d in exchange trust certificates T he plan enabled .
3
3 2 F I NAN C IAL ST A T E M E N T S
the trust to utilize many of the feat ures of a combination
in a more successful manner than was possible by the
formation of pools but adverse court decisions e v entu
,
ally caused the t rusts to be dissolved .
T h e plan of interlocking directorates came into
“
existence through the formation of the trust and through
the contro l of large amounts of private capital thereb y
a fforded T h e directorate of th e trust was composed of
stockholders in two or more co m
.
panies to an extent
w h ich enabled them to elect themselves or some employee
to the directorates of all the companies W ith the ex .
tension o f this plan the same group of men often com
,
posed the board of directors of several corporations and
were thus in con trol o f the management of the su p
p o se dl y separate and c o mpeting companies .
4 . Co m b in a t io n s b y Le a s e an d b y Pu r c h a s e
A t about t h e same time th at individual ownershi p
in the capital stock of di fferent companies became a
r e cognized means of control and combination there also ,
came into exist ence the combin atio n by lease and by out
right purchase of the business I n the combination by .
lease the entire property of one company was le ased to
,
another company for a term of years I n the combina .
tion by purchase the entire propert y was sold and the
,
selling corporation di ssolved Both of these methods.
required cash p ayments and were therefore limited in
their application Mor e over the original owners who
.
, ,
were also as a rule the managers or directors of the
property sold retired upon the disposal of their business
, ,
and the number of new plants that could be absorbed
q uickly b y a new organiz ation was limited wh en it was
M E T HO DS O F C OM BINA T ION S 3
3
3
necessary for the additional propert y to be managed
by the purchasing company .
5. Fo r m a t io n of Ho ld in g C o m p a n y
T he formation of p o ols and trusts and the purchase
and lease of propert ies were no longer necessary ex
e die nt s for the formation of c ombines when it became
p
legal for one corporat ion to own the st o ck of other cor
p o r a tio n s Statutes
. perm i tting such stock ownership by
corporations were passed in several states prior to 1 9 0 0
and with these enactments the modern holding company
came into existence T h e distinction between the com
.
bination by purchase and the holding company is im
’
portant T h e purchase of one c orporation s assets by
.
another usually extinguishes the identity of the pur
chased concern ; whereas the holding company owns the
capital stock of another corporation still in existence and
operating through the original organization even though
controlled .
T h e holding company is now the mo st common form
o f corporate combination and its popularity is indi
c a t e d by the fact that almost eve ry day corporations are
formed for the sole purpose of o wn ing the stocks of
other corporations When the holding company oper
.
ates unfairly and eliminates competition to the extent
”
of restraining trade it has in its turn also come into
“
, , ,
conflict with the law and today many of the larger hold
in g compani es are being di ssolved by order of the courts .
T h e Sherman A nti T rust L aw -
the C layton A ct
an d the universal feeling aroused in the mind
of the public during the last twenty years against the
monopo listic tendencies of the holdin g company when
3 4 F I NAN C I AL ST A T E M E N T S
its activities take on the character of those of a trust
have created the impression that the holding company ,
as well as the trust is illegal T h e illegality if any
, .
, ,
however is in the acts o f the holding c ompany I t does
,
.
not and in the writer s opinion should not prevent the
,
’
ownership b y one corporation of stock in another cor
p or at ion .
6 . Fo r m s of St o c k O w n e r s h ip
ownership by one corporation of the shares of
T he
capital stock of another corpor a tion does not always
imply that the ownership is that of a holdi ng company .
F or instance a corporation may invest its surplus funds
,
in the purchase of stocks of other corporations I n such .
cases the securi t ies so acquired represent legitimate in
,
vestments and should appear under the hea ding of I n “
”
vestments o u the balance sheet of the purchasing cor
,
r a tio n
p o .
T hus ,
building and construction companies often r e
ce iv e stocks of other companies as part or full p ayment
for the erection of buildings T h e capital stocks so .
acquired constitute ordinary current assets A s such .
stoc ks ar e received in settlement of accounts receivable ,
the securities are usually di sposed of at the first favor
able opportunity .
A gain bankers brokers trust companies and in
, , ,
vestment corporations always invest part of their work
ing capital i n shares of corp orate stock I n this case the .
secu rities are part of their stock in trade j ust as the - -
steel inventory of a machine shop is part of its stock in -
trade S e curities so held represent the o u hand inv e n
.
-
tor y resulting from dealing in negotiable p a pe r of all
M E T HO D S O F C O M B INA T ION S 3
35
kinds and should be classed as Stocks and B onds
u nder current assets on the balance sheet .
When securities are purchased for the p u rpose of
obta i n i ng control of other c orporations the securities ,
represent a permanent interest in the property of the
controlled company and they should appear on the bal
ance sheet in the group of fixed assets even though a
maj ority of the shares have not as yet been acquired .
T h e stocks in this case are evidence of ownership of
factory buildings real estate inventories or other
, , ,
properties o f the controlled companies Wheth e r the .
o wnership is to be stated on the balance sheet as plant
and property inventories etc or as securities is the
, , .
, ,
cause of most of the di ff erences of opinion which arise
as to the correct method of recording the investment on
the books of the holding company and of presenting
the consolidated bala nce sheet T hese matters will be
.
discussed in following chapters .
7. Pu r p o s e o f Ho ld in g C o m p a n y
From the foregoing discussion it develop s that a
holding company is one that is fo r med for the sole pur
pose o f controlling other corporations through stock
ownership T herefore the accounting on the books of
.
the parent company should show this condition rather
than that of incidental control through investments .
T h e possession of the stock by a holding company is
evidence of the o wnership of actual properties such ,
ownership being merely a meth o d of operating the prop
e r t ie s through a second corporation T his controlled .
operation may be a complete own ership thr ough the ‘
holding of the entire issue of stock ; or it may be o h
3
3 6 F I NAN C I AL ST AT E M E N T S
through the ownership of only a maj ori t y of the
t a in e d
stock ; or the control may be exercised by possession of
less than a maj ority of the shares issued T h e modern .
holding company usually holds the control of several
other corporations through stock o wnership sometimes ,
by a bare maj ority of only the voting class of stock of
the corporations thus controlled by the holding com
pany .
8 . Co m b in a t io n b y Pu r c h a s e of Pr o p e r t y
purchase of the property of one corporation by
T he
another corporation does not present a very di fficult
accounting problem I t is true that in the valuation of
.
the asset items and in the statement of liabilities all the ,
problems and points discussed in preceding chapters may
be raised but these are accounting problems common to
,
all types of organization T h e discussion here is con
.
cern ed only with the accounting required to record the
purchase on the books of the holding company after an
audit and investigation have produced a true statement
of assets and liabilities .
T h e purchase transaction if simple and usual in ,
character may be recorded in one j ournal entry which
, ,
reduced to the most simple terms consists of a list of the ,
assets of the subsidiary concern o ffset by its liabi lities ,
capital stock and profit or surplus
, .
For example let us assume that the A C ompany has
,
purchased all the assets other than cash and taken over
, ,
all the liabilities of B and C om pan v T h e purchase .
price is cash T h e balance sheet of B and
.
C ompan y at the date of the transaction appears as
below
M E T HO DS O F C O M B I NA T ION S 3
3
7
A s s e ts L ia b il it ie s a nd C a p ital
Ca s h A cc ou n ts y blPa a e S
A cc ou nt s R v l
e ce i a b e N ot es P y bl
a a e
P r tn r C p it l
’
B a nd a e s a a
R aw M a te ri l a s P rofit and L o ss
G ood s in P ro ce s s
P l a nt a nd P rop rt ye
M achin e ry a nd E q u ip
m e nt
entries on the books of the A
T he C ompany would
be as follows
P l an t ro pe r t y
an d P
M ch in r y n d E q u ip m n t
a e a e
I n v n t ory— R w M te r i l
e a a a
I v n tor y—G d in P r o e
n e w
oo s c ss
I n v e n t ory — F in i h d G o od s s e
A ou nt R iv b l
cc s ece a e
A ou n t P b l ecc s ay a
N t P bl o es ay a e
B n d C om p n y V n dor
a a , e
T o r ord t h e pur h
ec tc c as e , e .
B an d C om p a ny , V en d or
C ash
To r e ord
c th e p ay m en t , e tc .
9 . Co m b in a t io n b y Le a s e of Pr o p e r t y
A co mbination by the leas ing of property is not a
very co m mon occurrence Where it is found the pro b .
,
lem of valuing the lease is usually more di fficult t ha n
the recordin g of entries to show the control Where the .
e ntire property of one company is leased to another
3
3 8 I NAN C I AL
F ST AT E M E N T S
compan y for a long term of years the proper statement ,
of the accounts of the lessee company may present some
difficulties I n an actual case the writer considered it
.
proper to include the value of the leased property among
the assets of the operating company I n this instance .
the terms of the lease involved the guarantee by the
operating company of dividends on the entire capital
stock of the lessor company as rental for 9 9 9 years T h e .
real estate buildings etc were set up as assets and an
, , .
, ,
amount equal to the capital stock of the lessor company
was stated as a liabilit y on the books of the operating
c ompany .
I n the case of ordinary short term leases it would -
not be proper to value the leased property among the
assets of the lessee company unless a flat amount in con
sideration thereof had been paid at the beginning of the
term T his amount should then be amortized over the
.
entire life of the lease I n E ngland the amortization
.
of the lease is invariably accomplished by the annuit y
method .
A dditions to leased property may be capitalized as
made and should then be extinguished during the term
of the lease unless the lease contains some provision
covering reimbursement for improvements .
I n general the terms of each lease will determ ine the
,
need for unusual or special accounting entries T he .
simple form of short term lease involving an annual
-
'
r e nt a l paym e n t need not in any way a ffect the property
accounts of the operating company an d the entries to ,
record expenditures for rent and maintenance usuall y
may be confined to the expense accounts of the lessee ‘
company .
M E T HO DS O F C O M B INA T ION S 3
3
9
10 . Co m b in a t io n b y C o n s o lid a t io n
T hough
the term consolidation would properly be
used only when an actual consolidatio n of own ership
and a ccounts takes place it is often used to cover that ,
form of combination effected by the exchange of stocks
between corporations as distinguished from the combi ,
nation effected by the purchase for cash of stock in one
corporation by another H ere the intent is clear for .
,
the control cannot in any way be con sidered as inciden
tal to th e transaction T he transaction in short is the
.
, ,
purchase by a holding company o f some or all of the
stock o f another company ( thereafter a subsidiary com
pan y ) and as consideration therefor the holding com
pany makes payment in its o wn capital stock T h e re .
sult is that the holding company owns shares o f stock in
the subsidiary company and the subsidiary company
stockh olders own shares of stock in the holding com
pany .
I n the discussion of holding company accounts and
consolidated balance sheets the consideration or pur ,
chase price given by the holding company is immaterial .
T h e special points involved in such an exchange of stock
will be considered in the follow ing two chapters .
EVI EW QU E S T ION S
R
Wh t ae p
arool ? s
”
Wh t a in t rl o k ing
are e d i r t or t es ?
c ec a
Wh t ia h old in g om p n y ?
s a c a
H ow n om b in t io n b ff t d by l
ca c a ? s e e ec e e ase s
Wh t i th u u l w y f m kin g c o n s ol id tio n ?
a s e s a a o a a a
C HA P T ER XXVI I
HO L D I N G C O MP A NY B ALA N C E S HEE T
1 . Ho ld in g C o m p a n y ’
s v s. C o n s o lid a t e d Ba l a n c e Sh e e t
final goal or summary of all accounting for busi
T he
ness transactions is the balance sheet and the income
statement T hese statements will be discussed here
.
only as related to the accounting on the books of a hold
ing company and without attempting to show any con
solidation with subsidiary company accounts C o n .
solidated balance sheets and consolidated income state
ments will be covered in C hapter XX VI I I .
A t this point it may be stated that in the opinion
,
of the writer the bare statements of holding companies
are of no value as a means of showing the financial con
dition of a ffiliated companies ; and that anything short
of a consolidated balance sheet and consolidated income
statement may be actually misleading if it is intended to
represent the condition and operation of subsidiary com
panics a ffiliated through stock ownership T h e prepa .
ration o f statements for the holding company as a unit
is however necessary prior to the preparation of con
, ,
solidated statements I t should be understood there
.
,
fore that the following discussion is only preliminary
,
to the discussion of the final consolidation of holding
company accounts with those of subsidiary companies .
Where the argument seems to imply that a holding
company s statement reflects a true statement for a ffil
’
iat e d com p anies the reference is only to such a holding
,
3
40
HO L D I N G C O M PANY B ALAN C E S HEE T 3
41
company as does not actually control the corporations
investments in whose stock appear on the holding com
p a n y s ba lance sheet
’
.
2 . Ba l a n ce Sh e e t of Ho ld in g C o m p a n y
For the purpose of illustration it is ass u med that a ,
hol di ng company is a corporation whose assets in part
consist of the shares of capital stock of subsidiary cor
p o ra t io n s R educed to
. its s implest possible form the ,
balance sheet might read :
HO L D I NG C O M P ANY
BA L AN C E S H E E T
I v m
n e st e nt s p
C a it al S t o k of H old
c
r
sh a es of B C o in g C omp y O t
an u
l St k
.
C p it
a a oc . sta n ding
sh ra es of C C o
l St o k
.
C p it
a a c .
$ 1 OOO OOO OO
, , .
I n the above instance it is assumed that the holding
company owns the entire capital stock issues of the two
underlying companies and that the par value of the ,
stock as represented on the balance sheet is in each case
exactly the di ffer e nce between the assets and liabilities
of the subsidiary companies I t is true that this condi .
tion would rarel y if ever exist but the statement is ,
hypothetical and i s presented onl y for the purpose of
clarifying the discussion .
T 0 take a more probable case assume that the sub ,
s idiar y companies condition at the time of consolida
’
tion is as follows :
3 42 F I NAN C I A L ST AT E M E N T S
B C om pan y
C pi t l S to k O u t s t
a a c an d in g sha es r ( pa r $ 10 0 )
S ur p lu s
C C om p an y
C a p it a l St o k O u ts t
c an d in g sh a es r ( par $ 1 0 0 )
S ur plu s
T he holding company agrees to pay in shares
for the stock of B C ompany and in shares for ,
the stock of C C ompany T h e holding company s bal .
’
ance sheet wo u ld then appear as follows it being as ,
sumed that the excess in each case represents good
will
HOL D I N G C O M PAN Y
BA L AN C E S H E ET
I n v tm
es e nt s p l
C a i ta St o k of H old
c
r
sh a e s of B C o i ng C omp y O t
an u
l Sto k
.
C p it
a a c . st an d ing
sh ra es of C C O
l St o k
.
C p it
a a c .
I t will be observed that investments in subsidiary com
panics are stated in the above balance sheet at cost in
5
,
cluding go od will and the values are respectivel y $ 1 2
5
-
per share for the B C ompany stock and $ 1 0 per share ,
for th e C C ompany stock .
From the above it is apparent that in principle the
balance sheet of a holding company is not necessarily a
complicated statement I n actual practice however .
, ,
HO L DI NG C O M P AN Y B ALAN C E S HE E T 33
4
complications invariably arise which cann ot be ade
q u a te ly shown on the balance sheet of the holding com
pany I n the interests of good accounting then it b e
.
, ,
comes necessa ry to resort to the consolidated balance
sheet .
3. A d v a n c e s t o Su b s id ia r y Co m p a n ie s
T he first complication which arises is usually when
the holding company makes advances to a subsidiar y
for the purpose of adding to or extending the plant or
other fixed assets of the latter after they have be e n
,
acquired by the parent company ; or advances may be
made for the purchase of stock in trade and in this or
- -
o ther ways provide additional working capital for the
subsidiary company Under such circumst ances either
. ,
the advances may be repaid to the holding company or , ,
if any authorized stock of the subsidiar y i s available ,
pa yment to the holding company mav be made by an
additional stock issue T h e holding company however
. , ,
may prefer to rank to some e x te n t f as a creditor o f the
,
subsidiary instead of entirely as a stockholder in which
, ,
case notes or bonds may be taken in payment instead of
shares o f stock T h e complications with regard to such
.
advances arise chiefly when the latter are not represented
by additions to the ass ets of the subsidiar y company a nd ,
where in fact the advances are made necessa ry b y op e rat
ing losses I n such a case it is apparent that a loan of
.
this character should not appear as an asset on the hold
in g company s balance sheet unl ess o ffset by a corre
’
s po n di n g valuation reserve .
When a subsidiary company s o p erations result in a
’
deficit a holding com p any o wning a maj ority of the
,
3 44 F I NAN C I AL ST A T EM EN T S
subsidiary stock should write down the asset represe nt
ing this stock I f it were possible properly to record all
.
other details of the a ffiliated company there would not ,
’
be so much obj ection to the holding company s statement
representing that of a u nit or a single organization .
But it is im practicable properly to reflect all fluctuations
in the value of the securities of the subsidiary companies
on the holding company s balance sheet ’
.
4 . M e th o d s of Ba l a n c e Sh e e t P r e s e n t a t io n
T hough
the statements of holding companies and
subsidiaries may be presented in a hun dr ed di fferent
way s depending on the purpose to be served in general
, ,
all the metho ds ma y be classified u nder one of the fol
lowing heads
1 . T he consolidated balance sheet which includes ,
the a ccounts of the holding company and all
its subsidiaries .
T h e holding company s balance sh e et alone
’
2 .
,
without reference to the detailed assets of the
subsidiar y companies
3
.
T h e holding company s balance sheet showing
’
.
,
a proportionate share of the sub sidiary com
’
panies assets as indicated by the proportion
of the subsidiary companies stock held b y ’
the holding company .
T h e holding c ompany s balance sheet and as
’
4 .
much of the surplus of the subsidiary com
a n ie s as belongs to the holdi n g company
p
the amount of the surplus being in propor
tion to the amount of stock held by the hold
ing company .
HO L D IN G C O M P AN Y ALAN C E S H EE T
B 35
4
While the only method of presentation which r e
veals the whole truth and all the details is the firs t
method given above it is necessary to illustrate and
,
show t he purposes of the three other methods so that ,
the construction of the consolidated balance sheet may
be clearly understood T h e omission of all details as
.
to the assets of the subsidiaries on the holding company s ’
—
balance sheet the second method outlined above
occurs when the accounts of the holding comp any refle ct
as earnings only the dividends received on subsidiary
stock .
When d ividends are not declared the holding com ,
p a n y s balance sheet does not u sually give this informa
tion y et the public is entitled to it T h e investor is
, .
”
then left guessing as to whether profits have been
“
made but no dividends declared or whether no profits
, ,
have been made but in fact a loss sustained T h e in
, , , .
vestment account on the holding company s balance ’
sheet should be increased in proportion to the subsidiary
companies profits and be reduced in proportion to any
’
losses .
T hus while the second method may be but usually
, ,
is not a true statement as regards its total it cannot
, ,
show whether a loss has been caused by a reduction in
the value of the current or fixed assets of the subsidiary
companies T h e gain or loss can be shown only as an
.
increase or decrease in investments or fixed assets .
T h e third method is advocated by some accountants
who contend that the holding company s balance sheet ’
should show its proportionate ownership in the assets
and liabilities which appear on the subsidiary companies ’
balance sheets T hus if the holding com p an y owns
.
,
346 I NAN C I AL
F ST A T E M E N T S
90 % of the stock o f a subsidiary factor y worth
0 0 0 the holding comp any s balance sheet would show
’
plant and property at a value of and so on with
the other assets and liabilities Such a statement how
.
,
ever is incongruous in that it regards as divisible such
,
indivisible assets as buildings mortgages etc For this
, , .
reason this arbitrary method of showing asset values is
not frequently adopted .
Under the fourth method listed above the holding ,
company s statement shows in addition to investments
’
another account representing accrued earnings on in
vestments in underlying companies such earnings r e pr e,
senting the holding company s proper share of the sub
’
comp anies surplus T his method o f showing is similar
’
.
in some respects to the second method described above .
T h e accrued earnings in I nvestment account may b e
grouped under the current asset or fixed asset it e ms
as indicated by the permanency of the control exercised
over the operations of the underlying companies B ut .
ev e n when earnings are so stated the public is still ,
—
without essential details as to their source as in the cas e
under the second method .
From the foregoing it is seen th at anything s hort
of a consolidated balance sh eet cannot wholly satisf y
the stockholders of the holding company owning a ma
j ty o f stock in any subsidiary company T h e o nl v
o r i .
satisfa ctory and complete method of presentation ther e ,
fore is to show the actual facts of consolidation on a
,
combined balance sheet which gives details as to either
investm e nts or the total assets and liabilities of th e
p arent company .
Before presenting such a balance sheet two special ,
HOL D I NG C O M P AN Y ALAN C E
B S HE E T 37
4
points relating to the holding company s balance sheet ’
may with advantage be taken up Th e method of show .
ing the investments in the subsidiaries depends upon
whether or not the holding company also operates the
subsidiar y concerns I f the management of the sub
.
companies is not controlled by the parent com
pany all advances to or by each subcompany and
,
the stock of each subcompany at cost should be stated ,
separately on the holding company s balance sheet .
”
“
A t cost means the cost of acquisition by the holding
company with the par value of the stock shown separate
,
from the premium or discount if any has been paid I f , .
the holding company is also an operating company then ,
the assets and liabilities and details of its operations
should be recorded clearly on its books and should not
b e merged with any subcompany operations affecting
the parent corporation T his procedure is advisable so
.
that the operation of consolidation may be the more
readily and clearly effected .
5 . Illu s t r a t io n o f Ho ld in g Co m p a n y
’
s Ba l a n c e Sh e e t
illustrate the drawing up of the balance sheet
To
of a holding company in a form suitable for consolida
tion with the statements of its subsidiaries it is assumed ,
that the J ones C ompany owns 9 0 0 shares or 9 0 % of the
capital stock of the Brown C ompany and 40 0 shares or ,
80 % of the stock of the Smith C ompany T h e J ones .
C ompany has borrowed from the Brown C o m
pany on note and loaned it to the Smith C ompany on
5
,
mortgages T h e B rown C ompany s stock has cost $ 1 0
.
’
per share and the Smith C ompany s stock has been pur
,
’
chased for $ 9 0 per share payment having been made in
,
3 48 F I NAN C IAL ST A T E M E N T S
J ones C ompany capital stock of $ 1 0 0 par value T h e .
J ones C ompany is an operating company and has a
plant and inventory and other assets worth
with liabilities of of its stock has
been issued to the public and of the surplus of ,
has been carried to U ndivided Profits acco u nt .
T h e Brown C ompany declares and pays a dividen d
of 1 0 % on its outstanding stock I nterest on the J ones
5
.
’
C ompany s note at and on the Smith ompany s ’
% C
mort gage at 6 % has not been paid one year after th e
ac quisition of the s tock by the J ones C ompany A fter .
recording the accrued interest and the interest payable ,
the balance sheet of the J ones C ompany ( the holding
company ) wi ll show assets liabilities and surplus as
follows :
, ,
JON E S C O M P ANY
BA L AN C E S HEE T
D ece m b e r 3
1 19 19 ,
A s s e ts
P l t P rop r ty I v t or i C
an , e , n en e s, a sh , e tc .
( O p e r ating A s se t s
wh i h h ould b l ifi d )
c s e c ass e
I v tm t i B row C omp y
n es en n n an
9 00 h r of C p it l St o k :
s a es a a c
P v lu
ar a e
P r mium e
I v m
n e st mith C omp ny
e nt in S a
40 0 h r St o k :
s a es c
P V lu
ar a e
L —Di ou t
e ss sc n
M or t g g R iv b l
a e e ce a e
I t r t R
n e es iv b l e ce a e
HO L D I N G C O M P AN Y BALAN C E S HE E T 3
49
L ia b il itie s a nd C a p ita l
Li biliti ( whi h h ould
a es c s be fi d)
cl as si e
B row n C omp y: an
Not P y b le a a e
C a it ap l St o c k
To B row C omp y n an
To S m ith C omp ny a
S urplu s
U ppropr i t d
na a e
U d iv id d P rofit
n e s
B row C omp n y Divid d an en
Sm ith C omp ny I t r t a n e es
L —B rown Comp ny
e ss a I r
nte e s t P ai d
T he Surplus a ccount in the above il lustration is pur
posely set out in detail to show the in tercom p any items .
6 . Pr o t fi and Lo s s St a t e m e n t of Ho l d in g C o m p a n y
J ones C ompany s profit and loss statement
T he
’
shows the net profits of to be made up as fol
lows
P rofi t from O pe r tio n s a
D iv i d e n d s n B row n C om p n y St o k
o a c
I n t r t E rn d o n Sm ith C om p ny M o rt g
e es a e a a
ge
L e s — I n te r e st Ac ru ed
s c on N ot e P ayab le to B row n
C om p ny a
$1
3
5 0 F I NAN C I A L ST AT E M E N TS
T heincome o f a hol di ng company as such is de , ,
rived principally from dividends on the st ocks of sub
sidiar ie s and interest on loans to subsidiaries I f all .
subcompanies operate at a p rofit and pay the entire
profit in dividends to the pa rent company then the in ,
come account of the holding company would be a correct
statement of profit and loss W here however less .
, ,
than the full amount of the p rofit of the subsidiaries is
paid to the holding company in dividends or where one ,
or more of the subcompani es operate at a loss then the ,
’
holding company s income statement would not show
the full truth .
T h e balanc e sheet and profit and loss statement
shown above are now ready for consolidation B y this .
procedure all intercompany accounts are eliminated ,
leaving only the accounts a ff ecting the outside public .
T h e above method of presentation is suggested as pro
v id in a r e ady means for o ffsetting the intercompany
g
accounts of the hol di ng company against the intercom
pany accounts as they appear on the balance sheets of the
Brown C ompany and the Smith C ompan y the sub ,
s id ia r y companies .
7. Ob j e c t io n s to Ho l d in g C o m p a n y ’
s Ba l a n c e Sh e e t
I n fu rther explana tion it should be noted that the
,
above form of balance sheet would not be suitable for a
statement to be rendered to the public T h e su b co m .
panics may have O perated at a loss or at a profit but ,
that at present is of no con se quence since no attempt is
b e ing made to draw up a true balance sheet of the J ones
C omp any for public presentation T h e statement .
above as p reviously noted is a holding com p an y s bal
, ,
’
HO L D ING C O M P AN Y BA LAN C E S HE E T 3
5
1
an ce sheet drawn up in form suitable for consoli dation
with subc ompany statemen t s A n im portant ob j ection
.
to such a balance sheet cons idered as a fina ncial state
ment is illus trated by the fact that it doe s not disclose
the liab ilities of the Brown C ompany and the Smith
C ompany to outsiders although the capital stock of
,
those compa nies is shown as an asset Queri e s that .
would naturally arise in th e mind of the investor as he
scrutiniz
,
e s the statement are whether or not the Bro wn
,
C ompany has borrowed from outsiders the
loaned to the holding company ; whether or not the divi
dend is the resul t of profits earned in 1 9 1 9 ; and whether
or not the two su bsidiary companies are mortgaged to
”
the hilt . T h e foregoing queries may be answered by
taking up on the holding company s st atement a ny a c ’
cr u a ls of subcompany p rofits and by pro v iding for any
subcompany los ses .
But if this is to be done the problem arises as to the
,
term s to be used and the method of sho w ing such pro fits
or losses on the holding company s balance sheet T he ’
.
an s wer to the problem can o nl v be obta ined by an an a ly
sis o f each s u bco m pan y s balance shee t for the purpose
’
of ascerta in ing how the profits have be en disposed of or
what assets and liabilities have been affected by any
los ses O nly after these facts have been determi ned
.
,
can the a ccrued profit or loss be properly named on
the holding company s b al ance sheet U suall y this
’
.
method of presenta tion will require several subdivisions
of the different classes of as sets and the method thus ,
becomes cumbersome and confusing For the sake of .
clearness and simp licity when a s tatement is r e quired
,
for public pre sentation or for the scrutiny o f the share
3
52 F I NAN C IAL ST A T E M EN T S
holders of the p are nt company the holdi ng company s ,
’
balance sheet is invariab ly discarded in favor of the
consolidated balance sheet and consolidated income
statement .
REVI EW QU E ST ION S
In wh r pe t
at es c s is h ol d in g om p n y s b l n e
a s h e t d e fi cie n t
c a
’
a a c e
in h ow in g t h
s e fi n n ci l c o n d itio n f grou p
a a f n ol i d t d o a o co s a e
c or p or t io n s a
Sh oul d dv n e s t a u b s id i ry om p ni s l w ys b ca n l e d in
a c o s a c a e a a e ce
p pr e r i n a
g c o ns ol i d ta d b l n e s h ee t ? a e a a c
H ow h oul d t h e o s t f pit l t oc k f s ub s id i r y om p n y
s c o ca a s o a a c a
be s h ow n on o n s ol id te d b al n e h eet ?
a c a a c s
U n d e r w h t i r u m t n e would th e in om c ou nt f h ol d
a c c s a c s c e a c o a
in g om p n y b e
c a u ffi ie n t t te m n t f th e in c om f th
a s c s a e o e o e
o n ol i d t e d grou p f om p n ie s ?
c s a o c a
Wh t a th f ur m th od
are e o f b l n eh t p r e p r t io n f
s o c n
a a ce s ee a a or o
s ol id t e d c or p or t io n
a n d w h i h is be s t ?
a s, a c
C HA P T E R XXVII I
CO N S OL I D A T E D B ALAN C E S HE E T AND
IN C OM E S TAT E ME NT
1 . Pu rp o s e , an d In c o m e T a x Re g u l a t io n
T he main purpose of t h e consolidated balance sheet
is to present a statement of the combined balance sheets
of a group of affiliated companies in such a manner as
to eliminate all intercompany accoun ts and e xhibit the
assets and liabilities and n et wort h of the entire group
as one enterprise
5
.
G overnment R egulations N o 4 relating to the .
,
federal income tax on corporations contain a n au th or i
3
,
t a t iv e brief for the consolidate d statement in A rticle 6 1
which is quoted herewith
“
A ffiliated corporations T h e provision of the stat
.
ute requiring a ffiliated corporations to file consolidated
returns is based upon the principle of levying the tax
according to the true net income and invested capital
of a single business enterprise even though the business
,
is operated through more t han one corporation Where .
one corporation owns the capital stock of another co r
o ra tion or other corporations or where the stock of two
p ,
or more corporations is own e d by the same interests ,
a situat ion results which is closely analogous t o that of
a business maintaining o n e or more branch establish
ments I n the latter case because of the direct o wner
.
,
ship o f the propert y the invested capital and net in
,
come o f the branch form a p art of the invested capital
3
53
3
5 4 F I NAN C IAL ST AT E M EN T S
and net income of the entire organ ization W here such .
branches or units of a business are owned and controlled
through the medium of separate corporations it is nec ,
e s sa r v to require a consolidated return in order that
the invested capital and net income o f the entire group
may be accurately determined O therwise opportunity .
would be a fforded for the evasion of taxation by the
shifting of income through p rice fixing charges for ,
services and other means by which income could be ar
bitr a rily assigned to one or another unit of the group .
I n other cases without a consolidated return excessive
taxation might be imposed as a result of purely arti
ficia l conditions existing between cor p orations within a
”
controlled group .
2 . M e th o d of C o n s o lid a t io n
I n principle all that is required to accomplish the
,
consolidation is to substitute for the item of I nvest “
”
ments on the holding company s balance sheet the ao ’
tual assets and liabilities of the subsidiary companies
”
represented by the term I nvestments T o illustrate .
the procedure in its most simple form assume that ,
C ompany N o 1 owns the entire capital stock of C o m
3
.
pany N o 2 and C ompany N o and that there is no
—
. .
,
surplus or deficit or intercompany account as would of
course seldom if ever happen T h e balance sheet of
, , .
the holding company is as follows
CO M P ANY N O 1 .
BA L AN C E S H E E T
A s s e ts L ia bil itie s an d C ap ita l
I v m
n e st e nt s p l
C a it a St o
c k
C ON SOLI D A T E D S T A T E M EN T S 35 5
C ompany has plant worth No
other . 2
assets of and liabil ities of
C ompany N o has plant worth other as . 3
sets o f and liabilities of
T h e combined balance sheets of the subcompanies
appear as fo llows
A t
ss e s No 2 N 3 Tot l . o . a
L ia b ili t ies
A cons olidation of the balance sheets o f the t hree
companies would be e ff ected as follows :
C omb i d S b ne u
H oldi g C omp i O fl t C o oli d t d
'
A t
sse s n o . c an e s se ns a e
Pl ant d P rop rt y
an e
Ot h r A
e t s se s
I v tm t :
n es en s
C p it l S t o k N 2
C p it l S t o k N 3
a a c , o .
a a c , o .
p l
C a ita St o c k N o 1
k
, .
Ca p it l
a St o c , S u b co .
’
s
A s the investments of on th e b alance sheet
of C ompany N o 1 represent ing the total stock of the .
,
subsidiary companies are replaced by assets offset b y ,
li abilities the item of , is elimi nated on both
3
5 6 F I NAN C I AL ST A T E M E N T S
sides of the balance sheet of the consolidated companie s ,
which therefore appears as below :
O M P AN Y N O 1
C .
C ON SO L I D A T E D BALAN C E S HEET
A s s e ts L ia bil itie s and C a p ita l
P l a nt a nd P rop r ty
e Li ab i l it ies
O th e r A s se t s C apit al S t o k
c
From the above it i s seen that in principle the con
solidation of balance sheets is a simple matter I n ac .
tual practice however a number of complications
, ,
usually arise which make the work of substituting assets
and liabilities for I nvestments a puzzling problem “
if the statement of financial condition is to be true and
fair to all parties concerned T h e following list of .
suggestions will be found helpful in avoiding these com
plications and will indicate the nature of the problems
which are met in most cases of consoli dation .
1 . A ll subcompany balance sheets should be drawn
up in the same form .
2 . A ll subcompanies should be placed on the same
fiscal year basis and all subcompany balance
,
sheets should be drawn up at the same date
3
.
. T h e complete accounting systems including ,
costs of all companies should be reduced to
,
a uniform basis .
4 . A ll intercompany accounts should be stated
separately on all balance sheets
5
.
. T h e surplus or deficit of all subsidiar y com
panie s should be shown in two amounts
C ON SOLI DA T E D S TA T E M EN T S 3
57
(a) Am ount
accumulated up to date of
acquisition by the holding company .
( b ) Amount accumulated subsequent to
date of acquisition by the holding
company .
6 T h e capital stock a ccounts of all subcompanies
sho u ld be stated in three amounts V iz
.
( )
a Stock owned by holding company .
( )
b S tock owned by other subcompanies .
( c ) Stock owned by general public .
7 T ransfers of product and sales of service b e
.
tween the affiliate d companies should be at
cost .
8 Where intercompany sales include a profit an
.
,
examination of the books should be made to
determine whether any of this intercompan y
profit is in cluded in inventories of stock on
hand or has been charged to the cost o f con
,
struction where the product or the factory
facilities have been utilized in the co n stru c
tion of buildings or other fixed assets .
9 I nterest royalty and other expense payments
.
, ,
between the a ffi liated companies should be
stated separately in all income statements .
10 Dividends between companies should be stated
.
as separate items in the income statements
and surplus accounts of each company .
Most o f the above points are self ex p lanatory and
-
if the accounting policy they indicate is carried out on
or prior to the consolidation most of the di fficulties
,
which arise in consolidating will be readily solved .
A further explanation may be necessary in connec
3
5 8 F I NAN C I AL ST AT E M E N T S
tion with points 5 and 6 I n substituting the ass e ts and
.
liabilities for the I nvestment accounts it will usually ,
be found that the net aggregate of assets less liabilities
of the subsidiary companies will not equal the I nvest
ment account on the holding company books T h e dif .
ference will be composed of one or more of the three
following factors
1 . T he excess above par or the amount below par
pa id by the holding company for the sub
company stock .
2 . T h e surplus or deficit of the subcompany a c
cum ulated up to the time of acquisition by
the holding company
3
.
. T h e accumulated gain or loss of the su b com
pany subsequent to the date of acquisition by
the holding compan y .
3. Su r p l u s of Su b s id ia r ie s as Pr e m iu m
I n considering the above reasons for the di ff erence
between the book value of the investments and the net
assets of the subsidiaries it should be remembered that
,
when a holding company purchases the stock of an
other company the price paid for the capital stock rep
,
resents the value of the equity in the subsidiary com
pany as estimated by the holding company I f the .
price paid is equal to the capital stock and surplus of
the subcompany as at the date of purchase then the
, ,
premium paid above par for the stock represents the
accumulated surplus of the subcompany T herefore .
item 2 above is included in item 1 T h e surplus of the .
subsidiary earned prior to the time of purchase by the
holdin g company cannot be considered as s u rplus of the
C ON SOLI DA T E D S T A T E M EN T S 3
5 9
holding company and in consolidating the balance ,
sheets it will be off set against the premium paid for the
s u b co m p an c p ital stock ’
s a
y .
T o illustrate it is assumed that a holding company
,
issues its stock to the amount of for a sub
compan y s entire capital stock of th e par value of $ 0
’
5 ,
0 0 0 with an accumulated surplus of
, I f the
'
plant and other assets o f the subcompany equal
the conso lidated balance sheet would appear as follows
H oldi g Co lid t d n nso a e
Sub omp y C omp y E limin tion B l Sh t
c an an a s a a nc e ee
A s s e ts
P l a nt a nd O th e r As
se ts
I v m
n e st e nts a t pa r
P r mi um
e on I n v es t
m t en s
L ia bi li tie s
o k H old
C a pit a l St c ,
i g C omp
n y an
C p it l St o k
a a S b c , u
omp y
c an
S urpl t usq ui ia ac s
t io n
T he surplus of for which a
su b co m p an y s
’
premium of like amount is paid cann ot be con sidered ,
as a surplus of the holding company and for this rea
son it is eliminated .
4 . Pr o ts fi of Su b s idia r ie s Pr io r t o Co n so lid a t io n
Where no pre m ium is paid for the capital st o ck of
a subsidiary company but surplus is shown on its books ,
360 I NAN C IAL
F ST A T E M E N T S
at the date of ac quisition such surplus must be deducted
,
on the consolidated balance sheet from the Property or
Plant account of the consolidated compan y T his point .
is clearly and concisely brought out by A L owes D ick .
”
inson in A ccounting Practice and Procedure from
“
which the following paragraphs are quoted :
“
A question of considerable importance in its bear
ing upon the determination of profits in a hol di ng com
p any or
, in any corporation which has acquired a going
business is that of the proper disposition of the profits
,
of the consolidating companies or of the purchased ,
business earned prior to th e date of consolidation
, .
T here is a clear rule of common sense and probably ,
also of law that a corporation cannot earn profits b e
,
fore it exists ; when therefore a corporation at its o r
z
, ,
g a n i a t io n purchases an undertaking together with the ,
profits accrued from a certain prior date the whole of ,
such profits earned prior to the date of purchase must
be treated as a deduction from the purchase price and ,
not as a credit to I ncome account available for divi
d en d s .
T his
proposition is the more evident if it be remem
“
bered that these profits exist in the form of assets in
cluded among those purchased and that any realization ,
thereof is merely a return to the purchasing compan y
of a portion of the purchase money i e of the capital , . .
,
of the corporation S imilar reasoning will show that
.
where a holding corporation purchases the stocks of
several others all profits of the purchased corporations
,
accruing up to the date of the purchase must be treated
by the holding corporation as a deduction from the
p rice paid .
C ON SOLI DA T E D ST A T E M E N TS 3
61
5P . r e m iu m s a n d G oo d -
W ill
I t is generally conceded that a premiu m paid abo ve
par represents good will or as it is sometimes expressed
-
, ,
”
“
premium paid for capital stock of subcompany .
Whatever the term applied it may be properly co n sid ,
ered as an asset of the holding company ; but as the sur
plus o f the subcompany at acquisition is not a surplus
of the consolidated co mpany and must have been con ,
s id er e d in the price paid then such s u rplus at acqui si ,
tion sho ul d be deducted from the combined Property
accounts ( including good will ) of the companies to be -
consolidated I f in the above example the price paid
.
had been the total Property accou nts includ
ing go od will ( or premium on investments ) woul d have
-
amoun ted to From thi s shoul d be deducted
the surplus at acqu isition leaving net assets of ,
S ome accountants prefer to show such a Property a c
count in two items indi ca ting the item of good will
,
-
or Premi u m p aid for acquisition of sec u rities of B lank
“
C ompany representing excess of par value of securities
,
”
issued over par value of securities acquired
as di stinct from the plant and other assets valued at ,
6 . Tr e a tm e n t of Su r p lu s of Su b s idia r y
From the foregoing the rule develop s that the sur ,
plus o f a subsidiary comp any as at the date of acquisi ,
tion shoul d be deducted from the combined Property
,
acco un t when the subsidi ary company is consolidated
with the holdin g company T hi s ruling as wil l be ex .
,
pla ined later does not apply where the subcompany is
,
not entirely owned b y the holding comp an y T here are .
362 I NAN C I AL
F ST ATE M E N TS
obj ections to the above general rule or possibly only to
the wording thereof but usually it will be found accept
,
able and space does not permit an extended discussion
covering a different treatment for special cases .
Where the price paid falls below the total of the
’
surplus and par value of the subsidiary company s capi
tal stock the indication is that the assets on the sub
company s books are overvalued H ere again it is .
,
proper to deduct the surplus from the Property account .
T o revert to the preceding illustration let it be as ,
sumed that the price paid was O n consoli
dation the Property account including the premium ,
paid for capital stock becomes ,
less the sur
plus as at acquisition and the result is that the
value of the plant and other assets becomes
C onsequently when the aggregate net assets of the sub
,
sid iar company do not equal the I nvestment account
y
”
on the holding company s books the excess of offset
’
,
“
on the holding company s statement sh o uld be con
’
s id e r e d to apply to ( l ) the purchase of the surplus of
the subcompany as at the date of acquisition and ( 2 ) ,
the price paid for good will C onversely when the net
-
.
,
assets of the subsidiary company are greater than the
I nvestment account on the holding company s books ’
the deficiency of o ff set may be considered as the ex
“
tent o f the overvaluation of the assets on the subsidiary
compan y s books
’
.
H aving established the fact that a subsidiary com
’
pa n y s surplus a ccumulated prior to its purchase by a
holding company cannot be considered a surplus of the
holding company then the above treatment of such sur
,
plus will be generally accepted as correct in prin ciple
C ON SO L I DA T E D ST A T E M EN T S 336
if not in actual detail C ertainly no accountant would .
attempt to consolidate the surplus of the subcompany
before its acquisition by the holding comp any with the ,
surplus of the latter .
7 . Su r p l u s of Su b s id ia r y w h e n St o c k O n l y P a r t ly A c
q u ir e d
When the holding company has not acquired the e n
tire capital stock of a subsidiary company the account ,
ant must respect the rights of the minority interests i n
the surplus o f the latter T his right covers the entire .
surplus even though the amount accumulated up to the
time of acquisition is stated separately from the amount
thereafter accumulated .
T o illustrate this point take the following example ,
H C ompany purchases 9 0 0 shares or 9 0 % of S C om
pan y s capital stock giving in exchange therefor
’
shares of its own capital stock A t the time of pur .
chase S C ompany s assets amount to
,
’
which
are o ffset by capital stock and surplus
O ne year later S C ompany s assets have increased to ’
and the corresponding surplus amounts to
T h e following working sheet indicates the
method of consolidation in which provision is made for ,
the minority interest one year after the purchase of the
stock :
S C o m p a ny H C o mpany l min tio
E i a ns C o n ol id
s a te d
A s s e ts $ 140
I v m
n e st e nt ( P ar )
I v tm
n es e nt ( P re
mium )
3 64 F I NAN C IAL ST A T E M E N T S
L ia bili t ies H Co m pany E i l mi o
nat i ns
Surplu —M i ority s n
C p it l S t o k
a a (S c
H C omp y an
M i or it y
n
C p it l
a St o k
a c (H
Co )
A
.
S urplu s c qui is
ti n o
S urplu s H Co .
A balance sheet in technical formwould be
H C O M P ANY
C ON SO L I D A T E D B A L AN C E S H EE T
A s s e ts L ia bil itie s and C a pita l
A sse t s ( ite miz e d ) Li y t M i or ity I t r t in
a b ilit o n n e es S
G ood -
Will C r pr t d follow :
o e e se n e as s
C p it l S t o k
.
a a c
P ropor ti o n of Surplu s
8 . C o n s o lid a t e d In c o m e St a t e m e n t
ideal m e thod of showing an income statement
Th e
for a consolidated company is to consolidate income
stat e ments of the parent and subsidiary companies .
T h e foregoing discussion regarding the elimination of
all intercompany items from the consolidated balance
sheet applies with equal force to the consolidated in
come statement T he reader is here referred to the list
.
C ON S O L I DA T E D ST ATE M EN TS 3
5
6
o f suggestions given in g2 whi ch are equally app licable
‘
to an income as to a balance sheet consolidated state
ment Special reference should be given to the last four
.
T he profit made b y one company on a sale of its
product to another affiliated company should be o ffset
aga inst the same amo u nt charge d to cost by the pur
chasin g company Ai so interest paid by a sub sidiary
.
company to a holding company shoul d be elim inated
from the ex penses of the subsidi ary and o ffset against
the same amount in the income of the holding com
pany L ikewise in consolidating any di vidend paid
.
,
by a subsidiary on its capital stoc k owned by the hold
ing co mpan y should be elim inated from the accounts of
both companies .
T h e above items are merely indicative of the man
ner in wh ich all other i ntercomp any items of expense
and income sho u ld be treated T h e obj ect is apparent
. .
T h e co n so lidated income statement shoul d reflect those
items of expense and income onl y which a ffect the whole
group of companies as regards loss and gain outside the
entire organization I ntercompany profits betwee n
.
contro lled companies are of the same character in a
consoli dated statement as the int e r d e part m ent profits
of a sin gle company .
T hough in theo ry the procedure of elimination see m s
to present no difficul ty in practice it will be found to
,
be difficult especially as regards the treatment of costs
,
( 1 gross profits For thi s reas on most accountants
.
co ntent themselves and satisfy their c lients by climi
nating a ll intercompany in terest and dividends and po s ,
sib ly general exp ense s but no atte mpt is made to deal
,
3 66 F I NA NC IAL ST ATE M E N T S
with the items o f c osts and gross profits T h e general .
rule is that all intercompany interest payments and divi
dend payments must be eliminated and if other inter ,
company income and expense items are not eliminated
and o ffset then a reserve should be set up for the esti
,
mated amount of such intercompany profits still remain
ing in the asset accounts of the combined companies .
Such intercompany profits are usually derived from in
v e n to r y sales or transfers and from construction work
when one company sells its services or its products at a
profit to another affiliated company .
9 . Tr e a t m e n t of fi
In t e r c o m p a n y Pr o t s
Where there are a numbe r of subsidiary companies
engaged in manufacturing mining and transportation, , ,
with trans fers or sales between companies or where ,
transportation is carried on by subsidiary comp anies it ,
will be found d ifficult and sometimes impossible to e lim i
nate all profit from these intercompany transactions .
A practical method of overcoming this di fficulty in the
showing of a consolidated income statement although ,
not consistent is to combine all sales and all costs and
,
to show the aggregate of all items with a special division
of sales as between companies and to the outside publi c .
T h e resulting combined gross profit will then be cor
rect and most obj ections are met by the suggested di
vision o f sales but the total sales and total costs as
, ,
indicating the business done by one organization are ,
in reality exaggerated I n the case of large enterprises
.
this method is often the only practicable plan and it
”
is not a serious deviation from the whole truth unless “
the products of one subcompany are used in the con
C ON SO L I DA T E D S T A T E M EN T S 37
6
struction of fixed assets by another affiliated com p any .
Where a purchasing subcompany uses the products
of another subcompany in construction work and such ,
products have been purchased at a profit it will be seen ,
that the C onstruction accounts will contain an element
of intercompany or in te r d e partm e nt profit T his profit .
m ust be estimated and deducted from the C onstruction
account in a consolidated statement by means of a r e
serve created out of the consolidated profit Where .
minority interests are a ffected the reserve should ap ,
pea r o n the consolidated statement ; the same procedure
applies to the inventories which include intercompany
profits above costs I f all the product sold between.
companies at a profit is disposed of by the purchasing
company then a reserve is not n ecessary T h e sales
, .
and costs will be exaggerated but the gross profits will
*
be correct T h e following problem illustrates all the
.
poin ts covered in the preceding discussion and many of
the complexities of accounting for a consolidation .
10 . Illu s t r a t iv e C o n s o lid a t io n Pr o b le m
Four corporations are controlled by one o f the com
p a n ie s through stock o wners h ip T hey operate as sep .
arate concerns buying and sel ling to each other and to
,
outside parties I n preparing a consolidated balance
.
sheet and profit and loss account the following is r e
quired for each company
( a ) First cost of product sold
( )
b I n t ercompany profit on sale s
( )
c Stock on hand
Prepare statement show ing above from t h e follow
-
P bl m
ro f M
e o h tt 0 P A
ass acx mi ti 1 9 1 5
use s . . . e a na on, .
368 F I NAN C IAL ST ATE M E N TS
ing : T h e combination consists of C ompanies W X Y , , ,
and " C ompany W purchases raw material and sells
.
to outside p arties and cost price to C o m
pany X for leaving on hand C o m .
p any X spends in manufacture and ship s over
C ompany Y s railroad $ 7
’
to C ompany " and $ 2 0 ,
0 0 0 to outside part es C ompany " pays C ompany X
i .
for the goods and pays C ompany Y freight
which cost the latter expends in
manufacturing and sells , worth of finished prod
u e t to outside parties leaving a balance on hand
,
.
Solution :For the sake of brevity and clearness let ,
the consolidation of C ompanies W X Y and " be des , , ,
”
ig n at e d as C and be regarded as a unit T h e answers
“
.
re q uired are not as clearly in di cated as they mig ht have
been and the solution below is based on th e following
,
assumptions :
( )
a T hat
by cost of product sold is meant both
the cost shown on the books of the respective
companies and also the net cost to C C om .
”
pany Y sells transport ation service
“
.
”
( b ) T hat intercompany profit on sales also ap
“
plies to fr e ight charges of the railroad com
pany Y ; that is the profit shown on the ,
books of the companies which is not a profit
of C .
c
( ) T hat stock on hand is valued both at b ook
cost and at cost to C .
I t is also assumed that the sales to outside parties
by W b y X and
, by " ) are ,
at cos t price according to the books of the respective
,
companies I n the following tables the first column
.
C ON SOLI DAT E D ST ATE M EN T S 3
69
contains book costs and boo k profits sho wn separately ; ,
the second that portion of the amounts in the first aris
,
ing from in tercompany rela tions ; and the t hird net ,
costs to C .
P u r ch a s e s from u d r
O ts i e s
Stok c H d on an
B oo k P ro fit n S , o al es to X
C omp y X an
P r h
u c from W
a se s
uf t ur ing L b or
39
M an ac a and Ex
pn e se 4 00 0 0
C os t of Good M d s a e
S al es to O u t id r
s e s
St ok c H nd on a
B oo k P ro fit n o Sa l es to "
C omp y Y an
S la esof Fr e igh t to "
B oo k P ro fit on Fr e igh t S old t o " 8
C omp an
y "
Fr ur h d from
e igh t P c as e Y
Ma nuf t rin g L b r
ac u a o a nd Ex
3
7 0 F I NAN C I AL ST A T E M E N T S
B ook
F igures E i l mina t i ns o
Co t of G ood M d
s s a e
S l t O u t id r
a es o s e s
St o c k on H an d
With the foregoing working paper as a
solution is obtained as follows :
C o t of P rodu
s ct Sold
W
X
Y
"
T ta o l
(b)
I A dju m st e nt s u of
Be c a se
11t er co m p a ny
l
P r ofit
I r omp
nt e c any R l t io
e a ns P rofit s to C
T A dd
on Sa es
T o De du ct o
5 00
T tao l
St o c k on H an d
s
w
e
N
T tao l
Th e p
t o b e n o t e d in t h e
o in t s p p
r e ar a t ion o f t h e ab ov e t a b l e s a r e th a t 6% of th e
b oo k c o s t o f th e go o d s m a d e b y X is b e c a u s e o f W s b o o
’
r o fit kpa n d h e n c e is n ot a
i y
,
cos t t o C ; a n d s im l a r l th at 1 2 7% o f t h e b oo k c os t o f t h e g oo d s m a d e b y " is be
c a u se oi th e b oo k pr
o fits of W , X , a n d Y , h e n ce 1 8 n ot a c o s t to C
.
.
C ON SOLI DAT E D ST A T E M EN T S 3 71 .
I t is not to be understoo d that the total profit of C
is o nl y or that C s total stock on hand is $ 5
’
5
5
,
9 0 ; Y may have inventories and no doubt all four
,
companies have made profits on their sales to outsiders .
A final point to note is that in making up a consolidated
balance sheet for C ,should be deducted from the
s um of the b oo k inventories of W X Y and " ; and in , , ,
making up a consolidated profit and loss account for C ,
should be deducted f rom the sum of the book
profits ( both gross and net ) of W X Y and " , , , .
11 . Sp e c ia l Co n so lid a tio n P o in ts
For the pur p ose of completing the di scussion of con
so lid a t io n s a num ber of special points are covered b e
,
low wh ich frequently confront the accountant engaged
on this class of work I t should be noted that the fol
.
lowing statements represent the writer s op in ion and ’
are given w ithout di scussion because of the necessarily
lim ited treatment that can here be accorded to so broad
and comp licated a subj ect T h e reader is cautioned
.
that the accountin g procedure for conso lidations is still
in the stage of development and many of the assertions ,
though generally accepted as correct by accou ntants do ,
not necessarily co incide with legal decisions .
12 . W o r kin g Ca p ita l Pr o v id e d b y Su b s id ia r ie s
Where a su bsidiary company in addition to t u rning ,
over its stock or properties to a holding company also ,
provides ca sh for workin g capital thi s cash is in reality ,
a reduction of the price paid by the holding company
and should be so treated on its books Such working .
capital is assumed to be donated and therefore it cann ot
3
7 2 F I NANC IAL ST AT E M EN T S
properly be treated as surplus of the holding company .
T o pay out such surplus in dividends would in e ffect be
a di stribution of capital .
1 3
. Su r p lu s and Div id e n d s of Su b s id ia r y
Surplus accumulated by a subsidiary company prior
to the date o f its acquisition by a hol di ng company is
not surplus of the holding company and sh o uld not be
d istributed as dividends by it .
T h e declaration of a dividend by a subsidiary com
pany imm ediately upon the acquisition of its stock by
the holdi ng company cannot be treated as income of the
,
holding company H ere again the effect of such a divi
.
dend is to return to the holding company part of the
purchase price .
T h e minority interest outstanding in any subsidi ary
company should be clearly stated on the consolidated
balance sheet S uch interest should not appear as a
.
p art of the surplus or capital of the consolidated com
pany O utsiders will not regard the item as a liability
.
to creditors if it is properly described as including a
minority interest in the capital stock of the named sub
s idiar y company and thus owning a proportionate share
of the surplus applying thereto .
When the capital stock of a subsidiary company is
acquired during the year by a holding company on the
ba sis of the su b co m pa n y s b a lance sheet as at the first
’
of the year the accountant in the absence of any in
, ,
d icatio n s of ulterior motives may consider the su b sid
,
iar y company s earnings from the fir st of the year to
’
the date of the purchase as earnings of the consolidated
company I n such a case it will usually be found that
.
C ON SOLI DA T E D ST A T E M EN TS 73
3
interest on the purchase price is paid for the period
from the first of the year to the actual date of acquisi
tion and in a consolidated statement this interest should
,
be tre ated as a partial o ffset to the a ccumulated earn
ings of the subsidiary company .
Where the earnings of a subsidiary company are in
s uffic ie n t to pay a dividend on its cumulative preferred
s tock that fac t sho ul d be clearly shown on the consoli
,
dated balance sheet ; otherwise the entire surplus shown
thereon would appear to be available for distribution
to the stockholders of the holding compan y .
14 . A d v a n c e s t o Su b s id ia r ie s
A dvances to a subsidiary should either be elim inated
on conso li dation of the accounts or be shown on the
holding company s balance sheet in such a manner as to
’
indicate whether such advances ( 1 ) c an be liquidated by
the subsidiary out of current assets ( 2 ) are absorbed
3
,
in fixed assets or ( ) represent losses of the subsidiary
, .
1 5T
. r e a tm e n t of M in o r it y In t e r e s ts
W here the minority interests in a subsidiary com
pany are substantial the accounts of that subsidiary
,
should be shown as separate statements supporting and
amplifying the consolidated statements which include
the accounts of the subsidiar y company .
16 . Tr e a t m e n t of a Su b s id ia r y
’
s Lia b ilit ie s and De fi c it
O n the consolidation of the ac counts all assets and
”
liabilities should be shown gross i e the subsidiary “
, . .
,
company s assets and liabilities should appear on o p
’
p o s it e sides of the consolidated balance sheet I t is not .
3
7 4
‘
F I NAN C I AL ST A T E M EN TS
proper to s h ow the net assets ( assets less li abilities )
of subsidiaries as the assets of the consolidation omit ,
ting mention o f the liabi li ties .
A ny deficit of a subsidiary co mpany existing at the
date of acquisition should not be deducted from the
accumulated surplus o f other subsidiaries at that time .
E arnings accum ul ated subsequent to acqui sition by a
subsidiary whose books show a deficit at acquisition
should first be applied to the reduction of that deficit
before these earnin gs are distributed as dividends .
A consolidated balance sheet should alway s include
the accounts of a ll subsidiaries T o include some and .
leave out others invariably results in concealing the true
state of a ffairs T herefore a statement to be correct
.
, ,
should either leave out or include a ll subsidiary accounts .
T h e writer made an examination some time ago of a
large N ew Y ork corporation w hich controlled several
subsi di ary companies O perating many d i ff erent indus
tries T h e company had theretofore issued a statement
.
headed C onsolidated B alance Sheet of A C ompany
“
,
I ncluding B C ompany and C C ompany A dvantage .
had been taken of a technical subterfuge in the title .
T here were eighteen c ontrolled compani es in all An .
extended investigation revealed the fact that the B and
C C omp anies were the only profitable subsidiaries .
T h e other companies showed a deficit more than suffi
cient to o ff set the surplus of the combined A B and , ,
C C ompanies .
REVI E W
QUE ST I O N S
1 . Wh t a e th e r gum en t in f vor f m k in g
a r a s a o a a c o ns ol id at e d b al
nc e s h e e t fo
a ffil i te d orp or ti o n ?
r a a c a s
C ON SOLI DAT E D ST A T E M EN T S 3
5 7
3h oul d b
s k en in pr ep r ing t h e s ta te m en ts o f affil i
e ta a
r
p t
o ra i n fo o n
s ol i d
or ct i o n
s ? a
o s i ti no h oul d be m d
s f th e e r nings f s u bsidi r y
a e o a o a
i s pr ior t
e o n s ol id tio n ?
o c a
of th epita l t k
ca f s oc u b id i r y co m p ny is n t
o a s s a a o
h w h oul d its s urp lu s b e s t t d
o s n o n s ol id ted
a e o a c a
sh e e t ?
the d a n ge rs to be gu a rd e d a ga in s t in e li m in a tin g in
an
y p rofi ts on a co ns o lid at e d s t a te m e n t o f p ro fi t a n d
Par t V
an d Te stin g o f th e Acco u n t s
"E
C HAP T E R XX I X
E RROR S A N D T H E I R C LA S S I F I C AT I O N
1 . In t r o d u c t io n
So far as is k nown there is no comprehensive litera ,
ture on the subj ect of e rrors although many of the ,
points are touched upon in books on auditin g .
S ince to err is human errors are found in every de ,
p a rt m e n t o f life but probably in no other
, are they so
immediately important and troublesome as in business
account ing .
When the subj ect of errors in business accounting
is considered one naturally thinks of the professional
,
auditor whose duty in part is to deal with such matters .
T hese chapters on prevention detection and correction , ,
of errors however are not designed for him nor will
, , ,
they indicate completely how one can become an auditor ,
although it i s hoped that they may be of suggestive
value to a professional auditor s assistants T hey are ’
.
designed primarily for proprietors executives and , ,
members of accounting and book keeping departments
of business T heir purpose is to point out to such per
.
sons c erta in respects in which they can test the accuracy
and completeness of their boo ks of account .
T h e first three volumes of the set and the preceding
chapters of this volum e have ful l y discussed account ing
Ch p XX I X t XXX I I I i l i w G r l y th
of
a te r s
B u s m es s
‘‘
A o
cc o un tin g
t ib t d b
.
"
M d it
n c us v e e re co n r u e y r . ee e , e e or
3 80 VE RI FYI N G A ND T E ST I NG THE A C C OUN T S
p rinciplesand the accounting terms for all balance
sheet and income accou nt items T h e present discus .
sion is concerned only with the procedures to be fol
lowed in the detection and correction of errors T o .
apply these procedures adequately it will be necessary ,
for the reader to have a thorough understanding of the
other chapters in this volume and of the volumes which
have preceded it in the set .
2 . Pr e v e n t io n of Er r o r s
T heproverbial ounce of prevention is of great value
in the accounting department and should receive seri
o u s consideration whenever employees are engaged or
trained and whenever systems of accounts and bus iness ”
procedures are des igned and installed D espite the .
exercise of the utmost care in all of these respects how ,
ever errors will continue to occur as long as the human
,
element is employed in the conduct of business and there ,
is no present prospect of reducing the use of the human
element to any material extent C onsequently the de .
,
t e ct io n and correction of errors is of more general in
t er e st than the prevention of them and this chapter , ,
therefore rather briefly dismisses the latter topic
, .
T here are two chief expedients employed to prevent
errors O ne is mechanical and the other is a matter of
.
the organization of the human factors in the business .
T h e first expedient is the use wherever practicable of
, ,
o ffice machinery Such machinery is not limited to a c
.
counting devices such as bookkeeping adding and cal
, ,
c u l at in g machines but includes many which are used
,
in other departments but which indirectly a ff ect the ao
counting department T h e accounting department is
.
,
E R ROR S A ND T HEIR C LA SSI FI C A T ION 3
81
in fact the nervous system of the business and nothing
,
can happen anywhere in the business body which does
not sooner or later register its influence through the
accounting department For example time clocks to
.
,
record time mailing machines to record stamps and
, ,
typewriting or carbon devices to record sales are ,
obvious examples of mechani cal means related more or
less closely to the accounting department Mechanical .
aids should be employed in every case where sound
j udgment indicates that their first cost interest on the ,
investment represented by them and their cost of opera,
tion are likely to be less than the cost of clerical labor
without them together with the cost of delays due to
slower operation and the cost of detecting and correct
ing errors which will be unavoidable when the human
brain alone is utilized .
3. In t e r n a l C h e c ks
T he other preventive expedient is known as the
internal check U pon the same principle that the more
.
planks there are in a raft the harder it is to sink it the ,
more persons who check a transaction the more likely
it is to be handled corre ctly A n internal check is the
.
vouching or approval in whole or in part by one person
within the organization of the work of another person
°
within it I t is secured by making it one s duty ex
.
’
pressly to approve another s work or by so arranging
’
the business routine that his own function cannot be
satisfactorily performed if another err s in his work .
T h e latter method is preferable partly because pride ,
in one s own work is the strongest incentive to insist
’
ence u p on p ro p er co o p eration by others and p artl y b e
-
3 82 VE RI F YI NG A ND T E ST I NG THE A CC OUN T S
cause it obviates any irritation which might be caused
’
by making it one s duty to correct or report another s
’
error .
T h e fo llowing example of an internal chec k shows
how the work of four employees can be interrelated for
the protection of all of them and for the safeguarding
of the business as a whole I n an instalment house one . ,
clerk has the duty of opening a ledger account for each
cu stomer and noting on it the instalment terms R e .
m itt an ce s by customers are handled by a cashier who
prepares a daily record of cash receipts showing the ,
amount received from each customer and the total for
the day to be deposited T his record is then routed to
.
the clerk who opened the ledger accounts and he posts
the credits for the insta lments received A s the .
amounts and due dates of instalments vary he is likely ,
to notice any errors by the cashier in listing the remit
tances From this clerk the record is routed to a mes
.
senger who receives from the cashier the total indicated
and deposits it in the bank H e then turns the record .
over to the general bookkeeper who verifies its addition
and notes that the bank p ass book shows a deposit of -
an amount corresponding to the total appearing on the
record .
4 . C la s s i fi c a t io n o f Er r o r s
E rrors however cannot be entirely prevented and
, ,
thus they must be controlled in the most masterful way
practicable T h e first step in the solution of any prob
.
lem is a diagnosis or definition of the problem itself .
T herefore in dealing with errors it is desirable at the
,
outset to classify them in order to see what general prin
E R RO RS A ND T HE I R C LA SSI FI CA T ION 33 8
c iple s underlie their correction and what usual methods
can best be employed in correcting them .
Since the fundamental obj ect of account keeping -
as explained in V olume I is to show two things namely
, , ,
the financial condition of a business and the changes in
its condition since some preceding date it follows that ,
the most fundame n tal kind of error is one which results
in a misstatement of either of these conclusions A s a .
matter of fact a misstatement of either the financial
,
condition at a given date or of the changes since a pre
ceding one necessarily involves a misstatement in both
,
of them Fundamental errors of this kind have been
.
called errors of principle .
But errors may not be so fundamental in their e f
fect For example one account receivable may be over
.
,
stated and another understated by the same amount
without any resulting misstatemen t of the financial con
dition of the business as a whole Such errors may be
.
more immediately troublesome and may ultimately be
more costly than errors o f principle For the purp ose .
of classification they may be called statistical errors .
Both errors of principle and statistical errors may
be intentional or unintentional and this classification
,
is really the most fundamental one I n considering in
.
t e n tio n a l errors the motive underlying them is not im
,
portant from an accounting point of View I n some .
cases the motive is fraudulent as for example where
,
an employee endeavors to conceal a defalcation or where
a proprietor seeks to misrepresent his financial condi
tion or his earnings T h e question of the motive under
.
lying an intentional mistake does not however a fl ect ’
, ,
the detection and correction of it .
384 V E RI F YI NG A ND T E S T I NG THE A C C OUN T S
Unintentional errors of both kinds may be due to one
or more of three causes
1 Fail ure to understand accounting principles
.
Failure to understand accoun ting techniqu e
3
2 .
C arelessness
.
T h e following outline shows the classification of
errors which has j ust been proposed .
1 Int o l e rror s
e n ti n a
r
O f p in c ip le
S t a tis tic a l
p r in c ip e l
2 . U n int en ti o n l rro a e
s t i c al
F ilur t u n d r t n d
( a) a eou n tin g pr in ipl
o e s a a cc c e
F ilur e t u n d e r t n d
( b) a ou n tin g t e h n iq u e
o s a acc c
C r l s n
(0) a e e s ess
E rrors have been classified also as those of omission
and those of commission I t seems however that this .
, ,
classification is not fundamental because the effects of ,
an error and the means of detecting and correcting it
are the same whether the error was reflected in a wrong
entry or was occasioned by the failure to make any entry
at all.
I n addition errors are sometimes classified as ( 1 )
,
errors of principle and ( 2 ) er rors o f technique I t is .
di fficult to distinguish between the two however b e , ,
cause many errors o f technique result in the violation
of accounting principles I f a classification along this .
line is desired the following may be used :
,
1 . Formal errors which need correcting only to
,
improve the accounting style of the entries .
2 . Substantial errors which are either a correct ,
expression of a wrong idea or an incorrect
expression of a right idea .
E R ROR S A ND T H EI R C L ASS I FI C A T ION 35
8
N ither of these classifications however
e , , seems as
help ful as that given in the a bove outline .
5E
. x a m p le s o f Er r o r s
fo llow ing errors are i llustrati ve and serve to
T he
exemplify the headings used in the foregoin g c lassifi
cation
I ntentional E rror of Pr inciple
1. C hargin g buildi ng addi tions to R epairs to
underst ate the earning power in order to
induce a stockholder or other proprietor to
di spose of hi s interest .
2. C harging D iscoun ts and All owances instead
of C ash with m o n e v received from c u s
t o m e r s in order to cover a defalcation .
In tentional Statistical E rror
1 . C harging the wrong member of a club for
house charges in order to favor a member
who should have been charged ( I f the .
latter s accoun t were known to be worthless
’
this woul d be an error of principle ) .
U nin tentional E rror of Principle
Failure to understand accounting principles
1 .C rediting to principal the entire p roceeds
of a sale of bonds by a trustee which in
e ludes acc rued interest instead of cr e dit
,
in g the accrued interest to in come .
2 Failing to amortize the cost of o ffice altera
.
tions over the li fe of a short term lease
3
-
.
C rediting S ales with merchandise shipped
.
on consignment .
3
86 VE RI F YI N G A ND T ES T I NG T HE A C C OUN T S
”
4 . C re di tin g to income flat water rates co l
le cte d in advance by a municipality
5
.
. C harging to expense dividends paid b y a
corporation .
Failure to understand accounting technique
1 W riting o ff bad debts by charging th em to
.
S uspense without closing the latter into
Profit and L oss thus leaving the a o
,
counts as assets .
C arelessness
1 . Posting to an asset accoun t instead of to
an expense account or V ice versa
, .
U nintentional Statistical E rror
Failure to understand accounting principles
1 .C rediting notes receivable discounted to
N otes R eceivable instead of to a new ao
,
count entitled N otes R eceivable D is
counted .
F ailure to understand accounting technique
1 . A corporation having a sinking fund for
bonds and desiring to pass all payments
through the voucher register at the end ,
of the year entered a voucher for the
sinking fund instalment T h e result .
was a debit to Sinking Fun d and a credit
to A ccounts Payable T h e check in .
payment of the voucher however was , ,
not drawn until after the close of the
year T h e resulting error was an over
.
statement of cash in the sinking fund and
E RROR S A ND T HE I R C LASSI FI C A T ION 37
8
an overs tatement of the acco un ts pay
able .
2 . A similar error would occ ur if interest on
treasur bonds was accrued because it
y
,
would resul t in an oversta tement of bo th
the income and the expen se of I nterest .
C arelessness
1 . C harging or crediting the wr ong asset or
liab ilitv account or the wr ong income or
expense accoun t .
6 . Ne c e s s ity fo r C o r r e c tio n
I t might perhap s be assumed that the advi sability
, ,
of correcting errors is obvious N evertheless the most .
se r ious dangers which result from failure to correct e r
r o r s in each kin d of bus iness organization are noted
herein because in some cases business men and those
,
in th e ir employ have been foun d to neglect the corre e
tion o f errors on the gro u nd that they were immaterial .
I n this discussion matters of fraud and defalcation are
excluded be cau se the penalties for them are generally
k nown in advance I n cases of that kind the person
.
responsible for the error makes it d e lib e r at e lv in the
hope that it will escape detection E rrors which are .
not fraudulent however shoul d nevertheless be
, ,
promptly and carefully corrected ; some of the dangers
resultin g from the fail u re to make co rr e ctions are noted
in the follo w ing sections .
7 . Erro r s in a So le Pr o p r ie t o r s h ip
A n in t entional error in principle might result in the
loss of cre d it at a b ank or even in the prosecution of the
3 88 VE RI FY I N G A ND T E ST I N G T HE A CC OUN T S
o ffender for a crime I n some states it is a penal o f .
fe n se to make a false entry or a false statement from
books of account for the purpose of misleading anyone .
T here are also penalties under the state and federal
, ,
income tax laws for intentional errors in the statement
of financial condition or earning
When a sole proprietor makes an intentional statisti
cal error he runs the risk of fooling himself if he for
, ,
gets the error and fails to adj ust it when he wants the ,
exact facts of his financial condi tion or earnings and
expense items .
A n unintentional error of principle or an u n inte n
t io n a l statistical error from whatever cause is likely to
result in the dangers or penalties listed above except ,
for personal penalties which depend upon the inte n
t io n a l character of the act I n addition an u ninten .
,
t io n a l error may involve a substantial cost to correct it
and a loss of money or business if customers or creditors
are a ffected When future bids or budgets are based
.
on erroneous figures a loss of business or of profits ,
frequently results .
8 . Er r o r s in a Pa r t n e r s h ip
E rrors of all kinds in a partnership have su b st an
t ially the same results as similar errors in a sole propri
e t o r sh i
p but
, there is an added danger of costly li tiga
tion by partners and even of an involuntary dissolution
of partnership A n error might result also in an u n
.
warranted overdraft by one partner which the other
partners might not be able to recover or might fail to
detect and thus experience a substantial loss whether ,
known or u nkn own .
E R ROR S A ND T H EI R C LA SSI FI CA T ION 3
89
9 . Er r o r s in a C o r p o r a t io n
Special care should be exercised in keeping the a o
counts o f a corporation U ncorrected errors may in .
volve the same consequences as in the sole proprietor
ship with the additional risk o f personal liability im
,
posed o n directors if the capital is impaired A ctions .
at law by creditors or by stockholders may result from
errors T here is also the possibility of an action by
.
the attorney general of the state to dissolve the cor
p o r a t io n A s corporation
. taxes are higher and more
complicated than those for individuals and partnerships ,
the dangers of over and under payment are increased -
10 . Su m m a r y
E rrors therefore may be classified as intentional or
, ,
unintentional and may result in misstatements of fin an
c ial condition or earnings or in erroneous statistics of
the business R egardless of its cause an error of any
.
,
kind should be corrected at the first opportunity in ord e r
to avoid the dangers noted above C hapter XXX I I I .
is concerned with the methods of correction but before ,
errors can be corrected they must be discovered C o n .
sequently the next three chapters deal with methods of
detecting errors .
REVI EW QUE ST ION S
Wh t i m nt b y in t rn l h k ?
a s ea e a c ec
W hi h l c ific asst io n f rror do y
ca fin d mo t h l p ful ?
o e s ou s e
A ref r udul a t rror en lw y rror f pr in ip l ?
e s a a s e s o c e
S h ould r t n r in i t u o n t h e orrs st io n f rror s ? c ec o e
p a a p e
W h t d g r th r t n
a an e s or por tio n w h i h f il s t c orr e
ea e a c a c a o ct
rror s in it c oun ts ?
e s a c
C HA P T ER XX X
D E T E C T I ON O F ERROR S B Y BUS INE S S
E X E C U T IVE S
1 . Fu n c t io n s of Ex e c u t iv e s
A n executive in any line of business endeavor has
three functions to perform : he must organize deputize , ,
and supervise T o organize means to p lan the pro
.
ce d u r e s for all usual transactions and to provide for
the handling of unusual ones T o deputize means to .
select a suitable person to carry on each step of each pro
ce d u re and to delegate authority to him to do the meces
sary things T o supervise means to examine critically
.
the work of all persons selected and deputized to carry
on the work of the organization .
I t is a remarkable executive who is equally pro
ficie n t in all three functions Most persons excel in.
some one of them only for which there is a natural rea
,
son ; namely that the highest performance o f each func
,
tion depends upon qualifications di fferent from those
required in the other functions O rganization work de .
mands a constructive imaginative faculty ; selecting and
,
deputizing employees requires keen j udgment of human
nature and a considerable knowledge of vocational
placement ; proper supervision demands a critical
faculty .
T h e discussion of the second function of an e x ec u
tive would be bey ond the scope of these chapters T h e
3
.
90
D E T E C T ION O F E R ROR S BY E X E C U T I VE S 3 91
first fun ction that of orga n iz ing so far as the preven
, ,
tion of errors is co ncerned is exercised in es ta blishing
,
in ternal checks to which reference is made in C hapter
XX I X T h e presen t chapter dea ls with the third
.
f unction and po ints out some of the wavs b v which
errors can be detected through executive supervision .
T he very words executive supervision suggest a
limitation on the exercise o f thi s function in the d e t e c
tion o f errors E x e cutive work i s not detail work and
.
supervis ion necessarily implies examination of work
done by some other person H ence it follows that the
.
det e ction of errors by mean s o f an audit or of a de tailed
inspection of the acco u nts is not accomplished by e x e cu
tive supervision E xecutive supervision means s cr u
t in iz
.
ing employees work t o test its correctness E rrors
’
.
in accounts are discovered by executive supervision
when they are revealed by an exam in ation o f trial bal
auces statements and other data prepared by the book
, ,
keeping o r accounting department A business e x e cu .
tive should endeavor at a ll times to apply the test o f
reasonableness to figu res presented to him ; the foll ow
ing sections in di cate the principal means by which thi s
can be accomplis hed .
3. Pr e d e t e r m in e d Pe r c e n ta g e s
Probably the most practicable sin gle exp e dient for
testin g figures is the u se of predetermined percentages .
When a normal bus iness has been in op eration for a
nu mber of years fut u re operating re sults and relation
,
ships betw een assets and li abilities can be forecast al
3 92 V E RI FYI N G A ND T E ST IN G T HE A C C OUN T S
most with certainty by applying to estimates of futur e
business certain significant percentages fixed through
experience When later figures are presented to show
.
, ,
the actual results in a current year they should be tested ,
by the predetermined percentages and if they do not ,
stand the test investigation should imm ediately be made
,
to ascertain the reason for their deviation from normal .
I f the fi g ures are incorrect such an investigation would ,
disclose it .
4 . Pe r c e n t a g e of G r o s s Pr o t fi
simplest percentage test is that of gross profit
T he .
G ross profit being the excess of selling price over the
cost of goods sold should not vary to any considerable
,
extent except with the volume of sales T herefore if .
,
the reported gross profit for a current fiscal period is
an unusual percentage of sales the figures should be ,
verified C are should be exercised in applying this test
.
to compare like or similar periods I f the business is a .
seasonal one a comparison should normally be made
,
between the same months of di fferent years rather than
between one month and the month which immediatel y
follows :
5B
. a s is o f Pe r c e n t a g e of G r o s s Pr o t fi
percentage usually employed shows the rela
T he
t io n ship between gross profit and sales O ne might .
immediately inquire why gross profit is not related to
the cost of g oods sold instead of to the sell ing price .
W hen one invests money in stocks or bonds and su b s e
quently realizes a profit through sale he relates his ,
profit to his investment ; that is to the cost and not to ,
D E T E C T ION O F E RRO RS BY E X E C U T I VE S 33
9
the selling price For example if he buys a bond for
.
,
$ 9 0 0 and sells it for he has made a gross profit
roughly of $2 0 0 which he considers one of
, N ow ,
if instead of buying a bond he buys merchandise why ,
should he consider his profit to be
R etail merchants usually relate their gross profits
to sales because it is somewhat more convenient I t is .
easier to use the known quantity sales as 1 0 0 % and
, ,
subtract from it the percentage of gross profit than to ,
consider the known quantity sales as 1 0 0 % plus a per
, ,
centage of gross profit .
T h e basis on which percentages are to be calculated
should be fairly constant and it might be thought there
fore that the cost of goods sold would be better than
sales for the base to which to relate the gross profit b e
cause cost may be thought to fluctuate less tha n sales .
L eaving aside peculiar kinds or instances of retailing
which may be classified as somewhat speculative the ,
same laws of supply and demand which control the
wholesale price control also the retail price T h e fact .
that retail prices of standard articles of co m mon use
are subj ect to economic law and do not fluctuate widely
has been demonstrated by the H arvard Bureau of Busi
ness R esearch I n its Bulletin N o 1 issued O ctober
3 3
. .
,
0 191
, , it states that over 60 0 shoe retailers in 2 6
states and in two foreign countries have furnished the
bureau actual figures from their own businesses U pon .
these figures the Bureau was able to reach the following
conclusions as to gross profits all percentages being
,
reckoned upon the se lling price T h e Bureau is in
clin e d to think that under present conditions the typical
gross profit on shoes retailing at or under will be
3 94 VE RI FYIN G A ND T E ST I N G T HE A CC OUN T S
3 5
found to run from 2 % to 2 % and for those retailing
above that price a percentage of from 0 % to
”
% is 3 3
3
the type I n other words in normal business the
.
,
selling price is quite as safe a base to which to relate
gross profits as is the cost of goods sold .
6 . A d d it io n a l Us e s of fi
G r o s s Pr o t Pe r c e n t a g e
T he executive can use the percentage of gross
profit not only to test the accuracy of the amounts r e
ported as gross profit but also to test estimates of in
,
v e n t o r y at times when no actual inventory is taken .
T h e books of the average retail merchant do not and
could not conveniently show currently th e inventory
of goods on hand Y et it may be im portant to know the
.
inventory a t least approximately at certain times when
taking an inventory would be either impracticable or
impossible For instance it may be necessary to estab
.
,
lish the value of merchandise destroyed by fire at a time
when the actual inventor y was not known A lso it .
may be desirable to estimate the profit or loss for short
periods between times of stock taking I n both of -
.
these cases the executive can test the accuracy of esti
mated inventories by means o f the gross profit percent
age .
A n estimated inventory can be tested in the follow
ing manner :By subtracting from sales the estimated
amount of gross profit assumed to be at the same rate
as during a preceding similar period the estimated cost ,
of goods sold is determined T h e estimated inventory
.
should be the amount secured by subtracti ng the esti
mated cost of goods sold from the sum of the last actual
inventory and the p urchases th ereafter .
D E T E C T ION O F E R ROR S BY E X E C U T IVE S 35 9
7 . Ex a m p le of In v e n t o r y T e s t
A ssuming the sales to be the rate of gross
profit the opening inventory and the
purchases the present inventory could be
estimated in this way
I nv ent ory at b e gin n in g of
pe i dro
P ur ch a s e s d uri n g pe r io d
o l M e r h n d i e v il b l e f
T ta c a s le a a a or sa
D du t—E t im t e d C o st f M r h n d i se S ol d
e c s a o e c a
S l
Le — E s tim te d G ro s s P rofi t 3
a es
ss a 07 , 0
E s tim a te d I n v en tor y at c l os e of pe ri
o d
8 . Pe r c e n t a g e of Tu rn o v e r
T he
turnover o f merchandi se stock may be defined
as the use of it in trade or exchange ; that is to say it ,
is the selling of the merchandise and the converting of
it thereby into accounts and notes receivable and cash .
”
T urnover is sometimes called stock turn T h e ob j ect
“
.
of a merchant is to make this turnover or stock turn
by selling his merchandise at a price higher than its cost
'
,
thu s realizing a profit Such profit is k nown as gross .
profit because the expenses of making the turnover must
be considered before determining final or net profit .
I t is customary to state the turnover in percentage
terms but unless the percentage is correctly calculated
it is misleading to the executive S ince turnover is the .
use of merchandise through the selling of it we must ,
compare the inventory ( merchandise available for sale )
with the sales ( merchandise which h as been sold ) In .
396 V E RI F YIN G A ND T ES T I NG T HE A C C OUN T S
this comparison we must use not the amount realized
on sales but the cost of goods sold because inventories ,
are ( or should be ) stated at cost and comparison should ,
be made only between like elements .
T here are di fferences of opinion concerning the
determination of t h e inventory to be used in the com
parison S ome persons use the invento ry at the begin
.
ning of the period but it is believed that an average in
v e n t o r y during the period should be determined and
used A n average inventory is considered a more rep
.
r e se n ta t iv e figure because the beginning inventory is
usually the result of actual stock taking and is likely -
to be lower than the average inventories being taken ,
when stock is low in order to reduce the cost and incon
v e n ie n c e of taki n g them .
T h e turnover should be stated as a percentage of
the average inventory on hand during the period T his .
percentage is determined by dividing the cost of goods
sold by the average inventory For example if the .
,
cost of goods sold was and the average inventory
was the turnover would be For co nv e n
ie n ce it is stated as in other words the stock has ,
been turned over one and one half times -
.
T h e business executive should appreciate the real
significance of turnover Many of the expenses of
.
.
making the turnover are fairly fixed in amount and de
pend chiefly upon the element of time E xamples of .
these are rent wages payable on a time basis deprecia
, ,
tion heat light power taxes insurance and interest on
, , , , , ,
borrowed capital Such expenses continue from day
.
to day regardless of the volume of sales .
T he turnover must be m ade therefore as q uickly , ,
DE T E C T ION O F E R ROR S BY E X E C U T I VE S 37
9
as possible so that the general expenses to be deducted
from gross profit will be relatively low I f the same .
amount of goods which was sold in six months could
have been sold in five months the gross profit would
,
have been the same but the net profit woul d have
b een greater An other result of the quick turnover of
.
stock is that money secured thereby becomes available
for the purchase of new stock without the necessity of
bo rrowin g or investing more money .
T h e foll owing ill ustrates the calc u lation of t u rnover
I n a retail shoe store the average gross profit was
5
2 % of the sell ing price T h e sales during the six
3
.
m o nths ended Ju ne 0 1 9 1 9 were as foll ows :
, ,
J n u ry
a a
F b r ry
e ua
Followin g were the inventories at the dates given
J n u ry 1
a a
F b ru r y 1
e a
M r h I
a c
Ap r il 1
M ay 1
J n
u e 1
J ul y 1
What was the average turnover of the stock dur ing the
six months period ?
’
T h e cost of goods sold durin g the six months is esti
5
mated by ta king 7 % of the total sales T he average
.
inventory dur ing the period is calculated by finding the
average for each month ( obta ined by divi d ing by 2 the
3 98 VE RI FYIN G A ND T E ST I N G T HE A C C OUN T S
s um of th e inventories at the beginn ing and at the end
o f each mont h ) and dividing the total of these averages
by six T h e cost of goods sold is then divided by the
.
average inventor y and the tur nov er is ap p ro ximately
77 33 .
9 . O t h e r Pe r c e n t a g e s
In
testing figures by the use of perc entages a busi ,
ness executive is not limited merely to the percentage
of gross profit and percentage of turnover A ll ex .
p enses may be related to the volume of business done
to test the reasonableness of subse q uent expense figures .
T h e following example illustrates the use of pred e ter
mined percentages for various expenses :
A ssum ing the sal es for 1 9 1 8 to have been
and for 1 9 1 9 to have been the ex ecutive de
sires to test the reasonableness of the expense figures for
19 19 T h e corresponding items of expense are as fol
.
lows
M at e r ial s
D ir e c tL b ora
I n d ir t L b or
ec a
F t or y Exp n s
ac e
T r d in g E x p n e
a e s
O ffi E x pen s e
ce
A comparison of the dollar amounts of each expense
would serve no purpose S ince there has been a de
.
creas e in the volume of sal e s in 1 9 1 9 some o f the ex ,
penses of th at year should naturally be l ess than simi
lar expenses in 1 9 1 8 when the sales were g reater T h e .
only comparison whi ch would assist in the administra
D E T E C T I ON O F E RRO RS BY E X E C U T IVE S 3
99
tive control woul d be one in the light of the volume of
sales .
A true comparison to test the reasonableness of the
1 9 1 9 figures could be made in the following mann er :
T h e decrease in sales was or of the
1 9 1 8 s ales I f the net profits had dec reased propor
.
t io n a te ly with the decre a se in sales there would have
been a decre as e of of net profits of 1 9 1 8
or I n other words the portion in ,
dollars and cents of the decrease in net profits due to
reduced sales i s T he remainder of the de
crease in net profits must be due to increased expenses .
T herefore the next step is a comparison of the reported
expense items in 1 9 1 9 with the amounts which they
woul d have been i f they had been reduced proportion
ately with the decrease in sales .
S ince there has been a decrease in sales of
a corresponding decrease in expense items would make
each 1 9 1 9 item of the sim ilar one in 1 9 1 8 A .
comparison o f the reported items with the 1 9 1 8 amounts
as proportionately decreased will indicate the reason
ableness of the 1 9 1 9 figures and will show that the de
crease in net profits due to increased expenses is
62 . A dding the two elements or portions o f decrease .
gives the total decrease in net profits of
10 . G r a p h ic St a t e m e n ts
For the busy executive an y means for testing the
reasonableness of figures must be readi ly available and
must be such as to call his attention to possible errors
with the least chance of their escaping his notice T hus .
,
th e manner of testing figures becomes e xceedingly im
40 0 VE RI FYI N G A ND T
. E ST IN G THE A C C OUN T S
IEL e
3
5
66692
{3
5 92 9
D E T E CT ION O F E R RO RS BY E X E C U T IVE S 40 1
portant T o some executives the graphic method
.
presents e ff ectively many fluctuations which would not
be readily apparent in a statement of figures O ne will .
frequently notice the peaks and valleys in a curve when
he may overlook fluctuations in a tabular statement of
figures T h e principles underlying the preparation of
.
curves and other graphs have been outlined in V olume
”
I I I of Busines s A ccounting
“
to which reference ,
shoul d be made I t will be found practicable usually
.
to have a confidential secretary or other trained em
l
p y o e e prepare graphs currently to indicate the prob
able trend o f expenses and other significant figures and
then to note on the curve the actual reported figures
so that the executive can see at a glance whether the
figures appear to be reasonable .
Form 4 shows in graphic form the compari
son o f the 1 9 1 9 expenses with the amounts which
might have been expected from the change in the volume
of business done using the figures in the example
,
stated in 9 .
11 . C a s u a l Sc r u t in y
Some executives have a natural aptitude for carry
ing the essential details of their accounting and financial
transactions in their minds and thus by a casual ,
scrutiny can determine the reasonableness of figures .
A s an aid in such inspection substantial changes in ,
assets or liabilities which must necessarily be reflected
,
elsewhere in financial statements should be noted I t ,
.
frequently is help ful for the e xecutive to keep or have ,
his secretary or other confidential employee keep for
him a memorandum recording all of the substantial
,
40 2 VE RI F YI N G A ND T E ST I NG T HE A C C OUN TS
changes in financial condition which should be reflected
in subsequent rep orts prepared for him b y the book
keeping or accounting department By means of these .
tests errors are often discovered without the necessity
for an audit or a detailed insp ection of the acco u nts .
R EVIE W QU E ST ION S
W h at are r e e fu n ctio n s o f n e x ec u tiv e ?
th e th a
H ow i th p r ce n tage o f gr s p rofi t u s u l l y c l c ul te d ?
s e e os a a a
H ow c n th e tot l o f n in v e nt ory b t e s te d ?
a a a e
Wh t i t ur n ov e r n d wh y is it im port n t ?
a s a a
H w c n gr ph i ch r ts be e mplo ye d t o id in e x ec u tiv e s u pe r
o a a c a a
v is io n o f a cc ou n ts ?
C HAP T E R X XX I
D E T E C T I ON O F E RROR S B Y B O O KKE E P
I N G D E P AR T M E N T
1 . In tr o d u c t io n
S ince errors will occur despite every preventive
measure which can be adopted and enforced it is highly ,
desirable that the persons who make the errors detect
them before they a ffect the work of any other person
or department of the business A ccordingly the book
.
keeping department should go t o every reasonable
length in checking its work so that no errors will be
di scovered in statements or a ccounts prepared or kept
under its supervision T his chapter is concerned with
.
some of the methods whereby the bookkeeping depart
ment can check the accuracy of its own work .
2 . " in d s of M is t a ke s t o b e Ex p e c t e d
T he kind s o f errors which would ordinarily be de
t e ct e d by the bookkeeping department are usually not
those which would attract the attention of the executives
of the business T h e errors which the bookkeeping de
.
p a r tm e n t can reasonably be expected to detect and cor
rect consist principally of unintentional errors either of ,
principle or of a statistical nature resulting from any ,
of the three causes not e d in the classification of errors
in C hapter XX I X I ntentional errors ought to be de
.
te ct e d and corrected provided of course that the in
, , ,
40 4 VE RI FYI N G
. A ND T E ST IN G T HE A C C OUN T S
dividual who is responsible for the det e ction is not the
person w h o made the error For example if the head
.
,
of the bookkeep ing depart ment was an embezzler he ,
could hardly be expected to correct the errors in the a c
counts whereby he hoped to conceal his defalcations .
S imi larly if instead of being a defaulter he was inter
,
e ste d in falsifying the ope rating results of the business to
benefit one or more persons whose interests would be
a ffected he could not be expected to reverse the inte n
,
t io n al wrong entries which he originated I ntentional .
errors on the part of any person other than the one who
is responsible for the detection of errors should of ,
course be detected before they are allowed to affect an y
,
other individual or any other department of the busi
ness .
3. Tr ia l Ba la n c e Diff e r e n c e s
Probably the most common kind of clerical error is
a mi stake resulting in a trial balance di ff erence When .
such a mistake has been made the preparation of a ,
monthly or other trial balance cannot be completed .
T h e importance of having the accounts in balance r e
”
su lt s from the fact that if there i s a difference there is
“
no way of knowing whether it is the result of one error
which might be insignificant or the composite result of
,
many errors some of which might be vital Most of the .
trial balance difficulties which have come under the
writer s notice have been the result of more than one
’
error I t is unwise therefore to ignore an unlocated
.
, ,
error in a trial balance except as a last resort and then ,
it should be done only with the approval of the e x e c u
tiv e s of the business .
D E T E C T ION O F E R RO R S BY B OOKKE E P E R S 40 5
4 . G e n e r a l Ru le s fo r Lo c a t in g Diff e r e n ce s
Since the obj ect of a hunt for the trouble which
caused a trial balance di fference is its quick discovery ,
it is obvious that no rules of procedure need be applied
if the memory or ingenuity of the bookkeeper enables
him to locate it without an orderly search When how .
,
ever that cannot be done it is un deniable that an o r
, ,
d er ly procedur e will result in the discovery of the error
more readily and with much more certainty than a hap
hazard method o f in discriminate checking .
T h e first general rule is to make a note of the exact
amount of the di fference T his should be entered at
.
the top of a sheet of paper which we may call the di f
ference sheet and which should have enough space to
provide room for adj us tments of the di fference in case it
should be discovered to result from more than one mi s
take I f this di ff erence sheet is not used in an orderly
.
and precise way the difference may b e located without
,
the bookkeeper s realizing the fact and he m ay uselessly
’
search for further mistakes when none exist .
T h e next general rule of procedure is to ascertain
that the trial balance itself is correctly added and that
the balances of the controlling accounts are in agree
ment with their subsidiary ledgers .
T h e trial balance should then be scanned for any
apparent omi ssions of accounts or for any balances
which appear to be on the wrong side Frequently an .
account is omitted from the trial balance because it is
put in an unusual place in the ledger as for example ,
one of the back pages which are ordinarily unused .
I f the foregoing general rules do not indicate the source
of the error then the follo wing procedure should be
,
40 6 VE RI FYI N G A ND T E ST I N G T HE A C C OUN T S
followed sub j ect o f course to any modifications whi ch
,
may seem desirable in a p articular case .
5S
.
pe ci fi c Ru le s fo r Lo c a t in g Diffe r e n c e s
1 . T he following tests should be applied to the
trial balance di fference :
( )
a I f the di ff erence is a round a m ount such as ,
1 cent $ 1 0 or the like the error is probabl y
, , ,
one of addition or subtraction .
( )
b I f the di fference is 9 or a multiple of 9 up to
and includi ng 8 1 the error is probably a ,
transposition of figures T his holds true .
whatever places the di fference may occupy ;
there may be a transposition in the l cent -
and 1 0 cent columns or in the $ 1 and $ 1 0
-
columns or other two adj oining columns
, .
( c ) I f the di f ference is divisible b y two it may ,
have been caused by posting on the wrong
side an item of one half of the di fference -
.
2I f the application of the foregoing tests indicates
.
the nature of the di ff erence the next step is to look in ,
the most likely place for the error indicated I f the .
error may have been one of addition or subtr action the ,
smallest additions and subtractions should be examined
first because more mistakes are made in small arith
,
metical operations than in the more di fficult ones T his .
is probably due to the fact that when an addition or
subtraction is small the mind is not applied to it with
,
the same concentration that is used on complicated
work A n error is much more likely to occur in adding
3
.
two figures such as 8 9 and 641 than in adding a col
, ,
u mm of ten or twelve fig u res .
D E T E C T ION O F E RRO RS BY B OOKK EE P E R S 40 7
I f a rapid insp e ction of the small additions and sub
tractions does not disclose the error then all ledger ,
accounts should be footed the correctness of balances
,
should be ascertained and the posting of balances to
,
the trial balance should be verified .
I f the nature of the error is indicated as a trans
position the posting to the trial balance o f all figures
,
the transposition of which might have caused the par
t icu lar error should be verified I f the difference is 1 8
.
,
this may be caused by the transposition of digits which
di ff er from each other by 2 ( 1 8 being the second multi
ple of and all possible combinations of digits which
differ from each other by 2 should be listed Such a list .
,
for example would be :
,
0 2 w r it t n
3
s 2 0
3
e a
1 1
2 4 42
3
5 3
5
46 64
5
7 75
68 86
79 97
A fter the posting of the balances from the accounts
to the trial balance has been checked the next step ,
woul d be to check the postings of si m ilar figu res from
the books of original entry into the ledger accounts care ,
being taken to ch e ck mark each posting so ver ified in
-
order that it may be identified
3
.
. T h e next step should be to scan the folio columns
of the books of original entry to ascertain whether any
en try has not been posted T he ledger accounts should
.
then be examined to see whether any account has been
rul ed o ff without bringing down its balance or whether ,
40 8 VE RI F YI N G A ND T E ST I N G THE A CC OUN T S
an account has been closed but not ruled o ff so that its
former balance was used in error .
4. I f the error has not been disclosed by the p re
ceding tests the next step should be the completion of
,
the checking of balances on the trial balance and if that ,
does not disclose the mistake then the footings of all
,
ledger accounts which have not previousl y been verified
should be checked A t the same time the correctness
.
of the balance of each account should be ascertained ,
particular attention being paid to accounts some of
whose debits and credits exactly o ff set each other A n .
example of the latter kind of accoun t is Sundry A o
counts R eceivable where the practice is generally to
,
d e bit the account with small sales to customers showing ,
each customer individually and entering the credits op
p o s it e the debit it e ms to which they relate
5 A further step is to ascertain that the books of
.
original entry are in balance ; that is that all the d e bits
,
from each book of original entry equal in amount all the
credits from the same book Where a book with many
.
distribution columns is used mistakes frequently are
,
made in cross footing the totals so that the total credit
-
for example which will b e represented usually by one
,
figure does not exactly equal the total debits which may
,
be represented by a dozen or more figures .
6. T h e verification of all postings from the books
o f original entry to the ledger should then be completed .
Some postings will already have been checked but if
they were correctly marked they should cause no con
fusio n .
7 I f now the difference has not been located and
.
the bookkee p er feels confident that a repetition of all
D E T E C T I ON O F E RRO RS BY B OOKK EE P E R S 40 9
the processes previously foll owed will not locate it the ,
last resort is to analyze the ledger .
6 . A n a ly s is of th e Le d g e r
A n analysis of the ledger is a tabulation made from
each a ccount of all the items in it which were posted
from each book of original entry the debits be ing classi ,
fie d separately from the credits A fter these items hav e .
been so classified the total debits posted from each
,
book of origin al entry should equal the total credits
posted fro m th e same book I f these totals are not .
equal the error will be locali zed and one or more books
of original entry will be eliminated from the search .
T h e analysis of a ledger is a simple matter pro ,
v id e d the m e thod is thoro ughly understood and the fol ,
lowing simple p roblem is presented to i llustrate it
C AH S
De c . 3
1 C
M ER HAND I E
C S I N VE N TO RY
I
J an . 1 J
CA I AL
P T
I
J an . 1 J
D RA W ING A CCO UN T
De c 3 De c 31 C
I
. 1 C .
P UR HA E C S S
Dec 3V
I
. 1
A C CO UN TS R E E I VAB LE
C
De c 3
3
1 C
Dec . 1 J
41 0 VE RI FYI N G A ND T E ST I N G T HE A CC OUN T S
A CCO UN TS P AYAB LE
De c 3
3
. 1 C J an . 1 J 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0
O DC C. 1 V
S ALE S
De c 3 3
3
. 1 J De c . 1 C
De c . 1 S
E X E N SE
P
A trial balance of the above accounts shows that the
debit side exceeds the credit by Th e analys i s o f
the above ledger is shown below
ANALY SI S OF
Clas s ific a tion of D e bit E n trie s
C a sh
A cc ou nt s Re
c e iv a bl e
Me r ch a n dise in
A cc ou nt s P av
Sa l es
D r wi g
a n Ac
cou t n
E xp n e se
o
T t als
D E T E C T I ON O F E R RO RS BY B OOKKE E P E RS 41 1
7. M e t h od of A n a l y s is
E ach account shoul d be noted in the stub on the left
side of columnar paper O ne column should be as
.
signed to each of the classifications shown in the a c
companying chart the debit columns be ing grouped at
,
the left and the credit columns at the right .
C lassifi cation of Debit E ntries
O pening debit balance
J ournal
C ash book
Sales boo k
V oucher register
C losing cre d it balance
LE DG E R
C las s ific a tion o f C r e d it r
E n t ies
3
41 2 V E RI F Y I N G A ND T E S T I NG T HE A C C OUN T S
C lassification of C redit E ntries
O pening cred it balance
J ournal
C ash book
S ales book
V oucher register
C losing debit balance
I n entering the figures in their proper columns only ,
the total of the debit entries posted from each book of
original entry and the total credit entries need be e n
t er e d. But if the accounts are long and complicated ,
with many items from each book of original entry it is ,
advisable to allow more than one line for each account
and to enter each item in detail E nough sp ace should
.
be allowed to insure a clear and legible analysis .
From the above analysis it appears that the opening
debit balances were 1 cent less than the opening credit
balances ; hence the opening entries should be verified .
I n this case we will assume that the merchandise inv e n
tory was understated and that the amount should have
been
T h e analysis shows that the credits posted from the
cash book are $ 1 0 less than the debits A n examination .
of the cash book would confirm this and would disclose
eith e r an error in posting from the cash book or an error
in the cash book itself I n this case we will assume that
.
the cash sales were improperly entered in the cash book
and th a t they should have been
Since the analysis discloses an excess debit of $ 1 0
and an exces s credit of 1 cent it follows that the closing
,
credit balances are short of the closing debit bal
a n c e s which is the difference in the trial balance
, T he .
D E T E C T I ON O F E R ROR S BY B OO KK E E P E R S 41 3
analysis loc aliz
e s the mis t ake to the openin g balances
and to the posting from the cash book T hus while it .
,
does not disclose the specific errors it localizes them so ,
that they ca n be discovered v e r v much more quickly
than if they were searched for throughout all the bo oks
of acco u nt .
8 . Ar tic u l a tio n St a t e m e n t
An art iculation statement is one in which the figu res
are so arranged that the account debited and credited
with each figu re is shown by posting the figure in one
square R ea d ing to the left of the square the name of
.
the accoun t in the left hand margin is that to which
-
the item was debited and reading upwards the nam e
,
of the acc ount at the top of the col u mn is that to w hich
the amoun t was credited C ont inuing the facts used
.
in the ill ustra t ion above after correction o f the mist ak e s
,
and the addition of the closing entries the following ,
articul ation st atement can be prepared .
T his sta te ment shows in s imple form to what account
each amoun t was debited and to what acco u nt it was
credite d For example the returned sales of
.
,
were entered but once on the statement and are sho wn
by reading upwards to have been credited to A ccounts
R eceivable and by reading to the left to have been deb
it e d to S ales E ach transaction noted on the sta tement
.
can be read in the same mann er .
T h e prac tical usefu lness of an articulation stat ement
is problema t ica l C ertain state bo ards of C P A ex
. . . .
a m in ers have in the past requir ed the preparation of ar
t ic u la t io n statements from facts ver y much more com
plicated than the simple il lus tration use d here in and ,
41 4 VE RI FYI N G A ND T E ST IN G T HE A C C OUN T S
O p e nin
g C r d it
e
Ba l a nc e s
C a sh
A cc ou nt s Re
c e iv ab le
Me rdi ch a n se
I v tory
n en
A ou t P y
cc n s a
bl
a e
C p it l
a a
S l a es
D r wi ga A n c
ou t
c n
E xp e ns e
P ur h c ase s
P ro fit d Lo an ss
C lo i gs nD b it e
B l n a a ce s
T ta o l s
those persons planning to take such examination should
have an understanding o f this type of statement I n .
th e business world it is possible that an articulation
statement could be of use in presenting to a comptroll er
or other executive a brief summary of a year s tr an sac ’
tions or in presenting statistic ally in compact form the
,
result of many transactions .
9 . C u rr e n t T e s t s
V arious schemes have been proposed for the current
checking of bo okkeeping work but the practicability of ,
most of them is doubtful I t generall y re quires more
.
D E T E C T I ON O F E RROR S O KKE E P E RS
BY B O 41 5
time to prove the correc tn ess of postings than can be
spent on such work I t is desirable to take trial bal
.
a n ce s as frequently as practicable ; somet imes they may
be taken t wice a month instead of monthly E ach book
.
keeper should u se hi s ingenuity in trying to det e ct er rors
before the end of the month O ne test which should
.
always be app lied is that of the rea sonableness of the
figures When figures appear to be wrong from their
.
amoun t or from the ir position as debits or credits or
, ,
from the account in which they are ente red it is a d
,
visable to verify them at once without waiting for a
trial bala nce to disclose a po ssible error Man y such
.
41 6 V E RI F YI N G A ND T E ST I N G THE A C C OUN T S
mistakes would not be disclosed at all by a trial balance
because of the limitations o f that bookkeeping e x pe
dient as described in V ol u me I of B usiness A ccount
,
“
mg .
9,
R EVI E W QU E ST ION S
Sh oul d r l b l n e d iff e r e n e if s m l l b e ign or e d or rb i ”
a t ia a a c c a a
t ilyrard j u s te d ?
a
O u t l in th g n r l pro ed ur e t b f ol l w d in lo t ing th e
e e e e a c o e o e ca
rror s w h i h u d t h d iff r n e
e c ca se e e e c .
P r ep r l i t f ll d igit t h t r n p itio n f w h i h m igh t h v
a e a s o a s e a s os o c a e
c u da d iff r n f 5
se a 4 e e ce o .
W h t i n n ly i f l d g r n d w h n h ould it b m d ?
a s a a a s s o a e e a e s e a e
W h t is n r ti ul tio n s t te m e n t n d w h t pur p o s e s do es it
a a a c a a a a
s e rv e ?
C H A P T ER XX X I I
VE R I F I C A T I O N O F A S S E T S A ND
L IAB IL I T IE S
1 . Fa c t s v s. O p in io n s
two preceding cha p ters suggest means b y which
T he
executives and bookkeepers can detect errors in state
ments and accounts A final test however should be
.
, ,
applied in all cases where figures purport to reflect facts
rather than opinions T h e test should be the v e r ifica
.
tion of the existence of the fact itself A s explained .
in V olume I C hapter X I many items in balance
, ,
sheets and st atements of profit and loss represent opin
ions but some of them represent facts such for exampl e
, ,
as the amount of cash in hand and on deposit and the ,
cost value of the merchandise inventory A ll figu res .
showing facts as to assets should be finally tested for
accuracy by a verification of the asset itself I f that .
test is not app lied the figures may seemingly be correct
,
but may a ctu allv be entirely mi sleading in that the
assets which they app ear to represent ma y have no
existence in fact .
2 . Fu n d a m e n t a l Ste p s in V e r i fi c a t io n
pr ocess of verifying or auditing accounts or
T he
statements of assets and liabilities whether applied by ,
a business executive a bookkeeper or a professional , ,
auditor necessarily involves two fundamental steps
,
41 7
41 8 V E RI F Y I N G A ND T ES T ING T HE A C C OUN T S
1 . A verification of the ledger account .
2 . A v er ificat ion of the existence of the asset or
liability represented by the account .
I t would be difficult to state which of these two is more
important in practical application While it is essential .
that asset accounts should not be overstated or unde r
stated and that all liabilities should be listed to Show
,
the true obligations of the business it is equally essential ,
to ascertain that the business actually possesses the assets
and owes the liabilities reported .
T h e following actual experience would have been
amusing had it not been serious in its consequences A .
business desired to borrow money and presented its bal
ance sheet to the p rospective creditor H e made a most .
painstaking examination of the accounts from which it
was prepared and satisfied himself that all fixed assets
were correctly listed at cost less a reasonable depre ,
c iat io n A fter a scrutiny of the current assets and the
.
liabilities he made the loan only to di scover that a con
, ,
s id e r ab le part of the machinery had been fraudulently
removed before he was invited to lend his money T h e .
machinery account was correct except for the rather
important detail that the machinery on hand was very
much less than the value called for by the account T h e .
creditor had failed to take the second fund amental step
of verifying the existence of the asset .
3. Ve r i fi c a t io n o f t h e A c co u n t
verification of an account requires two processes
T he .
First the account must be examined to ascertain whether
,
or not all accounting principles involved have been
correctly applied S econd the arithmetical accuracy
.
,
VE R I FI CA T I ON OF ASSE TS —LIA BILI T I E S 41 9
of the account must be established B oth of these steps .
must be taken to insure a Complete verification .
A n accoun t ( or any figures prepared from it ) would
be erroneous if it were not kept in accordance with e s
ta blish e d accounting principles For example if the .
,
asset account for machinery includes charges for main
t e n a n c e and repairs an error of principle results
, A .
similar error would be caused if worthless accounts r e
ce iv a ble were debited to an asset account called Sus “
”
pense instead of to Profit and L oss or to R eserve for
B ad Debts O n the other hand the account would ob v i
.
,
o u s ly be wrong if it were mathematically incorrect for ,
instance if it contained errors in addition or if its bal
ance account were incorrectly calculated .
T h e detail work of verifying an account is usually
performed by professional audi tors and the methods ,
to be followed are fully outlined in such books as A udit “
— ”
ing T heory and Practice by R H Montgomery , . . .
”
A s Bus iness A ccounting is not designed for the pro
fe s s io na l auditor this phase of the detection of errors
,
is not covered herein T h e accounting principles which
.
should be applied in the keeping of accounts are set
fo rth and exp lained in this and other volumes of Busi “
”
ness A ccounting .
4 . Ve r i fi c a t io n of Ex is te n c e of A ss e t or Lia b il it y
verification of the existence of an asse t or a lia
T he
b ility is a single process but it may be accomplished in
,
either o f two ways namel y ,
1 . By a physical inspection of an asset or of the
written evidence of a liability .
42 0 V E RI FYI N G A ND T E ST I NG THE A C C OUN T S
2 . By inspection of a cert ificate from one who
holds an asset or t o whom a liability is due .
T his kind of verification should preferably be made
by t h e business ex e cutive in person Properly made .
,
it will disclose discrep ancies if any between actual as
, ,
sets and liabilities and the ledger figures which purport
to represent them I f such verification had been insti
.
t u t e d in the case referred to in 2 it would have r e ,
vealed the fraudulen t removal o f the machinery .
B efore discussing ways and means of making a veri
ficatio n it may not be amiss to point out the employer s
’
moral responsibility in the premises A n employer s .
’
responsibility toward his employee does not end with
paying a fair wage and providing suitable working con
d itio n s I t includes a positive obligation not to make
.
embezzlement easy A udits by professional auditors
.
are advisable and should occasionally be made without
notice to the persons whose accounts are to be audited ,
but in addition thereto it is an ex cellent practice for the
business executive to conduct verifications on his own
account I t should be understood th at these may be
.
made at any time I f they are done frankly an em
.
,
l
p y o e e cannot resent them N o greater mistake
. can be
made than to forego any verification in the case of old
and trusted employees I t is only the trusted employee
.
who has an opportunity to become an embezzler and ,
most cases of theft ranging from petty stealing up to
grand larceny have involved employees who have e n
j oyed the entire confidence of their employers A n .
incidental value of verifications apart from the safe
guarding o f employees from the temptation to m isap
r o r iat e funds is the fact that such a verification assists
p p
VE RI FI C AT ION OF A SS E T S—LIA BILI T I E S 42 1
employees in the detection of clerical and accounting
errors I n other words employers and employees
.
,
should c o operate to protect each other against in ad
-
v e r t e n t errors as well as against fraud .
I n the followin g sections no attempt is made to
describe completely the methods of making audits used
by professional auditors but suggestions are advanced
,
which will assist a business executive in verifying certain
specific assets and liabilities T here will be discussed .
some of the means by which certain assets and liabilities
can be verified through personal or physical inspection ,
or by the use of certificates obtained fro m persons out
side the business organization who hold ass ets belong ing
to it or to whom it owes liabilities .
5. Ve r i fi c a t io n o f C a s h in Ha n d
C ashis the most liquid of assets and is the one which
can most easily be misappropriated A ccordingly it .
will occur to most executives that the verification o f cash
in hand is an urgent and obvious duty T h e following .
procedures may be of suggestive value .
C ash in hand should be distinguished from cash on
deposit which is to be verified in another way C ash in
,
.
hand should invariably be handled by means of an
imprest petty cash fund as described in V olume I C hap ,
ter XVI I of this set A ll cash receipts no matter h o w
, .
,
small should find their way into the bank account so
, ,
that the only cash remaining in hand should be the u n
expended portion of the imprest petty cash fund T h e .
balance of such a fund should be counted frequently
without notice in advance and the petty cashier should
,
be given to understand that Such procedure will assist
42 2 VE RI F YI N G A ND T E ST IN G THE A CC OUN T S
him and that it should not be taken to imply possible
dishonesty on his part .
Many petty cashiers are unable to resist friendly
requests for advances from other e mployees of the busi
ness with the result that th e balance of petty cash
,
frequently is not entirely cash but is composed in a large
part of I O U s or other memoranda signed by various
’
persons some of whom may have received unauthorized
advances I t not infrequently happens that such
.
I O U s become uncollectible through the resignation or
’
di scharge of employees who have signed them and a ,
frequent verification of the petty c a sh balance will dis
close the practice if it exists of making these advances
, , .
Such an examinatio n will assist also in inducing the petty
cashier to keep proper vouchers for all payments made .
O ne of the principal necessities for such vouchers is not
the vindication of the petty cashier so far as the propri
ety of payments is concerned but the securing of a d ,
equate accounting information upon which proper
charges fo r payments made can be entered in the books
of account .
6 . Ve r i fi c a t io n of C a s h Re c e ip t s
T he verification of cash on deposit requires three
step s or processes namely the verification of cash r e
, ,
ce ipt s of cash payments and of the remaining balance
, ,
.
E ach of these steps requires a distinct p rocedure and
so each will be treated separately .
T h e greatest di fficulty in the verification of cash r e
c e ipt s lies in determining whether or not all cash which
has actually been received has been entered o n the rec
ords E xperience shows that a very large percentage
.
VE RI FI C A T ION OF A SSET S—L IABILI T I E S 42 3
of defalcations occur through withholding cash receipts
and making no record o f them at all on the books O ne .
of the best ways to prevent this type of embezzlement is
to have all incoming mail opened by one person or in
one department and to have a list of enclosures prepared
by the persons who open the mail T his list should show .
specifically the amount of cash or cash items inclosed
and should be routed to the executive or to some em
l o y e e in his confidence who can later compare it with
p ,
the entries in the cash book purporting to show the r e
c e ipt s
. I f this procedure is followed it becomes d iffi ,
cult for cash receipts to go astray .
A nother way of concealing shortages is by means of
j ournal entries crediting customers or other persons
from whom money is due with unauthorized allowances
and retaining cash actually collected from them A s .
a part of the verification of cash receipts attention should ,
be paid to the posting of such credits All credits should .
be expressly authorized by the business executive or by
a department head who i s k nown to be responsible and ,
the authorization in each case should be evidenced by
a wr itten voucher or slip T hese j ournal vouchers or
.
credit slip s should be preserved and examined from time
to time to ascertain that cash received from customers
,
or other persons has not been misappr opriated through
the use of unauthorized credits .
7. Ve r i fi c a t io n of C a s h Pa y m e n t s
All canceled checks returned by the bank should
be received in the first instance by the business executive
, ,
or by some one in his c onfidence T o insure this the .
,
bank should be re q uested either to mail the canceled
42 4 VE RI FYI N G A ND T E ST I NG THE A CC OUN T S
checks in an envelope addressed to the executive or to
deliver them in a sealed envelope so addressed C are .
should be taken that such envelopes reach the executive
before they have been opened H e should scrutinize
.
the signatures on the checks to satisfy himself that no
forgeries have been committed .
A lthough a bank which pays a forged check is obliged
to make good the amount of the check it will do so only ,
if it is supplied with evidence upon which to prosecute
the forger Within the writer s experience a number
.
’
of cases have arisen wherein the employer did not wish
to have the embezzler prosecuted partly for family ,
reasons and partly to avoid the incident publicity I n .
these cases the banks have very properly refused to make
good the shortage and the proprietor stood the loss I f .
he had scrutinized the signatures on the canceled checks
at the time they were returned b y the bank he would ,
very probably have detected the forgeries before the
practice had become established .
Whether or not two signatures should be required on
checks is a matter of internal management but when ,
two signatures are required it is generally undesirable
for one of the persons to sign checks in blank leaving ,
the sole discretion to the other Signor T his is often .
done in o ffices where one of the signors is likely to be
away frequently or for considerable periods of time .
I f it appears to be impracticable to require that both
signors examine the particular checks which they are to
sign then it is suggested that no result is secured through
,
having two signatures and that only one should be r e
quired .
While a detailed examination of canceled checks and
VE RI FI CA T ION OF A SSE T S—LIA B ILI T I E S 42 5
a comparison of them with supporting vouchers would
ordinarily be made only by professional au ditors it is ,
nevertheless desirable for a business executive from time
to time to examine the vouchers for checks of large
amount if for no other reason than to satisfy himself
,
that the proper supporting doc u ments are being pre
served .
8 . Ve r i fi c a t io n o f Ba l a n c e on De p o s it
verification of receipts and payments is likely to
T he
serve no p urpose unless the balance on deposit is fre
quently verified T h is verification in the ordinary case
.
would be monthly at which time the bank account should
,
be balanced by the bank T h e pass book as balance d .
-
or the statement prepared by the bank with the sup
porting canceled checks should be returned— as pointed,
—
out above directly to the executive or his secretary .
I t i s advisable to have a reconcilement of the bank bal
ance as explained in V olume I prepared from time to
, ,
time by the executive or under his immediate super
vision I f the reconcilement be left e nt ire lv to the book
.
keeping or accounting department it would facilitate ,
the concealment of shortages T h e value of such a .
verification would be very greatly reduced i f it consisted
merely of checking the reconcilement prepared by the
bookkeeping department or the accounting department ,
without receiving directly from the bank the pass book -
or statement and the canceled checks .
9 . Ve r i fi c a t io n o f A c c o u n t s Re c e iv a b le
cashier or other person who handles cash should
T he
not have access to t h e accounts receivable but if the ,
42 6 VE RI FYI N G A ND T E ST IN G TH E A C C OUN T S
busin ess is small and this division of labor impracticable ,
a verification of Considerable value could be secured by
havin g the executive or his confidential representative
personally mail statements to customers I f statements .
are mailed in this way and all inco m ing confirmations or
correspondence concerning them are received by the
executive it becomes difficult for anyone in the book
,
keeping or accounting department to conceal errors in
the accounts receivable without sending statements
which do not agree with the books T h e o ffice work .
should be so arranged that before statements are sent
out they can be readily checked with a trial balance of
the customers ledger or if they are sent out before such
,
a trial balance is prepared the balance shown on each ,
statement should be listed and subsequently compared
with the trial balance I n the bookkeeping departments
.
of many large concerns the statements are prepared
from day to day by the use of typewriting or other bill
,
ing machines as fast as the entries are made on the
,
books .
10 . Ve r i fi c a t io n of No t e s Re c e iv a b le
A ll notes receivable should be kept by the business
executive or under his imm ediate supervision so that ,
they cannot be discounted or otherwise negotiated .
T hese notes should not include any which have been
dishonored A s pointed out in V olume I of this set a
.
,
note which has been dishonored should be charged back
to the maker as an account receivable .
I t is advisable to inspect all notes receivable fre
quently and to see that they agree with the amounts
c alled for by the note registers .
VE RI FI C A T ION OF A SS E T S—LIA BILI T I E S 42 7
ll . Ve r i fi c a t io n o f In v e n to r ie s
T he verification of inventories is essentially a matter
for the professional accountant but the business ex ,
e c u t iv e should apply many of the same tests to inventory
figures presented to him R eference to A uditing .
“
”
T heory and Practice by R H Montgomery will show , . .
,
the principal ways of testing the accuracy of inventories .
12 . Ve r i fi c a t io n o f Se c u r it ie s
A ll securities p articularly those which are readily
,
negotiable should be kept under the direct supervision
,
of the business executive T hey should frequently be .
examined and where they consist of bonds in co n s id
,
e r a ble number should be carefully counted Defal
, .
cations are sometimes concealed by substituting false or
dummy bonds in place of the actual ones so carefully ,
that the false ones are counted as if they were real T hi s .
can sometimes be done with comparative safety in the
case of coupon bonds when they are bound on the end
with a cloth strip B onds and other securities when
.
counted should be exam ined individually to detect all
worthless papers .
I f the securities are o f any considerable volume par ,
t icu l ar care must be exercised to keep them under con
trol the entire time they are being counted Many de .
falcations have been concealed by means of having one
lot or block o f securities counted a second time T hat .
is to say after these securities have been counted once
,
they have been surreptitiously withdrawn from those
which have been examined and presented to the person
making the examination so that they were counted a
second time .
42 8 V E RI FYI N G A ND T E ST IN G T HE A C C OUN T S
1 3. Ve r i fi c a t io n o f Fix e d A s s e t s
A s a rule the best verification o f fixed assets to be
,
m ad e by the executive is to have all the principal fixed
'
assets like machinery and equipment numbered or
, ,
otherwise tagged for identification and to make a phys
ical inspection from time to time to see that all the units
called for by the accounts are actually on hand T o .
accomplish this it is necessary to have the asset accounts
so kept as to indicate the number of units of each kind
of fixed asset which should be on hand .
14 . Ve r i fi c a t io n o f Lia b ilit ie s
amounts of liabilities can easil y be verified cur
T he
re n t ly by having all incoming mail opened as suggested
in 6 I f this procedure is followed statements r e
.
,
c e ive d from creditors can be compared with the balances
shown by the trial balance Where liabilities consist .
of outstanding bonds some of which are redeemable from
time to time it is desirable for the business executive
,
personally to scrutinize the bond records and secure if ,
necessary certificates from any trustee for bondholders
,
or other banking depository which may assist him in ,
verifying the outstanding liability .
obj ect of the suggestions made in this chapter
The
is not to advise against audits made by professional audi
tors but rather to propose means by which the executive
,
can from time to time assist in maintaining correct ao
counts W ork that he does in this connection is roughly
.
analogous to the first aid work which can be performed
before the arrival of me di ca l or surgical p rac titioners .
IFI CAT IO N O F A SS E T S—L IA BILI T I E S 42 9
EVI EW QUE ST ION S
R
f un d m e n t l t ps s h oul d th e v e r i fi c tio n o f
a a s e a a sse t
b c o n du t d ?
e c e
5th v r ifi c tio n f n
e e a ou nt in volv e ?
o a a cc
th e x i te n
e s f n ce t bo v e r ifi d ?
a as s e e e
1d h r
ca s ipt b e v e r ifi d ?
e ce s e
l d b l n c e s d e f rom c u t om e r s b e v e r i fi e d ?
a a u s
C HAP T ER XX X I I I
C O RRE C T I ON O F E RR O R S
1 . Or g a n i zt i
a on and fi
Ef c ie n c y Re co r d s
T he efficient use of methods of correcting errors de
pends to a very large extent upon the proper organiz a
tion of the perso nnel of the accounting force while the ,
proper organization of the accounting force often de
pends largely upon an efficient system of detecting and
correcting errors T hus the two factors are in a sense
.
, ,
interdependent .
I n a small organization where the work of each em
l
p y o e e in the bookkeeping or accounting department
comes under the supervision of the proprietor or the '
chief executive efficiency records for such employees
,
are unnecessary because the executive is able to form a
,
fir st hand j udgment of the capability of each of them
-
.
When however the organization is larger and the
, ,
supervision is distributed among minor executives it is ,
advisable for the chief executive to have a system of e ffi
c ie n cy records which will a u t om a t ic a llv bring to his a t
tention the standard of performance attained by each
employee E fficiency or e ffectiveness i s expressed by
.
the ratio between actual performance of work and an
estimated or predetermined standard to which an em
l o e e is expected to attain For example an assistant
p y .
,
bookkeeper may be expected to make an average num
ber of postings per day and his e fli cien cy will be meas
3
4 0
C O RRE C T ION OF E RRO RS 3
4 1
ur ed in part by his ability to make the daily average I t .
is obvious that incorrect postings sho u ld not be co unted
in determining the number made and if mi stakes are ,
concealed the re cord of the bookkeeper s daily perform
,
’
ance will be wrong I t is o n ly by requirin g a frank
.
admission of mi stakes and an unequivocal correction of
them that a true record of efficiency ca n be secured .
T hus the app lication of the fundamental pr inciple
,
underlying the proper correction of errors namely— ,
that the error should be frankly admi tted and clearly
explained in the correctin g entry— becomes essential if
efficiency records are r equired .
2 . Fu n d a m e n ta l Pr in c ip le
T he fundamental principle—that the error should
be frankly admi tt ed and co mpletely explained in the
c orrecti n g en t ry — is fr e quently ignored ; often by omit
t ing sufficient explanatory deta il in the correc tion and ,
so metimes even to the extent of att empting to conceal
the original error T h e latter of course is attempted
.
, ,
when an intentional error was prompted by fraudulent
pur po se as for example when one seeks to conceal a
,
defalca tion to avoid the imposition of a j ust tax or to
, ,
defraud another who is or is about to become fin an cially
interested in the busin ess VVh e n such an e r ror is cor
.
r ec t e d by the person who is responsible for it every effort ,
naturally is made to conceal or minimize it .
But the principle of frank ack nowledgment and com
p le t e correction is many times ignored when there is
no such incentive I t often is felt that once the accounts
.
are restored to correc tness there can be no furt her c c
casion for r efe rr ing to the error and that bo th it and
3 VE R I
4 2 FYI N G A ND T E ST IN G T HE A CC OUN T S
its correction should be forgotten as soon as possible .
T his chapter directed against this idea outlines some
, ,
of the chief means of applying the fundamental prin
c iple suggested above A s these are studied it is b e
.
lie v e d that the soundness of the princi p le and its pra e
t icab ility will be evident .
3. Ru le s of Pr o c e d u r e
While it is impossible to prescribe exact methods for
correcting all conceivable errors because the possi ,
b ilitie s of error are practically infinite it is thought , ,
nevertheless that the following rules of procedure will
,
be helpful E ach is further explained and illustrated
.
in the succeeding sections .
R ule I T h e entry containing or reflecting the
.
error should be marked when the error is dis
covered so as to indicate its erroneous char
,
acter and to refer to the correcting entry .
R ule I I T he correcting entry should refer to the
.
erroneous entry which it corrects .
R ule I I I T h e c o rrecting entry should where
.
,
practicable be made in the same book which
,
contains the erroneous entry
:
.
R ule IV T h e correcting entry should contain an
explanation su fficiently complete so that the
error and its correction can readily be under
stood even after the transaction and its de
,
tails have been forgotten .
R ule V VVh e r e corrections necessitate numerous
.
adj ustments of C apital U ndivided Profits , ,
Surplus or similar proprietorship accounts
, ,
they should be reflected in an adj ustment
C ORRE C T ION OF E RRO RS 3
3
4
acco unt the balance of which should be
,
closed into the proprietors h ip acco u nt a f
fecte d .
4 . Th r e e St e p s in M a kin g C o r r e c tio n s
be satisfactory the correction of an error sho u ld
To ,
be completely made I f an y vestige of the error r e
.
mains the op eration for correction will prove unsuccess
,
ful and Sooner or later trouble will resul t T o insure .
complete correction the foll owing three step s should
invariably be taken :
1 . C orrect the entries in the book of original entry .
2 . C orrect the entries in the ledger accounts a f
f e c te d
3
.
. C orrect all statements whi ch in any way reflect
the error .
N othing
should be allowed to interfere with the o r
d e rly observance of this procedure I f for example .
, ,
the ledger accoun ts are adj usted through the j ournal
but the bo ok of original entry is not made to indicate
that the error noted has been corrected it i s almost cer
.
,
tain that someone sometime will rediscover the error and
not being familiar with its correction will spend valuable
time and e fl o rt in preparing a new correcting e n trv
’
.
C ases have been known where a second attempt to cor
rect an error has resulted in the most puzzling complica
tion of entries adj usting and readj usting fi g ures on
,
the b ooks I t is an even more serious omission to fail
.
to note necessary changes in statements because state ,
ments are usually the means by which figures in the
books of account are made kn own to per sons who are to
3 VE
4 4 R F I YI NG A ND T E ST IN G T HE A C C OUN T S
use and rely on them I f a statement is not corrected
.
to agree with the accounts when changed the reconcile ,
ment of it with a subsequent succeeding statement will
usually be impossible without reference to the accounts
themselves S uch a reference always is a nnoying and
.
sometimes is completely impracticable particularly when ,
immediate use of the statement is required or when the
persons who are to use it are not in th e city where the
accounts are being kept .
5C h
. ec k M a r k in g C o r r e c t io n s
-
Before correcting entries can be prepared it usually ,
is necessary to examine a n u mber of entries already
made to ascertain their exact effect upon the accounts
as a whole I n making such an examination refer
.
,
e n c e s and cross references to many accounts and sep
-
arate books frequently are required and it becomes a d ,
visable to indicate precisely the figures and entries which
have been examined and approved or marked for cor
rection T he adoption of a uniform system of check
.
marking it e ms which have been scrutinized will mater
ially assist not only the person who is preparing the
correcting entries but also anyone else who later m ay
,
have occasion to examine the correction .
I ndiscri m inate or meaningless marking of figures is
worse than no marking at all Many persons su ffer .
from a curious p sychological obsession under which they
seem unable to look at any figure in any boo k account , ,
or statement without making some sort of mark against
it T h e writer has seen accountants and others who
.
“
should have known better deliberately check mark fig -
ures when no purpose whatever was to be served by the
C OR RE C T ION OF E R RO RS 4 3
5
marks A fter such a person has idly placed his several
.
kinds of marks upon an account or statement one who ,
later has to examin e the figures critically must erase a ll
these marks before his work can be begun and thereby
loses completely any verification value which the marks
might possess E ven if verification later is not required
.
,
bo oks accounts and statements are made unsightly by
, ,
indi scriminate marking .
6 . Sy s t e m of C h e c k M a r ks
-
Many years use of the fo llowing system of che ck
’
marks in the conduct of audits has shown that it furnishes
d e finite and satisfactory evidence of the precise step s
taken in the verification of the e ntries I t is r e com .
men d ed for use in any verification which may be a pre
requisite to the preparation of adj ustments for errors .
T h e main idea underlying t h e system is that each mark
has a defi nite and unvarying significance .
VVh e n an item has been verified the following mark ,
is placed to the right or the left of it as con
v e n ie n ce may dictate T his mark on an item in a state
.
ment means that the statement is in agreement with the
ledger account When the mark is placed on an item in
.
a ledger account it denotes that the item has been cor
,
r e c tly posted from the indicated book of original entry .
When it appears in a book of original entry it sign ifies ,
that the figu re has been vouched or verified by support
ing documents vouchers letters or by some other means
, , ,
satisfactory to the person making the verification .
T h e same mark placed u nd e r a figure indicates that
the item is th e correct total of all figures which were
Th m rk
e se wh
a d i
s, p r t i h ld t
en u sed nf i h i
ac z ce , s ou no e xce e o an nc n Si e .
3
4 6 VE RI FYI N G A ND T E ST I N G T HE A C C OUN T S
added to obtain it When the item has been further
.
verified by cross footing that fact can be indicated by
-
making the mark somewhat longer and drawing a line
through it as follows
, 9 A For example this ,
mark under the total of the A ccounts Payable column
in a voucher register would signify that the column had
been correctly added and that the total was the sum o f
the totals o f all distribution columns .
W hen the posting of an item from a book of original
entry to an account or an item from or the balance o f
,
an account to a statement has been verified the follo w , ,
ing mark should be placed at the right or left of
it as may be convenient I f also the item itself had been
.
vouched or approved then the verification mark ,
would be placed on it in addition to the mark which
shows that the item has been correctly posted .
7. Illu s t r a t io n of Ru le I
In this and succeeding sections examples are given
to Show the application of the rules suggested in 3 .
R ule I requires that the entry containing or r e fl e c t
ing the error should be marked when the error is dis
covered so as to indicate its erroneous character an d to
refer to the correcting entry T his is illustrated bv the .
following case .
A company manu facturing oxygen hydrogen , .
nitrous oxide and other gases for commercial and m e d
,
ical use had a cost sv ste m under which the total m o nth lv
expense of cylinder repairs maintenance and u p keep , ,
-
was distributed over the products on a percentage basis .
T h e j ournal e n trv effecting the distri bution was com
plicated because the elements composing the cylinder
C O RRE C T ION OF E R RO RS 3
7
4
maintenance ( painting testing and the like ) were
, ,
distributed individually in addition to showing the por
tion of the total expense chargeable to each product .
I n one monthly entry a mistake was made by using
wrong percentages and this resulted in some twenty
errors o f a statistical nature in the ledger accounts .
U pon di scovery of the mistake before the close of
the fiscal quarter a correcting j ournal entry was made
,
and immediately the following indorsement or note was
written in red ink in the margin of the j ournal alongside
the erroneous entry :E ntry wrong— wrong percentage
“
used— corrected on j ournal folio T his fixed for
,
all time the erroneous character of the first entry and
enabled anyone interested to refer instantly to the cor ~
r ec tin g entry .
8 . Illu s t r a t io n of Ru le 11
R ule I I specifies that the correcting entry should
refer to the erroneous one which it adj usts I n the case .
cited above the entry on folio 1 67 of the j ournal spe
c ifically referred to the first one by stating :T his entry
“
to correct erroneous entry on j ournal folio 1 1 T hen , 5 .
followed the explanation required by R ule IV .
I ncidentally this is an example of the application of
the fundamental principle that mistakes should not be
concealed I f instead of making a new j ournal entry
.
to correct the wrong distribution the bookk e e per had ,
attempted to ch ange the figures in the j ournal entry
and in all the ledger accounts which were a ff ected he ,
would have been obliged either to erase the figures orig
in ally made or to draw lines through them and write
the correct figures above the former ones T h e latter .
4 8 3 VE I YI N G
R F A ND T E S T I NG T HE A CC OUN TS
pr cedure although better than the fir st would res ul t
o , ,
in entries which would be confusing to the eye and likely
to lead to err ors in addition E rasing the fi gures might .
lead to a troublesome di fference in the trial balance and
in any event would raise a question as to what the orig
in al figures had been and why it was necessary to change
them Figures should be like C a sar s wife—above sus
.
’
picio n .
9 . Illu s t r a t io n of Ru le III
correcting entry should where practicable be
The , ,
made in the same book which contains the erroneous
entry T o illustrate this assum e that a sale of Depart
.
,
ment G was credited in error to Department D in a
sales book containing a column for each department ,
and assume further that the error was not discovered
until the following month after the sales book for the
month in question had been closed and posted .
T h e first step following R ule I should be to note
, ,
the error opposite th e erroneous extension of the sale
and then to note under the monthly total of each depart
ment a ffected the exact amount by which that total was
over or short giving there the sale number date page
, , , ,
or other identification pointing to the individual exten
sion which was wrong .
A t this p oint many acco u ntants would make a j our
nal entry debiting Department D Sales and crediting
Department G S ales I t is better however to make
.
, ,
this correction in the sales book itself I f the mon thly .
totals by departments are of no special significance an ,
entry at the end of the following month increasing the
sales of Department G and reducing those of Depart
C O RRE C T ION OF E RRO RS 3
4 9
ment D ca n r e a dily be made by entering the amount to
’
be tr ansferr e d in the D ep artment G co lumn in black
ink and in the Department D column in red ink the ,
latter b eing subtracted from the preceding figures in
the column to determ ine the monthl y total for post ing .
I f the monthl y totals shown b v the ledger are u s e d in
the preparation of statements or are otherwise of real
value during the fiscal year the correct ing entry may ,
st ill be made in the sales b ook and posted indi vidually
in the same manner as it would be posted from the j our
nal T h e underlying idea of thi s rule is to preserve
.
uni formity in p osting a n d to reduce the number of e u
tries in the j ournal T h e latter book as explained in
.
,
V olume I should conta in only opening and closing
,
entries and su ch adj usting ent ri es as ca nnot conve n iently
be made in any o ther book of original en t ry .
10 . Illu s tr a tio n of Ru le IV
U nder R ule IV the co rrecting e ntrv should conta in
an explanation sufficiently complete so that the error
and its co rrection can readily be understood even after
the transaction and its details have been forgotten .
H ere generally is provided an opportuni t y for the
, ,
ca reful and precise use of words as well as figu res .
Prolixity must be avoided but on the other hand the
, , ,
explanation must explain I t must be as clear years
.
a fterwards as it is at the time it is made when the facts
involved are fresh in the memory I t is in this respect .
probably more than in a n y other that many correcting
entries are at fault BI u ch coul d be wr itten in ill u st ra
.
tion of t h is rule because many ins tances of corrections
insufficiently exp la in e d w ill occur to anyone who has
440 VE RI FYI NG A ND T E ST IN G THE A C C OUN T S
had occ asion to make corre ctions or to examine those
made by others T h e following example will indicate
.
t h e general idea of R ule IV T h e application of it to .
c omplicated cases re q uires keen analysis and careful
constructive writing .
A contract between a corporation and its general
manager provided that he was to receive 1 0 of the net
profits but it did not specify whether h is 1 0 % was to
,
be considered an expense before the final net profits
could be determined T h e board of directors created a .
reserve for contingencies none of which were imm inent ,
or clearly foreseen T h e amount of this res e rve was .
deducted from the profits for the year and the manager
was credited with 1 0 % of the remaining balance A fter .
these entries had been made an d the Profit and L oss
account closed into S urplus it was decided that the ,
reserve should have been charged to Surplus and not
against the current profits and also that the manager s ,
’
share should have been considered an expense of the
business T he correcting j ournal entry carried the
.
following explanation which it is believed is su fli ciently ,
complete :
Su p lu
r s
M n g r
a a e
T o in r m n ge r s h r e f pr fi t f ’
c ea se a a s a o o s or
1 9 1 9 f rom $ 6 0 0 r d it d o n j our n l fol i o
c e e a ,
79 t $ 1 0 0 0
,
o l ul te d
, ,
f ol low s :N t
ca c a as e
p rofi t w ithsou t d d u t ion f e r e rv c o se e
c h r g d in
a e rror t P rofi t n d L o s n
e o a s o
j our n l fol io 78 w r
a , ,
M n g r e e a a e
’
s
s h r e b in
a b u
e i n s e x ns es w e s e, as
g p
1 1 0 7 f th
0 on t p r fi ts w h i h
e e m unt t o c a o o
f w h i h 1 0 % is
o c
C OR RE C T ION OF E RRO RS 441
11 . Illu s tr a t io n o f Ru le V
Where corrections necessitate numerous ad j ustments
of C apital U ndivided Profits Surplus or similar pro
, , ,
p r ie t o r shi
p accounts they should be reflected
, in an
adj ustment account the balance of which should be
,
closed into the proprietorship account a ffected .
I t is obvious that the correction of an error a fl e ctin g
the operating result of any previous year should not in
fl u e n ce the Profit and L oss accoun t for the current year .
C onsequently such adj ustments should b e o ff set in the
Surplus or other proprietorship accoun t excluding of , ,
course any accounts for capital stock O nly two or
,
.
three adj ustments of this kind can conv e niently be made
directly in the proprietorship accounts When more are .
necessary or when partners capital accounts with vary
,
’
ing pro fit sharing ratios are involved it is much more
-
conve ni ent to use a separate adj ustment accoun t to
collect all of the alterations in capital and then to close ,
the balance of thi s accoun t into the one or more capital
accounts a ff e cted T his rule seems too obvious to re
.
quire a concrete illustration .
12 . C o n c lu s io n
I n thi s and in the four preceding chapters an attempt
has been made to classify errors to define t h e pr inciples ,
underlying their correctio n and to suggest proc e dur es,
for recording the corrections O nly the surface of this .
topic has been touched A separate volum e on it coul d
.
well be w ritten but such a book would appeal more to
the professional accountant and auditor than to the
business men the executives the bookkeepers and clerks
, , ,
”
for whom Busin ess A ccount ing has been designed
“
.
442 VE RI FYI NG A ND T E ST IN G T HE A C C OUN T S
T he dangers of errors however and some of th e means
, ,
for their p rom p t and explicit correction h ave been in
di cate d .
EVI E W QUE ST ION S
R
Wh at re e m p lo y e s ffi i n y r ord n d w h en e t h ey u s e ful ?
a e
’
e c e c ec s a ar
W h t is th e fu n d m e n t l p r in ipl e u n d rl yin g t h e c orr ec tio n f
a a a c e o
e rror s ?
W h t th r e e s te ps mu st be fol low e d t ins ur e c om pl e te c orr ect io n
a o
of n rror ? a e
W h y is u n iform y t m f h e k m rk in g dv is b l e ?
a s s e o c c -
a a a
W h t a e th e fiv e r ul e s to b e f llow e d in m k in g c orr e c tio ns ?
a r o a
INDEX
pit l h rg
o n, ca a c a es , 47, 61, 2 3
53 -
2 7
Am ort iz tio
3 bo d 1 2 8 1 3
a n,
di ti gui h d f ro m e e l men t ry 5
op of 3 — 3
s n s e a n s,
d bt 15
, ,
sc 11
e , e ,
with 1 53 15 4
Annuity 144— 15 l o Si ki g
, ,
assign m en t of , 22 1 4 (S , ee a s n n
fu d ) ”
3 3
n
lo ssa o n, as c lo i g probl m
s n e , 1 mou t of 146—
a 148 1 5
n 1— 15 , ,
val u ti o omput tio of
3
a n, 2 18 c a n
omp d di ou t 1 49 15
,
3
c o un sc n
mpou d i t t 144—146 15
, ,
v rifi
e ca ti n o of , 41 8 co n n eres , ,
t ur of prob l m 9
na e e ,
3
cas h b as is 19 , 2 0
futur worth 146 148 15 1 15
,
— 3
e
151 15
-
, , ,
“
Def e r ddre e b its p w rt worth 1
en 48 , .
r t of 146
en s
Appr i l (S V lu tion
,
a sa ee a a
Addi io t ns , e xp n ditu
e res on, 47
fix d t 96
dv d ou ti g op of 3 — l d v lu 2 3
e as se s ,
t d fi d 41 3
an ce 11 n n an 1 a
orpor t divid d 5 5
—
a acc , sc e , es ,
Arti ul tio t t m
3
94 en n s a e en e ne
d f rr d r di t 2 6—
c a e s, c a , ,
2 Am t d li b ilit y m thod of d t rmin
an
d f rr d d b it 1 2 —
c e s e e e
2 5
e e e a e
5
o
,
e e e e s, i g profit or lo
n 2 s
s ,
Fir lo djustments ) ”
3
fi l (S
omp y 3
re oss ee e ss a
65
profit d t rm i ti o 3
i t
n erc 66
3 5
an , ,
— arra nge m en t on
d fu d 1 04—
4 na n, 2 81
—
e e
r rvese es 1 18
an n s, c urr e n t, 2 1 52 29
i ki g fu d 1 60 ou r v l m of
103
ece i a b e, ass ign
—
s n n n ac c n ts ent
urpl 9 5
, ,
s us , 22 1
2 18
ru d e 27 d
bad eb ts r rv for 2 16 e
s e e
of v lu tio of 44 45
ac c , , ,
basis
5
n
l ifi d 2 15
a a . ,
good will v lu a e of, 18, 2 4 c ass e
-
,
444 I ND EX
Asse ts —C onti nued
urr t—C ti d
en on nue
d fi d 2 15
c
e ne ,
m r h di i v tory 2 2 2
e c an se n en ,
m r h di i v tory i u
e c an se n en , ns r ance exi t of t 419
s e nce asse ,
of 2 2 7 2 2 8 , , import of 417 a nce ,
m r h ndi e inv ntory pri ing of
e c a s e . c , l dg r ount 418
e e acc ,
ou ti g for 2 3
2 24
u of 5
o k in tr d 2 2 3 23
nat re , 2 1 acc n9 n ,
d finitio d tr tm nt
3 4 3
3 3
st c 2 27 8
5
- -
a e, e n an ea e
to k
, ,
s d bo d
c s an n s as , ,
xi t of v rifi tio of 419
fix d 2 3 2 3
e s e nce e ca n
0—
, ,
ounting 3
e 8 ,
ppr i t io of h w h dl d 9 6
a ec a Auditi g r l tio t n o an e n e a n o acc
b i of v lu t io of 44 45
, , , ,
Av r g th ory of
b u ilding 2 3 23
as s a a n e a es , e
4—
, , ,
7 s,
h g i v l t io of 9 6
c an e s ppli d t k ping books n h
n a ua n , a e o ee o cas
d pr i tio ( S D pr i tio
l d 23 23
e ec a b i 90 n ee e ec a n as s,
1—
m hi ry d quipm t 2 3
an 4 ,
ac 7 ne an e en
B
, .
m nuf turi g b u in 40 Bad d Debts bad )
”
t ur of 2 3
a ac n s es s, e bts ( See ,
na 0 Bal ance ,
1 15
e ,
r rv for d pr i tio ec a n o n,
r o ili tion of 42 5
ese e e
to k d b o d ow d for pur
po i o trol 3 3
s an n ne ec nc
5
s c s a
v rifi tio of 42 5
,
5410
ses o c n , e ca n ,
v l tio ff t of d pr i tion n tri l lo t i g diff
2 93
in
h t 2 79—
a ua n, e ec e ec a o , a , n
ca n ere ces , 40 -
49 B l
a ance s ee ,
v rifi tio of 42 8
e ca n , a rr g m t of ntent
an e en co ,
flo t ing ( S ubh ding Current
pit l 2 83
a ee s ea asse ts , 2 81
b ov )
a e ca a
int gib l 2 5 0—
,
an 2 64 e, li biliti 2 82
a es ,
opyrigh t 2 61 omp r tiv 2 88
fr hi 2 63
c s, c a a e,
a nc o d d form 2 85
n ense
25
c
—
se s,
5
,
ood w l Form 2 8 6 2 87
o ol id t d 3 3 3
il 2 0 7
75
g
n tur of 2 5 5 —
-
, , ,
ub idi ri 3 73
a 0 e c ns a e
p t t 25 7—
, ,
a en s , 2 60 adv tances o s s a es ,
roy l ti 2 62 ompl i tio ugg tio for
voidi g 3 6— 3
a es, c ca ns , s es ns
t r d m rk 2 60 5 5
good will 3
a e -
a s, a 8 n ,
tr d r t 2 61
3
4— 3
61
5 5
a e sec e s , -
,
r v lu tio r l t io t urplus 100 illu tr t iv t t m t
i om t x r gul t io 3 3
e a a n, e a n o s s a e6 s a e en s ,
5
,
urpl from l of 9 9
v lu tio of 7 41—
us nc a n,
45
s sa e , e e a
inv t m t ou t ub titution
of t d li biliti for 3
1 68 n en n s,
d t our of 45
es
5
a a , , , acc s s
ki d of 42 43 3
6
5
a a, s ces , asse s an a es , ,
n s , , 8
I ND EX 44 5
li b ilit i
a es an d d fi it of
e c a su bsid
s p ecia l po i t 2 88 n s,
tie u p with in om c e sta te m ent, 2 92
-
33
3 72 , 7
pro fit s of s u b si diariss prio r t o co n
r
c eati n o of urplu s s, 96
u plu and di i vd e nd s of s u bsid rplu d u di vid d profit
3
s r s su s an n e s dis
rplu of ub idi ri 3 61 3
63
iaries , 72
k 3
su s s s a es,
urplu of u b idi ri wh t o k
,
v tm ents orpor o
only p rt ly quir d 363
s s s s a es en s c in e
s in c a te st c s, 8 4
ou t d r port of tru t 3
a ac e ,
ppr i l of p op rt y 3
acc n s an 22 e s s ee s,
d finition 2 79
dfii y t tm t 3 19 3
e , a a sa 22 r e .
di id d umul u p id
priority of d b t 323
v en s, c a tive , n a , 2 91 e c e nc 26 s a e en , ,
i 3
e s,
rf
8 19 3
e erees 2 1 n,
t t m t of ff ir
3—3 mploy d i 3
s a e en 24 s,
5(
a a ,
o
h lding c omp ny a , 40 2 See as lo t t m t
s a e en s e 19 e n,
t ru t in ppo in tm t d duti
3
s ees , a en an e s,
19
c omp r d with
a e co ns olid te d a bal Be tt e rm
rofi t xp nd d for
en ts , p s e e e . as
b i of divid d 61
as s e n s,
Bo d divid nd 74 9 2
33
n e s, ,
i llu t s rati ve sta te ments . 41, 42 , Bo d t b l
n u of 9
a es, se ,
Bo d
ounting for 1 3
n s,
od of h owi g inv tm nt in 2 —
ub idi ri 3
met h
inv tm t 1 3 13
s n es e s acc 1 42
2—
,
13
th 47
9—
e s s a es , e
s 9 en .
meth od of pr nt ti n omp r d i u
3—3
s ese a o c a e , ss1 42 es,
umul tio d fin d 12 9
13 1 13
47
mortiz tion 1 2 8 —
44 acc a n e e
5
,
y for o
ne ces s i t olid t d l
ba ance
3 3
c ns a e a a , ,
shee t, 4 as curr nt t of e rt in orpor asse s ce a c a
illu tr tiv form 2 8 5
s a —2 87 e , b rok r e age o n, 12 3
im port f 2 79
an ce o ,
le dg r b l orr t h owing of orpor t 12 1
oupon 12 2 1 2 3
e a a nces , c ec s , c a e,
2 91 c , ,
d fi d 12 1
e ne ,
d nomi tion of 12 2
di ou t 9 1 2 4 13
e na ,
3 13
mercantil e b usiuem flh , s trativ e sta te sc 7 141
n , , , ,
m nt e , 11 nt rie n b ook 7 1 41
es o s. .
M6 I NDEX
o d —C ti d
B n s on nu e Bo un s sto c k , 2 09
di ti gu i h d from not 1 2 2
int r t 1 2 3 3
s n s e es ,
ou
313 ro k r g bo d 12 3
1 2 7 1 40 n t ing,
ru d 1 3
e es ,
-
, acc
acc 4 1 42
e B e a e on n s,
Brok r
, , ,
ff t iv l ul tio of 12 7 i v tm nt orpor t
to k 3 3
’
e ec e , ca c a n , e s in n es e s c a e
ff t iv r t
ff t iv r ordi g 13
e ec 12 6 e, a e, s 4 c s,
e ec 2 e, ec n Build i g d o tru tio
n mp ni
an c ns c n co a es ,
t o k of o th r orpor tio
,
in t lm t 1 2 6 r iv d
vi 3 3
s a en s , s c s c a ns ece e
m rk t r t flu t u t io of 1 2 5
e
a e a e, c a n , in p ym t for a 4 en ser ces ,
omin l ff t iv 12 6 1 2 7 Building ( S l o P l nt ) ”
p id p v lu 1 2 3 o t 23 32 3
“
n a vs . e ec e, , s ee a s a
a on ar a e, c s 4, ,
p ym t of 1 40
a
inv t m t v lu
en
l ul tio
,
r p ir d r w l —
3
53
13
es en a e, ca c a n e a s an e ne 2 2 7
2—
a s,
Bu in x utiv ( S Exec ti u v
“
142 s ess e ec es ee es ,
bal ance sh ee t t eat r m of 3
3
5
3
ent ,
jour l
na e nt ie s, 1 6 r
Ew e
di ount 1 41 p
in b oo k 1 3 l n h t p nt ti n of 2 83
sc , C a ital ,
tri
d fi d 2 83
en 9 1 40
es s, , ba a ce s ee rese a o ,
int r t 1 40 e ne
divid d t t b p id from 5
e es , ,
pr mium 141
v lu 12 3
e , en 7s no o e a ,
xp ditu
pr mium 9 1 2 4 12 513 4 13
5141
p ar a e, e en res ,
r l t d t profi t 61
ou t i g for 1 3
e as e a e o s,
5
, , , , , ,
omp r d with r v u p di
b oo k 1 3 — 97 2 323
en e ex e n
45
n n
—
5
acc , c a e e
tri t ur
pri 12 3
en 6 1 41
es o n s, , 49 61 7
e s, , , ,
ce ,12 4 ,
f tor d t rmining 12 4
ac s e e e xp e nses , 2 96, 2 9 7 ( See als o ubh d
s ea
m rk t v lu 12 4
,
l 13 profit 3 4 3
“
5
a e a e,
profit d lo an 8 ss o n sa es ,
5
, ,
r l t t di ting i h d from
ea es a e , s u s e profit b l n r t in d a a ce e a e as, 9
porate 12 1 , C p it l
a t (S a A asse s ee
“
s s ets , fix de
”
)
r d m b l t f v lu 12 4
di ou t 3
e ace a e, C ash,
52 44
ee a e a
r gi t r d 12 2
13 divid nd 72 82 83
e s e e , sc n , ,
l of profit d lo
sa e 8 an ss o n, e s,
v rifi tio 42 1 42 5
, , ,
secu rit y for 12 2 e ca( S e l o Ve i n, -
e a s r
sink ing fu d
,
t provid for r tir n fica tio n
”
)
5
o e e e
m t of ( S Si ki g fu d ) k
,
”
b an bal ance 42
“
en ee n n n ,
term 1 2 2
p ym nt 42 3
, cash in b and 42 1 ,
a e s,
1 55
5 7 1 r ipt 42 2
ece s,
ru t 12 1 15
,
C h m th od of h n dling ou t 19
43
4—43
t 7
s ee , as e s a acc n s,
Ch k m r ki g orr tio
,
uni u d 140
y t m of h k m rk 43
6
omputi g 12 4—
ec n ns ,
5
ss e ,
-
a c ec
v lu
3
—3 A t of 1 9 14 3
3
3
a e, c 12 6 n , s s e c ec -
a s,
inv tm nt v lu m th d
es e a e e o , 1 2 1 9 C l yt
a on c ,
I NDEX 447
lo ing tri 6 7 12
l u 2 68—
C s en es, , ,
C o in ur s a nce 2 71 ( S c a se, ee a s lo
Fir lo dju tm t )e ss a s en s
”
C on olid tio
s a ns ( See C ombin tio a ns and
apportio m t of li b ility 2 70
n en a
ru t io work nti ip tio
.
d fin d 2 69 Co nst of
profit 3
e e , c n , a c a n
obj t of 2 69
ec , 6 s,
C oin r r 2 69
su e , C o ti gn i r rv for ( S
n e nc es , ese e ee Re
l of prop rt y 3 3 2 3 3 C o t ing t l i biliti ( S Li biliti
33
by ea se 7 e , , n en a es ee a es
diffi ul t y of v luing l C o troll i g ou t
of prop rt y 3 3 6 3 3
7
32 3
c a eas e , n n acc n s,
by pur h 7 d pr i tio r rv 184
Form 183
c ase e , , , e ec a n ese e,
di tingui h d from holding m pl t 1 81 184
p y 3 3 3
s s e co an , ,
Form 182
u l di g t 3 3
an , ,
C op rativ m th od for ombin tio
o ol id tio 3 3 of orpor tio 3 3
ca ses ea0 n o, c -
e e e s c a n
c ns 9 a n, 1 c a ns ,
divid d ( S Divid d C opyrigh t 2 61
d d v lopm t of 3 3
“
en s ee en s s,
growth C orpor tio
omp ny 3 3 3— 3
an 0 e e en a n,
5
,
h olding 2 c (S bo d ( S a Bo d ee n s ee n s
pit l r v u xp ditur 45
,
l o Holding omp ny ) ”
3 3 46 61 9 7 2 3 — 23
“
en
—
a ca vs en
5
a s c a . e e e e s, ,
illu t r t iv po
m th od of 3 3
i 7 71
33
t 6 n s, 7
0—
s a e , , ,
e 9 s , on olid t io ( S l o Combin c s a n ee a s a
pool d g ntl m gr m nts t io d o l id tion ) ”
33 u whi h l d t 3
’
3
s an e e en s a ee e , ns an c n so a s
p i l point 3 71 3 ombi tio by 3 3
1 0 c a ses c
75
ea o,
t ru t 3 3 ill u t r tiv prob l m 3 67 3
s ec a s,
-
9 c na n ,
p i l poi t 3 3
1 s s, 71 s a e e
75
-
working pit l provid d by b 71—
,
3
ca a e su s ec a n s,
idi i s 71 ar es , wo king pit l p ovid d by b r ca a r e su
C mmu it y i t io for ombin
33
o n asso c a ns , c a
tio of orpor tio divid d ( S Divid d
h ol din g omp y 3 3 3 3
n 1 c a ns , en s ee en s
Comp r tiv t t m t of profi t nd 5
ub idi ri 3 43 3 73
a a e s a e en 2 a c an ,
-
lo dv
F d r l R rv Bo rd form 3 h t 3 3
t a ances o s
40 —
ss, s a
5
es , ,
b l l o
Form 3 00 3
e e a ese 00 e a 2 (S . a a nce s ee , ee a s
B l
”
3
h t )
“
01 a a nce s
C ompou d di ou t 149 1 5
, , ee
o olid t d in om t t m nt
3
n sc n ns a e
rul for fi ding 1 5
, , c c e s a e e
C ompou d int r t 144— 3
n
1 46 1 5
e ,
di t i gui h d from ombin tion b
pur h 3 33
n (S
e es , , ee s n s e c a v
l o A uity ) ”
3 form tio of 3 33
“
nn c ase ,
rul for finding 15
a s
f 3
a n
5
e , ,
C ompo d int r t t b l f 9 in om hi f our
3 3
un e es a 0
e s, us e o , c e, c e s ce o .
Co ol id t d b l n h t (S B l n t ill g l p
profit d lo t t m nt 3
ns a e a a ce s ee4 ee a o e a er Be,
h t
a nce on olid t d )
s ee , c s a e 49
”
an ss s a e e ,
olid t d in om t t m t
limi tion 3 r t ining tr d 3 3 3
C o ns en
65
a e c e s a e ,
int r ompany adju tm n t 3 3 t t m nt 3
na
65
e s, es ra a e,
e c 66 s 40 e s, , s a e e s,
448 I N DE X
C orpor tio —C ti d r rv for 1051 152 16
h old i g omp y—
a n on nu e ese es , , ,
Co ti v lu tio of ou t r iv b l
3
3
3
n cd an n nu e a a n ac c n s ece a e,
t tu t
s a p rmitting form tio
es e a n, 2 18
worki g p it l provid d by su b priorit y of in ba n krup y pr d
3 3
3
n ca a e , tc ocee ?
s id iaries , 71 ings 2
o k of o h r
,
i v m orpor De f rr d
3
i
o 3
n e st e nt n st c t e c a e e
—
,
h rg l o ubh ding
3
t i ns , 4 c a es , 12 19 ( See a s s ea
no te s 1 2 1 , 1 2 2 2 4
“
Deb its be low)
dju ti g tri 15 —
,
org z t io xp n
ani a n e e ses , a s n 17 en es ,
capit l iz t io 17
a a n, profit ff t d by m
s as a ec e anner of
wh t writ ff 1 7 t r tm t 1 4
r dit 2 6— 3
en o e o , ea en ,
profi t ( S P fit ) “ ”
d i ou t bo d 13
2
rip 74 7585
s ee ro s c e s,
sc sc n 7 on n s,
jour l tri illu tr t d 85
, , .
xp ru d 2 7
in om d f rr d 3 3
na en es, s a e e e nse s acc e
to k ( S St o k ) 0—
, ,
”
s c ee c c e, 2 e e e ,
ub idi ri l i b ilit i ru d 2 6
343 373
s s a es , a es acc e ,
adv t ances o, , t x a e s accru d 2 9 e .
divid d d l r d upo qui itio
of to k by h old i g omp y 3
en s ec a e n ac s n
ou m th od
d d fi it 3
c a sh
73
s c 72 n c an , acc nts , e s o f han
l i bil iti
72 3
73
d ling 19
mi ority i t r t of 3
a e s an e c , ,
ru d in te r r
3
n n e es s , , ac c e es t vs . int e es t se
profit of prior t o ol id tio
3
d 1
53
s , o c ns a n, cru e
urplu pr mium 3
9, 60 a d v ert is m g 1 8
5
,
d v d d r v bl 2 4
urplu tr tm t of 3
i i e n s ece i
61 3
s 8 s as e , a e,
s s,72 in om
ea ru d 1 9 2 4 ( S l o
en c e a cc e -
ee a s
urplu t r tm t of wh to k I om ru d )
, , ,
o ly p rtly q i r d 3
“
63
en en s c nc
1 4—
s s, ea , e , a cc e
in ur
worki g pit l provid d by 3
n a 17 ac u e s a n ce ,
I tr t
,
int r t ( S
“
n 71 ca a e , e es ee n e es
C r d it d f rr d ( S e
e s D f rr d r d
e e org iz t io xp
e e 17
“
e e e c e an a n e e nse s ,
it s pr p id xp 12 — 19 (S l e a e e nses , e e a so
D
u bh ding Ch r g b ov ) s ea
“
a es a e
roy l ti 18 a es ,
D bit
e d f rr d ( Se
s, D f rr d
e e exp e (S ubh di g Ch g e e e e ense ee s ea n ar es
d bit e s bov ) a e
D bte s, li biliti ( S ubh di g C r dit ”
a es ee s ea n e s
mort iz tio of omp r d with ink bov )
3D fi i y t t m t 3 19 3
a a n c a e s a e
i g fu d m th od of p ym t 15
,
ill tr t iv t t m t 3
n n e 2 6 a en e c e nc s a e en
15
, , , ,
4 2 9 us a e s a e en ,
D fi it h owi g of n b l n h t e c , s n , o a a ce s ee ,
ou ting for 2 19
—
acc n
omput tio of prob b l lo from D pr i tio 1 65
,
n 1 88 n,
ou ti g for 179—
c a a e ss , e ec a
2 17 188 acc n n ,
i om tnc r quir m t 2 2 0
e ax tu l d t im t d v ry 99 100
e e en s , ac a an es a e a , ,
r l tio b tw n lo
e a dn l ppr i l m th od 1 66
e ee s ses an sa es , a a sa e ,
2 16 di dv nt g of 166 sa a a es ,
I N DE X 449
l l r og itio 3
3 d du t d in a
profit 3
n n, cas h, no t c e scertai ning
5
ega ec e
ff v lu tion gro
3
ect o n 49
ompou d 149 15
e a a , ss ,
3
c n
rul for fi di g 15
, ,
e n n ,
p id i dv n 1 4
a n a a ce,
leas e h old s, 1 67
ro profit s, 3
5
p t t 25
g ss
8
a e n s,
prin ipl nd p li i
c es a o c es, 16 5 b o d n 74
purp of 5
,
0 e ntr ies for 92
—
ose , ,
3
ra tw , deter mining 1 69 1 78 , cas h , 72
c ompo it r s e a te, 1 69 , 1 77 e nt ri for
es , 82 , 8
m th od 1 73 ri for 89 9 1 —
d l r tio of 62 —
e1 74 , , en t es ,
fix d p opo tion m thod
k 3
e r r e s, ec a a 64 n ,
1 72 lo i g t r f r b o
c s n a ns e o 64
s, 6 ,
rvi m th od 172
—
se ce e
i king fu d m t h od 1 75
,
s n 177 n e , d ecla e rd , sta t us of , 66
st r igh t li
a m th od 171 -
ne e
worki g h our m t h od 1 72 or b ook
,
n s e , divid d en sh ee t , 79
e n tri e s for , 86, 87
x p tion 1 67
e ce , e xp di t ren u es , r v nu
e e e and ca pit l
a ,
r rv for ( S R rv ”
l 93
Sinking
“ “
ese e ee e se es , 61
ll
3
i e ga ,
acc ou ting f
n or, 9
r v for 1 15
eser e ,
v lua tim tio of 1 68
es, es a n , li t 79
s ,
pr tio 1 68 1 69 ns, Form 80
N w Y or k l w 5
e ca u , ,
e 6 a .
n tio of 69 ce
k p rti ip tio i 65
,
Dic ins on A Low quot d
73
n n,
p ym t 70 —
, . es, e , a c a
m int n n xp n dit ur 47
a e a ce e e es , a 77 79
en , ,
-
profi t d l t t m nt 2 98 2 9 9 fo m of 72
pit l 93
an oss s a e e , , r ,
t of
ou ca a ,
pro dur for 77 ce e .
rmerv es , r rgum nt for and
3
sec e t, a e s
3
3
agains t, 11
Direct orates interlocking , , 2 p ofit v il b l for 5
r 8
s a a a e .
5
4 0 I N DE X
v d nd —
Di i e C nti n d s o ue
prop rt y 75
3
—
e ,
ou ti g for 92
p in m king 43 3
acc n n . 4 6 441
r iv bl 2 4
ece a e, th r e e s te s a
det t io of b y b oo kk p i g d p rt
,
rip 74
m nt 40 3
n
for 85
sc ec n
—
, , ee e a
ntr i
an ly i of th l dg r 409 41 3
416
6—5
e e
ou of 5
es , ,
rti ul tio t t m t 413
s r ces 8 , a s s e e e ,
-
p i l 86
of 40 3
s ec a , a c a n s a e en ,
t ri
en for 86 87 es import a n ce
kind of mi t k t b xp t d
, , ,
t t u of d l d 66
t o k 73 3
s a s ec ar e , s s a es o e e ec e ,
s c , 40
tr i for 9 1
h u tt 73
en es , tests , 414
proh ibit d in M
o of by x utiv 3
e assac se s,
ub idi ry omp i l imi tion n d
h t 3
a n es , e na s o etect i n 9 0 402
65
s s a c , e ec es , -
o ol id t d b l u l ruti y 40 1
p r t g of 3
c ns a a nce s n
W ti g t rpri 5 7 5
a e ee , cas a sc ,
xp
3
n 8 en e se s , e e nse s , 98 e ce n a e
Engl i h d i ion 5 —
as , ,
8 s ec s , gr pahi t t m t 9 9 40 1
c s a e en s ,
gro profit p r t g of 3 92 3
m fl of 3
ss 94 e ce n a e
95
-
,
E
,
inv t ory t t
33 per t g m th od 3 91 3
en es , e xa e ,
t g of 3 3
Efiiciency 4 0 4 1 ce n a e 99
95
, , e s, -
r ord ppl o orr o t r ov r p r
of 3 3
ica ti ect i n of
rror 3
ec s a n to c u n e 97 e ce n a e
85
-
, , ,
e s, 4 0 ex mpl
a 87 es -
r rd p o pr
3
of
3
333
Enginee ing t a e, antici ati n of
its , 6 inte nt i o l na , 8 -
86. 88
d r
le ge y i of illu t d
413
anal
dju ti g 4—
, s s , s rate ,
l o Adjust
f pri ipl 3 83 3
a s 6 (S n , ee a s
m nt ) ”
h k m rki g orr t ion 43 4 43 f t hniq u 3 3
s 88 nc
8 4—
e o e,
-
p rt r h ip 3
—
6 n 87 c ec s, o ec e,
d f rr d h rg 15
c ec a
- -
3 — 3
e e 17 e c a 88 es , a ne s
i ki g fu d 160
,
r v o of
int rn l h k 3
s n n p ntni 8
, 0 82 e e n ,
lo ing 6 7 12
m h ni l d vi 3 80 3
c s , , . 81 e a c ec ,
Equipm t
ou ti g for 2 3 propri t or hip ol 3 88 3
en , 81 ec a ca e ces, -
d pr i tio 2 3 stati ti l 3 3 86 3
7
83
n n 89
—
acc , e s , s e, -
sub t nt i l 3
e ec a7 n, 88 s ca , ,
Error
t profi t 9 3
s, 84 s a a ,
tri l b l diff r n 40 4
l ifi tio 3 82 3 85
o s, a a an ce e e ces ,
rul for lo ting 40 5
as
orpor t io 3
c as s ca n,
uni t ntion l 82 — 386 3
409 es ca
3
- -
,
orr tio of 43
89 n, 88 n e
7 41 45
c a a , ,
E tim tio of t v lu
h k m rki g 43 4 43
c ec 0 442 n ,
-
s a n as se a es , ,
-
utiv b u i
fu d m t l pri ipl 43
c ec 6 -
E a n ,
-
xec es , s n e ss ,
d t t io of rror by $ 90 402
fu tio 3 90 3
n a 1 en a nc e, e ec n e s .
-
o g niz tio by 3 90 3
91 nc ns , ,
org niz tion nd ffi i n y r o d
up rvi ion 3 90 3
a a a 91 e c e c ec r s, r a a n , ,
91 s e s , ,
I N DE X 4 1 5
x
E pe n it d ur ( See p l
Ca ita expendi
r t 1 70 —
es
tu r ) es
”
1 72
a es ,
rvi m th d 172
se ce e o ,
accru d 2 7 e t r igh t li
s a m th od 171 -
ne e
worki g h our m thod 172
, ,
capit l 2 9 6 2 97 ( S
a lo ee as Ca ita p l n s e
Forf it d t o k 2 10 2 11
, ,
xp dit r ) ”
3
e en u es e e s c , ,
comp ri o of gr phi 40 1
a s n , a c, Franchises 2 6 , 2 64
Fo m 400 r
York Pub li
,
d ng r of
a pit lizing 46
e ca a , New c Ser ice C m v o mi s
Fu nds ( See l o R rv ” “
Sin ing k
5
a s es e es ,
sin king h md trea tm en t of , 1 8
x
E tensi o ns , r rvese e for ( See
“
Re c omp d with r rv
a re ese es , 106 1 1 1 -
t ru t for
s ee , 1 10
M alice sh eet form r eco m m dd
en e ,
Ge nt lmn
e e
’
s agre e m nt e s, 3
8 1
adv t i i g xp n p it liz d
er s n e e se ca a e 18
d fi d 25
as ,
om p r ti v profit lo
3
c a a e and ss sta te
1ne
d pr i tio of 2 5
e
5
.
33
me nt , 00
n
ec a
d t rmin tio m th od of 2 5
e
Form 00 0 1 ,
3 2
, ,
e e a n, e
Fini h d good profi t
p t nt 2 5
,
s e s. o n, 7
a e 8 2 60
s, -
Fi lo d ju tm t
re ss a s en s ,
p mium d n olid t d
3
re s an , o n co s a e bal
ance sh ee t, 61
rl
e a tio n to t rd a e ma rk s an d p
a ten ts ,
co ins uran c e cl a use, 2 68 2 71
-
obj t of 2 69 ec ,
G ro p ofit ( S
ss r ee Pr ofit s
d pr i tio f t or 2 74 n
vid n of v lu 2 65
e ec a ac ,
e e ces a e,
H
in v nt ry v lu tio 2 72
e o a a n, Ha rvard Bureau of Bu in M s es s h,
c
li bilit y of in ur
a omp ny 2 68 s an ce c a , ul
B l et in No 1 o lu io .
, c nc s ns as to
l o ubh ding C oin
3
3
3—
3
“
2 71 ( S
5(
ee a s s ea
lu b ov ) Holding omp y lo
”
w n '
c an 2 Se e
n t r of prob l m 2 65
s a ee c a se a e , as
a u e
2 65
e ,
p o f of lo
3
333
r o ss ,
ttl m t of low v ub idi ri 7
3—3
en 2 67 2 68 es, ad ance s to s s a es , 4
5
se e , ,
Fi d t ( S A t fix d
xe ass e s ee
“
sse s , e bd a nce sh eet , 40 2
Fix d p r t g of dim i i hi g v lu
m thod d p i tion r t 1 73 3
e e ce n a e n s n a e
e , e re c a a es , ance W t, 40
4 2 5 I NDEX
Hold ing omp ny—Co nti nu ed I om r gul tion
—C
c a nc e tax e a s,
l b d d bt r rv for 2 2 0
3
33 3
ba a nce s h ee t o n tin ued
h t 3
a e s, ese e
5
,
ompl i tio o olid t d b l
33 p l ti for i t tion l rror 3
c ca ns , 4 , 44 c ns a e a a nce s ee ,
illu tr t iv m
3—3
s a e sta te e n ts , 41, 42 , e na es 88 n en a e s,
47 49
m th od of h owi g i v tm t i fire ( See l o Fir lo dju t m t ) ”
ub idi ri 3
e s n n es en s n a s e ss a s en
s 47
s a e s, oi ur
c ns l 2 68—2 71
a nce c a use ,
m th od of pr t tio omp r d i uring m r h di i v t ory
3— 3
e s ese n a n, c a e . ns e c an se n en ,
44 47 dvi b il ity of 2 2 7 2 2 8
a sa , ,
y for o ol d d l b a ance pol i y 2 66
3 3
necess it c ns i a te c ,
t t m t h owi g mou t
3 o t illu tr t d 3
sh ee t, 4 s a e en d n n s an
5
s a
oj o
m 3
b ec t i n
14—
to , 0 c s s 14 s a e ,
o ol d om pr mium p id in dv
3
c ns idate inc e s tate e nt , 64 e 17 a a ance,
66 I t r t
n e es .
d u d from om o ru d
dju t i g tri 2 3 —
isting ish e binati by
3
33
c n acc e ,
pur
3
ch ase
form o of 3 3
, a s 24 n en es ,
di ti gui h d from r d in
f our of 3 3
“
ati n s n acc u e
5
, s e
om ”
3
3
inc e , ch ie s ce , 0 te res t, 1
ll l xp
m 3
not i e ga pe r se , 4 e e nse , 27
profi lo
t a nd om
ss s tate e nt , 49 inc e, 19
o d ( o d
rd 3 3
3 3( l o
b Se e B
“
— 5
n , n s
r r ompo d
3
es t a ining t a e, c un 144 1 46, 1 See a s
A uy
,
m
form o 3 33 l
state e nts , 40 nn it
u p rm o of o ol d d a t i n, iminat i
3
sta t te s e it t in g e n on c ns i ate in
work 5
,
p l prov d d o m
3
ing ca ita i e by s ub s id c me s ta te e nt s , 6
pr p d
3
ai
3
iaries, 71 e 14
I rlo k d r or
,
n te c ing i ec t a t es , 2
I r l k for pr v o of rror
3
nt e na c h ec en ti n
3
s e e s,
3 —3 I v ory
80 , 81
Improv m u d 5 b il ings
o f or 3
e ents to , 2 2 7 n e nt ,
( lo Rp r
See a s r wl ) d pr
“
e a i s an d e ne a s
”
e ec ia t i n ac t 2 2
I om
,
d
d 3
nc e, en ing 1 2 ,
ru d
33
es t im at e 94
for —
acc e
5
, ,
ou
acc n t ing , 2 0 2 4 t es t ing, 9 4, 9
a dj ri 2 1 2 4
us t ing e nt es ,
-
good o ig m t 2 2 2
s on c ns n en ,
cas h m th od of h dl i g
e s an n acc ou n ts , i ur
ns of 2 2 7 2 2 8
ance
m uf t ur i g 2 1 5
, ,
19 an ac n
m r h di 2 2 2 —
,
di ti gui h d from d f rr d i om
s n s e e e e nc e, e c 2 29
an se ,
wh it m h ould t b d
d f rr d ou ting for 3 th b oo k 2 2 3
19 en e s s no e ente re
r iv d b t t y t r d 12 13
e e e , 0acc n , on e s,
u no ea n e ov rh d ppl i bl 2 2 7
ea
i k i g fu d t r t m t of 1 5
ece e e , , e a ca e,
s n n n 8 ea en v lu tio
a a n,
I
, ,
om t t m t fi lo dju tm t 2 72
on l id t d 3 64—3
nc en re en
m th od of 2 2 4—
e s a e , ss a s ,
c so 66a e , e 2 2 6 s ,
ti p with b l
e u
-
h t 2 92 a an ce s ee , v rifi tio of 42 7
e ca n ,
I NDE X 4 3
5
diff r e e n t ia te d f om fix d li biliti
r e a es ,
St oc k s
acc ou t y of 9 n a nc di ou t tr tm t of 2 44
sc n s, ea en
orpor tio in to k of oth
, ,
divid d d l r d b t t p id
po tio 3 3
c a ns , s c er cor en s ec a e u no a ,
r l t t 23 23
4 ta ns , 2 44
2— xp ru d 2 7 2 42
2 43
ea 4
es a e , e e n ses acc e
inki g fu d 9 1 5 k
, ,
lo m uf t ur i g b u in
ot p y bl 2 43
7 (S Sin
“
s n n , , ee a s an ac n s ess .
ing fu d )
”
2 43
n n es a a e,
r t il bu i
e a s ness ,
L nd h ort t rm lo n 2 42
ou i g for 2 323
1—
a , s -
e a s,
d f rr d ( S D f r d r dit
ppr i tio 2 3
“
acc nt n 4 , e e e ee e er e c e s
d fi itio 2 42
d p i tio 2 3
a 1 ec a n, e n n,
e 2
rec a n, fix d 2 42
e
ou t with t o kh old r op n
,
d v lopm t d rry ing o t
in v tm t in 2 3
2 23
3
e e en an ca c s s. acc n s s c e s, e .
pu h d for r l 2 3
es en s , ,
rc 4
ase esa e , bo d ( S Bo d
n s ee n s
coll t r l lo 19 2 45
a e a a ns , ,
at pur chase pri ce , ite m s incl ud d i e n, d fi d 2 42
e ne
rt in kind
,
ot p y bl
u t u tio in 2 3
n es a a e, ce a s
ombi tion by 3 3
7 3 3
fl c1 a ns ,
Le as e , c 8 na , , purpo of 2 42 se ,
L hold r l t t mortg
dditio t l d prop rt y 3 3
ease s, ea es a e ages , 244
mortiz tio 168 3 3
a ns 8 o eas e e ,
v rifi o of xi t of 419
3
ca ti n
E gl d m th od in 3
8 s ence
oll t r l 19 2 45
a a n, , e e ,
n 8an , e , L n
oa s o n c a e a , ,
d pr i tio 1 67
e ec a n, Lo ( S l o D bt b d
ss es ee a s
“
e s, a
xp t d u t r iv bl
ot r iv bl 1 3
e ec e , o n ac co n s ece a e an d
n es ece a e,
fi (Sre Fir lo d ju tm nt
ee
“
e ss a s e s
Form 1 82 183
pla nt, 180
Li bil iti 2 42 — ou ti g for 2 3
, ,
d pr i tio 2 3
a 2 49
es acc 7 n n ,
ou t g for hi f point t 7
id r 2 43
acc n in , c e s o co n e ec a n,
s e , M a in te na nce,
ru d 2 6 u ld
b i ings r p ir s a nd i mprov m
3
53
acc e , , e a e e nts
b l h t
a a nce s rr g m t ee , a an e en o n, 2 82 to , 2 ~
2 7
l
c ass ifi t io 2 42 ca n, c ha rg ea b e l to ca pit l wh a , e n, 47, 61,
o ting t 2 42 2 47
c n en , ,
accommod tio indor m nt a n se e 2 48 d pr i tio d 16
e ec a n an
ki d of 2 47 2 49
,
n s , ,
M uf t uri g b m
an ac n us ess ,
pit l
ca rv ua vs en xp ditur en
5
e e e es,
—
.
c urr e nt, 2 42 2 44 4 4 9 , 61
profit of s , 40
MM I NDE X
u
M an fact uring bu ine — N
t t m nt of 3 03 3
C nti s ss o nued otes,
— omp r d with b nd 12 2 '
rr g m t of 3 03 p y bl 2 43
s a e e 08 s , c a e o s,
n 13
a an e en , a a2 44 e, ,
b l h t ill u t tiv re eiv bl lo
m t 3 04—3
a an ce s ee , s ra e state c a e, sses o ,
tit t t p rt 3 03
en 06 ,
co ns u en a s,
c o t of good old illu t r ti
m nt 3
ve st ate
s s s s a
r
O gani zatio
3
,
n,
08
e ,
by b u in sss e exec utiv e, 90
trate d , 2 9 9 , 3 07
xp
e 14 17
r ord r l tio
e ns es, ,
orr o
rror 43
ec s, e a n to c e cti n of
urplu dju tm nt of llu
3
s s, a s e s , i s
0e s,
trate d, 06
Ov rh d ppli bl
e ea a ca e to st ck o in tra d e,
uf turing v ntory d fin d
- -
,
M an ac in e e e
5 2 27
, ,
2 1
rr d wom
M a ie t o kh old 68
e n, as s c ers ,
M h i l d vi for pr ntion f
rror 3 3
ec an ca e ces eve o
80 — 81 P t nt a e
ounting for 2 5
e s, s,
M r ntil b u i
t t m t of 3 10 3
e ca e s n ess, 9 2 60 acc
d fi d 25
, ,
dju tm t illu t ted 3
en s 18 7 ne
15
s a e ,
-
e ,
a s en s, s ra ,
n ly i of l umm rized illu r l tion t good will d tr d mark
t t m t 3
a a s s sa es s a , s e a o -
an a e -
s.
t ti 17
rr g m t of 3
ra ve s a e en ,
h t ill u tr t iv 3 11 3
a an e 10 en
pit l 9 5
,
b l n t profi t r t i d
on t itu t p rt 3 profit 3 92 3
a a nce s ee 12 , s a e, , e e a ne as ca a ,
P r t g of gro
l 3 92 3
c s 10en a s, 94 e ce n a e ss ,
-
o t of i ur d u xp ir d d
pr mium 3
c s ns b an ce 94 an ne e as e o n sa es , -
H rv rd Bur u of Bu in Re
rh 3 93
e 14 s, a a ea s ess
u tom r ou t r iv bl
t t m t 3 13
’
t im t d in v t ory t t i g 3
c s e s a cc n s ece a e, sea c ,
ill u tr t iv
t t for d t tio of rror 3 92 3
s a e s a e 94
en , es a e en , es n ,
profit d lo illu tr tiv t te
m t 3 t g of t ur ov r 3 3
an ss , s 94 a e s a es e ec n
—
e s,
95
-
P r
3
en16 , 98 e ce n a e n e ,
M r h d i i v t ory ( See
e c an se n I v n illu t r tiv
en l ul t io 97 u e s a e ca c a n,
t ory P r nt g (S l o D pr i t ion
“
e ce ee a s
t k in tr d d fin d 2 15
a es e ec a
M r h di rt ) ”
e c an se s oc - -
a e, e e , a es
M i orit y i t r t ( S e C rpor t io
d t ting rror by 3
“
3
n n e es s e o n,
9 1—
a
b id i ri 99 ( S e ec ee
2 44 2 45
su s a es e s ,
M ort g g l o Error )
”
t t 3
“
a es , , a s s
a ccru d i om from 19
e nc eu f for mp r i , 98 se o , co a so n es s ,
omp r d with bo d 12 1 l o Buil ding ) ”
ru d 2 3
Pl nt ( S
“
c a e n s, a ee a s s
i t r t
n e es acc 24 e ou t 1 81 184
o n, , acc n , ,
asse ts , 1 79
items , l
c ass i cati n fi o of , 1 79
l r 180
Form 1 82 183
ed ge ,
ruling as to ch arges to fran ch ise , ,
Pl dg right t divid nd
’
e ee s o e s, 68, 69
INDE X
P ool s, 3
3 1
— ppr i l f t v lu 41 42
”
o d ( S e Bonds )
p t of v l u 42 43
“
b n e a a sa o as se a es , ,
ins ur p id in d a vance. 14 17
d li b ility m t h od 5
an ce a as ec s a e, ,
to k (S
p it l p ofit 3
s c ee as se t an a 2 e ,
Pre p id xp
a e(S e nse ee
“
Deferred ca a r4 ,
h rg
”
p it l r v u xp ndit ur s
3
53
) a e en e e e e
5
c a es ca vs .
4 , 61 , 97, 2 -
2 7
profit or lo 5
2 ss,
re pd r wl
rs, e ne a s, a nd r pl
e ace
s a 3
umm ry of pri ipl of 5 nc es ,
v l u tio b i of 44
v lu tio kind of 42 43
a a n, as s ,
a a n, s , ,
Form 2 99
5
,
4
efie ct of ppr
a ecia ti n on, o 5
0
d ie d f d pr e c ia tion o n,
3
o e 49
m
3
e nt , 16
m 5
3
sta te en ts , 6
profit or lo res lt ing ss u from opera g ross . 5
Har vard Bure a u u
B siness Re
93
of
purpo 2 94 r Bull tin No 1 3
upporting h dule 3
s e, sea c h , e . ,
m nuf turi g profi t diff nti
t d from 3
s 0 1 802 sc e s, a ac n s ere
5
.
Profit ( S l o Surpl ) “ ”
s ee a s us a e ,
pe nt g of t t for d t
rce a e tion of , es e ec
a pporti o m n en t, 6
orp r tion 5 9—61 95
5
c o a s, ,
clo di trib uti f p fits
se , s on o ro , 6
'
difierences of opinio n as to what
erro rs
'
afiecting, 9 3( See also
3
n
Erro rs )
( 6
p r for b tt ments
3
ex e nditu es e er 61 on finis h ed goods , 7
t d profit 5
.
in v 9 60 on work in process 6
i gul r di trib ution 5
es e s, , ,
r re a 6 s prepa id expenses as afiected by txm t
own r hip of 5 5
,
me nt of 14
5 5
e s
5
, ,
W
3
surplus, re ta ine d as ca pital. 9
6—
to 9 60 , 9
55 5
o ver ,
so urce of dividends , 8 d
tr a ing,
I N DE X
'
r lu tion f t 10 1
eva a o asse s ,
t o k i tr d
s c 1 15
-
n -
a e,
ti no di po itio of n p ym nt of bo d
s s n , o a e n
R l t t ( S l o L nd
ea es a e ee a s a i u 161 ss e,
bo d d mortg g
n d i ti gui h d
an s n s e e q uiv l t t urplu in Germ ny 9 5
a en o s s, a
115
a e, ,
from orpor t bo d 12 1 n s, es t im t d lo a e
42 5
c a e s ses ,
R o ili tio of b nk b l
ec nc a n a a a nce , for xt io 105
e e ns ns ,
R w l ( S R p ir d r w l
e ne
“
e s an e ne a s i juri t
n mploy 1 18
es o e
ki d of 104 1051 14 115
a s ee a ees ,
2 3
Re nt n s
u d 1 9 2 1—
, , , , ,
accr e 27 , , , n t ur of 1 0 7
a e ,
pr p id xp
e a 14 e e nse ,
“
ry 1 14
necessa ,
”
R t of
en s uity 1 46 an ann , ( See a s lo pr t tioese n a b l h t 2 84 n on a ance s ee ,
A uit y )
“ ”
nn purpo of 104 se ,
R p ir d r w l r l tio t profit 6
3
—3
s an e ne n
r t 1 1 1—
e e a o s,
5
a a s,
b ildi g improv m t t
rgum t for d g in t 113
2 2 7 1 14
—
n s, sec e
54
u e en s o, ,
h rg b l t p it l wh
3
c a ea e o ca a , en , 4 9, a en s an a a s ,
-
2 7 h w r t d 111
o c ea e ,
d pr i tio
e ec a n an d, 167 propri ty of 112 e ,
R pl
e m t ace en s ( See R p ir
e a s an d re sh ow b ln on h t 2 84 a a nce s ee
i king f d 15
,
Sinking
”
ne wals ) 6 (S e b
“
s n un , e a o
R rv fu d ( S l o R rv
ese e n ee a s ese es fu d ) n
”
b low) e t ru 1 04 1 0 5
e, 114
di n t rm for urplu 9 5
, ,
C ana a s s,
f tor d t rmi ing 1 15
e
omp r d with r rv
c a e ount “
ese e acc ac s e e n
v lu tio 10 4 10 51 14 1 151 17
, ,
a a n, , , , ,
R rv ( S l o Fund ou ting for 1 1 7 1 18
10 3
ese ee a s n
ou ti g for 1 0 1—
es s acc
h t 105
, ,
acc n n , h ow s b l n on a ance s ee ,
accou t 180 n s, volu t ry 1 14
n a
w ti g t d pl tion of 1152 40
,
v il bl wh 109
a a a e, e n, as n asse s , e e
b d d bt 1 0 5 1 15 R t E gli h t rm for urplu 9 5
, ,
”
a e 2 16 s, , , es , n s e s s,
in om t cr quir m t 2 2 0
e ax e e n s, Re tr i ing tr d by holding omp ni
s a n e a
h t tr tm t of 10 5
e a c es ,
omp d with fu d 106—
b l a a nce s ee ea en ,
v nu xp dit ur omp r d with
—
c 11 1 n s, Re en
pit l xpe dit ur 45
ar e e e e es , c a e
o ting t 105
—3
3
c n en 49 61
r t d from rplu 104 105
ca a e n es ,
5
, , ,
c ea e su s, , 9 7, 2 2 7
d m g l im 1 18
a a e c a s,
d fi itio 104 d fi d 2 62
3
e n n, ne
d pr i tio 105
e
e ec a n, minimum p ym a ent per y r ea , 18, 2 6
ou t 181 1 84 187 188 paid in dv n
Form 1 83
acc n s, , , , a a ce, 14
,
99 Sal es
5
.
fix d e asse ts , 11 expen e ommi ion 2 7 s , c ss s,
jour n al en t ri es , i llu t r tiv
s a e, 184 p r nt g of gro profit
e ce a e ss s b ase d o n,
1 87
I N DE X 4 7 5
r p divid d ( S e Divid nd
Sc i m th od f r ting 144
p ym nt int o 15
en s e e s e s o c ea
k
,
S uriti ( S l o Bo d St o
”
purpo of 143
“ “
ec es ee a s 6 n s, c a e s ,
se
r r 15
,
6
t ru t d d prov on of 15 515
ese ve,
7 s ee isi s
r port of 1 5
, , ,
t ru t
Sh rm n An ti Tru t L w of 1 890 3 3
3Sinki g fund—m th od d pr i tio
7 s ee , e
e a s a n ec a n
r t 175
-
, e , e
Ship b uilding tr d ti ip tio
profit 3 St t m t of ff ir 3 19 3
f a 177e, an c a n o a e s,
lo
Si ki g fund 1 43
6 s, 2 4 (S a e en a a s, ee a s
B k rup t y )
,
163 19 3
“
dfii y t tm t 3
n n 1 64 an
ou ti g pro du 15 5 —
,
-
c
x mpl 3
acc n n ce r e, 2 6 e c e nc s a e en ,
-
dju ting tri 160 illu t r tiv
ill u t r tiv x mpl 3 3
a s en es , 29 s a e e a e,
di po itio of fund ft r p yment
s s n 2 7— 29 a e a s a e e a e,
of d b t 1 61 St t m t
rti ul tio 413
a e en s ,
xp n 15
e ,
illu t r tiv prob l m 1 62 1 63
e 8 e ses , a c a n,
s a d fi i y (S e
e e Statem nt of, , e c e nc e e
v tm nt 9 10 15
in 7 gr phi 3— 99 40 1
p ym t into fund 15
es e s, , , a c,
6 en s
r d mptio of d bt 15
a ,
9 n e
rv 1 5
e e
i ki g f d r
,
s n n 6 un ese e,
a dju ti g ntri 1 60
s n e es ,
m nuf t uring b u i ( S M u
a ac s ness ee an
fund m th od of p ym nt f t i g b u in
”
315
sink ing e a e ac ur n ) s ess
5
,
m r til b u i ( See M r ntil
—5( S
1 4 , e can e s n ess e ca e
ann uit y m th 144 1 4 e od , ee a s lo b u in ) s ess
”
Annuit y ) pr p r tio of 10 1 1
—
“ ”
e a a n , ,
computing 144 148 profit d lo ( S Profit and lo
an ss ee ss
5
,
futur worth of uity t t m nt )
”
3
e ann 146, 1 1, s a e e
5
,
1
pr t worth of uity 15
3
esen ann 148 1
15
-
, ,
act u l i u 190
a ss es,
mpou d int r t m thod of l diff r t ki d of 196
—
co n e es e ca cu e en n s
l ting d pr i tio 1 75
,
1 77 n t ur of prob l m 8 9
192 —
a e ec a n, a e e , ,
r ti g m th od of 144 t o t l u th oriz d i u 194
1 15
n s a e
d bt r d m ption f 144 15
c ea , e , a ss e,
e e 4 e o acc ou t purpo of 1 89
n s, se
5
-
, , , , ,
q uir d from oth r orpor tio 19
d fin d 1 43
1 9 ac e e c a ns ,
purpo of o trol 3 3
e e
5
,
di po itio of 161
of i v t m nt 3
3
s s n , for ses c n ,
ntri f p rpo
ill g l wh n 3 3
1 61 u 4 n es
xp n d t 15
e es , or ses e ,
n t ill g l 3 3
e e 8
s es ue o, e a 1, e ,
illu tr tiv pro bl m 162
llowing 3 33
s a e e , o 4 e a ,
t tu t
s a es a
5
,
in v tm
es e nts , 9 , 10 , 1 7
su rplu req uired
s . 2 00
5
4 8 I NDEX
St o k—C ntinu d
c o e reserve for . 11 5( S ee lo
a s
“
Re s
bo u 2 09
n s,
unting for 2 09 rh d ppli b l t 2 2 7
lo i g tr n f r b oo k 63
acco , ove ea a ca e o,
St o k t ur T urnov r
“ ”
(S
“
c s n 64 a s e s, , c n ee e
di ou t n 9 199
sc n o , , Str igh t l i m t h od d pr i tio r
a -
ne e , e ec a n a tes ,
ounting for 2 00
acc 1 71
n t llow bl in t t of N w Yor k
,
o a a e s a e e , u d r
S b si ia ies ( See Co rp ro a tio n, s ub
19 9
divid d en s ( See Di i vd e n ds S urplu s,
w orpor tio ou t
3
3
exch a nged be t een c a ns , acc n ,
9 omp r d with u divid d profits
c a e n e
forf it d 2 10
e e ,
surplu from 2 1 1 ri t 98
own d for purpo of o trol 3 3 3
ent
5
s . es o.
ou ti g for 10 1
ow d for purpo of i v tm nt 3 3
e ses c n , acc n n ,
-
10
ff t of tri l
own r hip form of 3 3
ne 4 ses n es e , e ec en es o n ba ance shee t ,
e s 4 , s , 102
p ym t for by in t lm nt 194
a en , s a e ,
pr mium
e provi io for 2 00 s n
d fi it io 9 5
, ,
good will 3
n n,
divid d d l r d from 5 55
e
as 61 -
en s 9 ec a e -
forf it d t o k p ym nt
, ,
di po itio of 1 99
10 3
s s n e e 2 11s c a e s o n,
95
, ,
n tu e
a d our r an
rplu of ub idi ry 85
s ces ,
r r from 104 10 5
-
su 8 861
s s s a , , ese ve (S lo R , , ee a s e
s b rip tion
u sc divid d ppli d t s, en s a e o. 87
tr ury 2 0 1 2 0 8
eas of 60
ad vis ibility
f t or d t rmi ing 115
-
, ,
ac s e e n ,
l r tm t 2 08
ba ance s heet t ea en , r v lu tio of t 100
e a a n asse s.
d fin d 2 0 1
e e , l of t 99
sa e asse s ,
pur h bov p 2 07
c a se , a e ar, sour of 9 6 ces
it m oth r th n r l iz d profi t 9 5
.
p r h b low p 2 06
u c e ar, e s e a ea e s,
p i l ou t 5
ase ,
pur h 2 05
c a se s , s ec a 1 96 acc n s, ,
t ru t omp y 2 00
s c an , p i lly r t d
s ec a org iz tion of c ea e on an a
without p v lu 2 00 a n e nterprh e, 96
5
ar a e,
b l h t r f
a ance s to 2 0 1 ee e erence , u n ea ne r d p il unt for
, s ec a acco . 1
tri
en2 01 es , Sus pense ou t 2 2 2 7
acc n s, ,
es ta tes , 69 T
x
Ta es, ru d acc e , 2 9
n oti of divid d
ce e n s, 69 ory of v r
T he a e a ges , 2 0, 2 6
Trad di ou te sc n s,
pl dg 68 dedu t d in rt ro
3
c e asce aining g ss
5
e ees ,
St o k i t r d
c n e,
d fin d 2 15
- -
a
sh oul d pp r ook
3
e e , no t a ea on b s
d pr i tion n
e ec a o , 22 , 224 ount
c , 2 44
I NDEX 5
4 9
'
efl ect of de pr o
ec ia ti n o n, 49
dfi de ne , 2 60 fl u tu tio
c a ns , m t h od e of re o ding
c r . 7
l tio good will
3
and patents , 2 60
—
n to
525
re a -
good will , 2 7
Tra v l i g xp
e n 27 e e nses ,
Tr ury to k ( S Sto k
eas s c ee
“
c inv ntory 2 2 4 2 2 6
e ,
-
Tri l b l diff r in h w lo fi lo dju tm nt
ki d of 42 43
a a a nce , e e nces o re ss a s e 2 72
t d 40 5—
, ,
l d 23
ca e 40 9 n s
to k
, , ,
t omp i i v tm t i
of oth r orpor tio 3 3
M c a n es , n es en s n s c s an 1 ,
4
51 14 1 15117 ( S
e c a ns ,
Tru t d d uri g bo d i u provi
ee n n ss e, r rv
ese e, 10 4, 10 ee
of 15 515
s sec , , ,
io 7
oy l ti 2 62 2 63
s ns . ,
Tru t r a
o r of d t for 45
s ee, es ,
i b nkrup t y ( S B kr pt y
,
n a c ee an u c s u ces a a
ink i g fu d 1 5 tr d m rk 2 60
,
s 7
n n , a e -
a s,
Tru t ( S l o Holding mp ny tr d
C l yt o A t 3 3 3
“
s s ee a s co a a t 2 61
e se cre s ,
d v lopm t of 3 3
a n c .
ou t 418
A ti Tru t L w 3 33
e e 1 en , acc n ,
Sh rm e an n -
s a , acc o nt r iv bl
u s ece a e, 42 6
d l i b il it i
'
l ul t io of 3
l \l rno ve r , asse s a nt a es , 41 7 42 9-
xi t of 418
dfi d 3
ca c 97
a n e s ence 42 1
95
-
, ,
t fix d 42 8
h w t t d 3
e ne asse s , e
k 5
, ,
o 96s a e . ban bala nce 42 ,
d
p ym t 42 3 —
cas h in ha n , 42 2
cash 42 5
a en s ,
U
cash r ip t 42 2 ece s,
Und r lu tion 41 42
e va a , , f t opi io 417
ac s v s . n ns ,
Undivid d profit ( S Surplu
e s ee s f nd m t l t p 417
u en a s e s,
Un r d urplu 5
a
ea n e 1 s s,
Unit d St t Supr m C ourt profit
e a es e e , s in v tori 42 6
en es ,
t of whi h divid nd
ou m y b c e a e l dg r ou t 418
e a cc n
d l r d d fined 5
s e ,
8
ec a e , e , n ot r iv b l 42 6
es ece a e,
V lu tio lo rofit d t r W
33
a a n, ( See a s P s, e e
W i
ast ng asse ts, 2 8, 2 9
r rvese e for 11 5
W i
,
ou r v l ”
rpri
—5 5
ece i ab e ,
—
acc nts 2 18 as t ng e nte se s
divid d m y b p d t of pit l
3
asse ts , 41 4 2 1 2 40 en s e ai ou
wh n 5 75
a ca a
krup
, ,
ban tc cee ings, 2 2 y pro d 8
5
e , ,
bas is of W t r xp 27
6 3
44 4
profit 3
ense ,
—
a e e
W ork in pro
, ,
o d
3
—3
b n s 12 4 12 6 7 cess, on ,
Worki g hour m th od d pr i tion
, ,
v m v u m od
in es t ent al e eth 1 2 1 9 , n s e , e ec a
c opyright 2 61 s, r t 172 a e s,
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