Transcriber’s Notes:
Underscores “_” before and after a word or phrase indicate _italics_
in the original text.
Equal signs “=” before and after a word or phrase indicate =bold=
in the original text.
Small capitals have been converted to SOLID capitals.
Illustrations have been moved so they do not break up paragraphs.
Typographical and punctuation errors have been silently corrected.
ACCOUNTING
THEORY AND PRACTICE
A TEXT-BOOK FOR COLLEGES AND
SCHOOLS OF BUSINESS ADMINISTRATION
BY
ROY B. KESTER, PH.D.
CERTIFIED PUBLIC ACCOUNTANT;
PROFESSOR OF ACCOUNTING,
SCHOOL OF BUSINESS,
COLUMBIA UNIVERSITY
VOLUME I
(FIRST YEAR)
SECOND EDITION
[Illustration]
_Third Printing_
NEW YORK
THE RONALD PRESS COMPANY
1922
Copyright, 1917, by
THE RONALD PRESS COMPANY
Copyright, 1922, by
THE RONALD PRESS COMPANY
_All Rights Reserved_
To My Father and Mother
AN APPRECIATION OF THEIR STEADFAST
INTEREST IN MY WORK
PREFACE
The basic soundness of the method of instruction in Accounting
developed in this book has received substantial demonstration
throughout five years of test. The Introduction to the first edition
contained the following statement regarding the development of the
subject:
“The method of approach as given in this volume is perhaps not orthodox
but it has seemed that the student, given an understanding of the
purpose which the accounting records are to serve, will be able to
make that record with real intelligence instead of by rule-of-thumb.
Accordingly, the balance sheet and the profit and loss statement are
presented first, as the goal towards which all record-keeping looks.
The student is taught to analyze business facts and conditions from
the very beginning. He is then led, step by step, through the use of
non-technical terms, into the ledger, where he sees the way in which
the data which he has been using are summarized. The books of original
entry are next explained, and the method by which the information is
classified as it is brought onto the books. Finally, the business
papers and documents which constitute the source of all entries are
described.”
To quote again from the original Introduction: “The subject is
developed in such a way that the student knowing something of
bookkeeping has little or no advantage over the one without such
knowledge. This book has been written for the use of students in our
colleges and universities desiring a first course in accounting. It
gives the scope of the work in accounting offered in the first year of
the School of Business of Columbia University.”
The method then advocated and used in a few institutions has become
quite generally accepted. It has justified itself by the ease and
extent to which students without any previous training in accounting
have grasped the essentials of the subject. Experience with the book
in the classroom, however, and changing ideas with regard to manner
of presentation and sequence of material, have shown as desirable a
rearrangement of some parts and an addition of new material in places.
Accordingly, a systematic revision has been made.
The arrangement of the subject matter of the first portion of the book
has been altered but slightly. The use and function of the balance
sheet and profit and loss statement have been somewhat amplified. The
working sheet has been introduced earlier than in the first edition
to afford an easy summary of the period’s results. It should later on
be made a part of the regular work of summarization. The controlling
account is also explained earlier so as to afford more practice in its
use. The accounting features of the partnership and of the corporation
are given continuous treatment. Here a new chapter has been added,
which discusses certain features of the corporation not treated in
the original book such as the issue and sale of treasury stock and of
bonds, bond interest as related to premium and discount, sinking fund,
sinking fund reserve, redemption of bonds, etc.
The material presented in the last quarter of the book deals with
the interrelations of accounting, financial management, buying, and
marketing. Thus the chapters dealing with the handling of cash, notes
receivable and payable, cash discounts, and balance sheet valuation,
treat of the relations between accounting and financial management.
Several chapters at the end treat of some special methods of accounting
practice and of the basic principles of single entry. In this portion
of the book new chapters on balance sheet valuation and on buying have
been added.
Entirely new problem material has been furnished, carefully graded and
related so far as possible to the subject matter of the chapters of the
text. For the convenience of the student this material is separated
from the text, and grouped in three appendices. A few of the problems
have been drawn from the examinations of various state boards and the
regents of the University of the State of New York, and from other
miscellaneous sources, to all of which acknowledgment is due. The
author is indebted to Mr. George B. Kelley for assistance in building
up a large part of the practice material. It need hardly be said that
a fundamentally sound knowledge of accounting cannot be gained without
ample practice work. Theory can never be sure of itself until put to
the test of practice.
The author desires to acknowledge again his debt to the many friends
whose counsel and aid counted so largely in the first writing of
this book. In the revision he finds himself still further indebted
to many instructors in all sections of the country for criticism and
suggestion. He desires especially to express his appreciation of
the active co-operation of his associates on the Columbia staff of
instructors in First Year Accounting, in particular Miss Nina Miller
and Messrs. Ralph T. Bickell and E. Gaylord Davis. In the actual work
of revision Messrs. Eskholme Wade, John Jaffee, and Raymond Gatchell
have given valuable assistance.
ROY B. KESTER
Columbia University,
New York City,
July 22, 1922
CONTENTS
CHAPTER PAGE
I BASIC RELATIONSHIPS—PROPRIETORSHIP 1
II ASSETS, LIABILITIES, AND CAPITAL 11
III THE BALANCE SHEET 22
IV THE COMPARATIVE BALANCE SHEET 32
V THE ECONOMIC OR PROFIT AND LOSS ELEMENTS
OF A BUSINESS 38
VI THE PROFIT AND LOSS SUMMARY 44
VII INTERRELATION BETWEEN THE ECONOMIC AND THE
FINANCIAL ELEMENTS OF A BUSINESS, AND SOME
INTER-RATIOS 57
VIII THE ACCOUNT 67
IX THE ACCOUNT (Continued) 72
X THE PHILOSOPHY OF DEBIT AND CREDIT 78
XI DEBIT AND CREDIT AS APPLIED TO ASSET AND
LIABILITY ACCOUNTS 85
XII DEBIT AND CREDIT AS APPLIED TO
PROPRIETORSHIP ACCOUNTS 91
XIII DEBIT AND CREDIT AS APPLIED TO MIXED ACCOUNTS 97
XIV PERIODIC WORK ON THE LEDGER 106
XV PERIODIC ADJUSTMENTS AND SUMMARIZATION 115
XVI SOURCES OF DATA FOR THE LEDGER 132
XVII THE SUBDIVISION OF THE JOURNAL 136
XVIII THE PURCHASE AND SALES JOURNALS 139
XIX THE CASH JOURNALS 147
XX THE MODERN JOURNAL 162
XXI BUSINESS PAPERS—NEGOTIABLE INSTRUMENTS 173
XXII BUSINESS PAPERS—THE GOODS INVOICE AND
BILL OF LADING 185
XXIII BANKS AND THEIR METHODS 192
XXIV METHODS OF POSTING 199
XXV THE TRIAL BALANCE AND METHODS OF LOCATING
ERRORS 204
XXVI THE CLASSIFICATION OF ACCOUNTS 213
XXVII THE WORK SHEET AND SUMMARY STATEMENTS 221
XXVIII ADJUSTING AND CLOSING THE BOOKS 237
XXIX TYPES OF ACCOUNTING RECORDS AND THEIR DEVELOPMENT 251
XXX CONTROLLING ACCOUNTS 264
XXXI HANDLING CONTROLLING ACCOUNTS 272
XXXII PARTNERSHIP FROM A BUSINESS VIEWPOINT 284
XXXIII PARTNERSHIP FROM THE ACCOUNTING VIEWPOINT 290
XXXIV CAPITALIZATION OF THE PARTNERSHIP 297
XXXV OTHER PARTNERSHIP PROBLEMS 305
XXXVI PARTNERSHIP PROFITS 313
XXXVII PARTNERSHIP DISSOLUTION 321
XXXVIII THE CORPORATION 330
XXXIX OPENING THE CORPORATION BOOKS 338
XL CURRENT AND CLOSING ENTRIES FOR THE CORPORATION 351
XLI HANDLING THE CASH 366
XLII NOTES RECEIVABLE AND PAYABLE 376
XLIII PROBLEMS ENCOUNTERED IN RECORDING NOTES
RECEIVABLE AND PAYABLE 384
XLIV DISCOUNTS 392
XLV BALANCE SHEET VALUATION 403
XLVI BUYING AND STOCK CONTROL 420
XLVII SALES 433
XLVIII CONSIGNMENTS 447
XLIX ADVENTURE SALES 460
L ACCOUNTS CURRENT 468
LI BALANCING METHODS 477
LII SOME APPLICATION OF INTEREST AND PROPORTION 485
LIII SINGLE OR SIMPLE ENTRY 495
LIV ILLUSTRATION OF SINGLE ENTRY 504
Appendix A—PRACTICE WORK FOR STUDENT—FIRST HALF-YEAR 513
B—PRACTICE WORK FOR STUDENT—SECOND HALF-YEAR 553
C—MISCELLANEOUS PROBLEMS FOR SUPPLEMENTARY WORK 597
FORMS
FORM PAGE
1. Form of Ledger Accounts 70
2. Chart of Accounts 75
3. Accounts Balanced and Ruled 109
4. Transfer of Accounts to a New Page 112
5. Personal and Notes Payable Accounts 113
6. Standard Form of Journal 135
7. Purchase Journal 142
8. Modern Type of Purchase Journal 142
9. Departmental Purchase Journal 144
10. Cash Book (Cash Receipts Journal) 148
11. Cash Book (Disbursements Journal) 149
12. Columnar Cash Book—Debit Side 158
13. Columnar Cash Book—Credit Side 159
14. Divided Column Journal 164
15. Opening Entries on Books 166
16. A Promissory Note 175
17. A Draft 175
18. A Bank Draft 180
19. Forms of Checks 182
20. Monthly Statement of Account 191
21. Bank Deposit Ticket 193
22. Cross-indexing in Posting 202
23. Work Sheet 226-227
24. Balance Sheet—Report Form 232
25. Balance Sheet—Account Form 233
26. Statement of Profit and Loss—Report Form 234
27. Statement of Profit and Loss—Account Form 235
28. Profit and Loss Account in Ledger 249
29. Standard Ledger—Divided Column 258
30. Standard Ledger—Center Column 258
31. Balance Ledger Rulings 259
32. Balance Ledger Rulings 259
33. Boston Ledger Sometimes Used for Depositors 262
34. General Journal 279
35. Sales Journal Summary 279
36. General Journal Summary 281
37. Cash Book Summary Book—Receipts Side 282
38. Cash Books Summary Book—Disbursements Side 282
39. Petty Cash Book 369
40. Weekly Statement of Receipts and Disbursements 375
41. Notes Receivable Journal 380
42. Discount Columns Used for Cash Balance 400
43. Stock Control Card 430
44. Account Sales 451
45. Form of Adjusted Account Current 470
46. Account Marked for Analysis 478
47. Ledger Analysis Sheet 480
Accounting—Theory and Practice
CHAPTER I
BASIC RELATIONSHIPS—PROPRIETORSHIP
=Records and Their Functions.=—As far back as our knowledge reaches,
records of some sort have been kept and used and they have frequently
formed the basis on which our knowledge rests. In a broad sense a
record may be defined as a written memorial, a register or history of
events, a testimony. Even though the desire to make and hand on to
the future a record of achievement is a deep-seated characteristic,
record-making has seldom been an end in itself. Knowledge of what has
been done has always been a starting point and a guide for future
achievement. The longhand or narrative record is indispensable in some
fields of knowledge; the shorthand or statistical record is equally
necessary in others. The statistical method and accounting are, without
question, most potent agencies for the advancement of human knowledge
and for the control of human relationships. They provide the basis in
fact on which judgments must largely rest. This book, therefore, may
begin by sketching the relation of accounting to some of the larger
fields of human endeavor—the economic organization of society and the
law—to point out its place in the business unit and briefly state the
basic function it performs therein.
=The Business Unit.=—To carry on its various activities, economic
society has organized itself into numberless separate units or
business organizations. These units are the means through which
society operates, their ultimate purpose being the easy and efficient
satisfaction of human economic wants. Individual business units,
conducted as they are by members of society, are under the broad
general supervision of society as a whole. This is evidenced everywhere
by the laws, licenses, and regulations by which society attempts to
regulate the activities of the individual for the larger interest of
society as a whole. As business is conducted in most parts of the
world, it is highly individualized rather than communized. There is a
growing tendency, however, for society to exercise a larger control and
supervision over all types of individual activity, particularly with
a view to conserving the welfare of its members. The business unit is
thus the medium through which society works to satisfy its economic
wants.
=Internal Organization of the Business Unit.=—Society early found that
only by means of a highly specialized division of its activities was
it possible to satisfy without waste its rapidly increasing economic
wants. Individual business units are thus organized for the purpose of
carrying on some one or more of these greatly subdivided activities.
Within itself the business unit is organized into departments or
divisions for the efficient and thrifty handling of its work. The
two large divisions in any business undertaking have to do with what
the economist calls the production and exchange of wealth, that is,
commodities, services, and so forth. In carrying on these activities
of production and exchange it has usually been found desirable to
segregate into separate departments certain major functions which are
common both to production and to exchange. What the major departments
may be depends very largely upon the size of the business unit,
its relative complexity of organization, and to some extent on the
individual ideas of its managers. Throughout the business world one
notes, however, a quite general departmentization under the following
heads:
1. Finance
2. Procurement or production
3. Marketing or distribution
4. Personnel
5. General administration
There are two main activities under the control of the finance division
of a business: (a) the problem of original investment, including that
of location and acquisition of a plant suitable for the conduct of
a contemplated business; and (b) the problem of operating finance,
that is, of providing the business with a fund of working capital for
its efficient operation. The financing of purchases, sales, credits,
operating expenses, and so forth, comprises a large part of the work of
finance of an operating or going concern.
In the second of the major departments, that of procurement or
production, one finds these activities: (a) the purchasing of the
stock-in-trade to be dealt in, if the concern is a trading business;
or (b) the manufacture of the stock-in-trade, if the concern is a
manufacturing business.
In the department of marketing or distribution, the following
activities center: (a) those having for their purpose the creation of
a market or demand for the commodity dealt in—the sales organization,
the advertising activities, and so forth; (b) the actual selling of the
commodity; and (c) the transportation and delivery of the product.
In the personnel department are included the human relations between
employer and employee. The hiring and training of the employee, his
classification and rating, his welfare and promotion, are the major
activities here.
The function of the department of general administration is in the
main that of supervision and management of the business as a whole.
The general manager must have a view of all of the activities of the
business. He must see that the various departments through which its
activities are carried on are properly correlated, that it is so
organized that its departments function smoothly and efficiently in
the performance of their several duties. A consideration of the means
employed by the general manager for the proper performance of his duty
indicates the place of accounting in the business unit.
=Place of Accounting in Business.=—In a small business where the
owner and manager is in close and intimate contact with these several
departments, or perhaps where he focuses all of them within himself, he
has no need of special means of keeping himself informed concerning the
activities of his assistants, nor does he require an elaborate system
of records to indicate the condition and state of the business at any
time. In large businesses, however, where the volume and complexity of
the commercial activities make it impossible for the executive, on whom
rest the responsibilities for the successful conduct of the business,
to have an intimate personal knowledge of all phases of the business,
it is very necessary that some means be employed for supplying him
with this vital information. Two types of information are necessary to
him: (1) information about the business unit itself, its activities
and condition; and (2) information about general economic conditions
in the country, and particularly about other businesses in the same
line of activity as his own. It is the function of accounting to supply
information of the first type; it is the chief purpose of statistics
to supply information of the second type. The accounting department,
therefore, deals largely with the internal activities of the business,
while the statistical department provides knowledge of the external
relations of the business. A proper control and management of business
affairs cannot be exercised without the information supplied by both
departments. In the accomplishment of its function to supply the
internal information, the accounting department reaches out into all of
the main departments indicated above for data from which to make its
record of the various activities of the business unit.
=Purpose of Accounts.=—Accounts record the business history of a
concern. Their main purpose is to secure information concerning the
results of business activity and endeavor. The record required for this
purpose can be condensed and made very brief, although the full history
of every business comprises a multitude of transactions with a great
mass of details. The whole scheme and method of account-keeping is
designed chiefly to collect the detail and use it mainly for building
up a summary which shall give in rapid review the entire record for the
fiscal period.
Account-keeping is to the bookkeeper what shorthand is to the
stenographer—an abbreviated method of making the record. The uses to
which the records are put, however, differ radically. Stenography
abbreviates the writing of the spoken word with a view to its
transcription into longhand; accounting records business transactions
in abbreviated form with a view to summarizing them further so as to
secure a bird’s-eye view of the operations of the business as a whole
and to use it in the formulation of administrative judgments and
policies.
In a large business there are executive duties within each of the
five main departments. Accounting must supply the information on which
each departmental executive will base his judgments and policies. The
student will see, therefore, that the accounting department brings
together a record of the activities of each of the main departments
of a business. He will see, too, how the final output or product of
the accounting department must be a summarization and interpretation
of these departmental activities in order to provide a basis for the
various executives on which to formulate their judgments and business
policies. Accounting is, therefore, a handmaiden of the executives
in the conduct and management of the business. It is the purpose of
this volume to develop the technique of the bookkeeping and accounting
record and to indicate some of its uses in the management of business.
=Relation of Accountancy to Economics.=—Economics is sometimes defined
as the science of wealth, by which is meant a body of classified
knowledge relating to wealth in the aggregate. Under the present-day
political and social system, the ownership of wealth is very largely
private. Furthermore, the division of labor, as industry is now
organized, has been carried to a very high degree. Because of these
facts the present elaborate organizations for producing wealth have
given rise to an urgent need for some effective means of keeping record
of their activities.
The effort of every individual engaged in industry is to increase
wealth. He labors to extract the raw materials from nature, to shape
and mould them so as to supply the wants of his fellowmen. He then
distributes them by means of markets and exchanges so as to secure the
greatest possible returns for his effort. As competition becomes keener
and the margin of return per unit of product becomes smaller, he has to
increase his volume of business to secure the same amount of profit as
when he did a lesser volume of business.
To produce goods it is necessary to use the saved wealth of former
periods to pay the expenses of materials, labor, management, etc., of
the present period. One must consume wealth to produce wealth. After
his product is made, he must seek the best market for its exchange or
sale. This necessitates the use of a complex system of transportation
and communication. Finally, during the whole process of production and
exchange the estimated returns from the article must be distributed
among the several parties engaged in their creation. To make this
distribution on the basis of estimated returns, gives rise to the
need—the absolute necessity—of an accurate record of the costs of the
activities and processes all along the line. The record, then, of
the value of the rights and properties of the various parties to the
production and distribution of wealth, as society is now organized for
its economic well being, is the special field assigned to Accountancy
as related to Economics.
=Relation of Accountancy to Law.=—The determination of the rights of
the several parties to the creation, exchange, and ultimate consumption
of a product is the field of Law, more particularly Business Law. The
determination by means of its records of the value and extent of these
rights is the province of Accountancy as related to Law. Accountancy is
thus seen to be the handmaiden of both Economics and Law. None of them
can progress far without the help of the other two. All being related
to, and arising out of manifold human endeavors, their progress and
development is dependent upon, and limited only by, the progress of
these endeavors.
=The Fundamental Problem of Accountancy.=—The aim of all private
businesses being the increase of wealth, the first problem of
accountancy is to determine how much wealth is invested in a given
enterprise and what ownership or proprietorship exists at given
periods, so that by comparison the increases and decreases in the
proprietorship may be known. When accurate information is obtained, an
intelligent plan of action can be adopted to remedy such ills of the
business as are shown and to increase any profitable line of activity.
Accordingly, proprietorship and its changing values are the basic
problems of accountancy as well as of business.
=Definition of Terms.=—Before proceeding to a definition or
determination of proprietorship, it is necessary to understand what is
meant by the terms “assets” and “liabilities.” The root idea of the
word “assets” is “sufficiency.” Specifically, assets are the “entire
property of all sorts, of a person, association, or corporation
applicable or subject to the payment of debts.” Similarly, the
liabilities of a person, firm, or corporation are his or its pecuniary
obligations or debts. Proprietorship is the difference between the
value of the assets and the amount of the liabilities, and is defined
and measured by the equation:
Assets - Liabilities = Proprietorship
This proprietorship equation is a basic formula. It is also written:
Assets = Liabilities + Proprietorship
It will thus be seen that proprietorship represents the equity of the
owners of an enterprise in its assets. The assets are first applied in
paying the claims of creditors of the business, and whatever of them
remains belongs to the owners of the business.
=Development of the Proprietorship Equation—The Balance Sheet.=—To
indicate the basis of the standard form of the proprietorship equation,
several illustrations will be given. The equation is in its simplest
form when it indicates proprietorship in a new business immediately
after the owner has invested cash to provide the business with capital.
For example, assume that on January 1, 19—, James T. Runyon starts
business by investing $5,000 cash capital in the enterprise.
Here the proprietorship equation is:
Assets (cash $5,000) = Proprietorship ($5,000)
As yet there are no liabilities. However, in order to carry on his
business, Runyon must purchase a stock of merchandise and equipment for
his store. Accordingly, he purchases store furniture and fixtures from
Lowell Brothers for $500, of which he pays $250 in cash, and owes the
balance. He also buys a stock of groceries for $2,500 from Reid Murdock
& Co. on 10 days’ time. He now has more assets than the original $5,000
cash, but he has become indebted for the additional amount, so that
the amount of his proprietorship has not changed—as is shown by the
following equation, somewhat more complex than the first:
ASSETS - LIABILITIES = PROPRIETORSHIP
Cash $4,750 Lowell Bros.
Furniture 500 Claim $ 250
Merchandise 2,500 Reid Murdock
Claim 2,500
------ ------
$7,750 - $2,750 = $5,000
Runyon now begins operations and after six months finds that his
activities have comprised the purchase of delivery equipment for
$300 cash; sale of goods amounting to $6,000; the payment of $1,000
cash for rent, clerk hire, and advertising; and sundry purchases of
stock-in-trade and other items as needed. As a result he now has $1,000
cash on hand; customers owe him $3,000; his stock of goods still on
hand is worth $2,100; he owes creditors $1,000 for goods bought and his
clerks $50 for services rendered.
It is readily seen that as the number of assets and liabilities
increases, the method of showing them that was used above becomes
awkward and cumbersome; therefore, still using the equation, we make
the following vertical tabulation to determine and show proprietorship:
_Assets_
Cash $1,000.00
Customers 3,000.00
Merchandise 2,100.00
Furniture 500.00
Delivery Equipment 300.00
---------
Total Assets $6,900.00
_Liabilities_
Creditors for Merchandise $1,000.00
Clerks for Services 50.00
---------
Total Liabilities 1,050.00
---------
_Proprietorship_
Capital $5,850.00
=========
This method of expressing the proprietorship equation is called a
“Balance Sheet,” or “Financial Statement.”
Further analysis of the above information discloses the amount of
Runyon’s purchases and of his payments to creditors. Taking the
transactions involving cash, we find that he had $5,000 to start with
and received $3,000 from sales, or $8,000 in all. He bought furniture
and delivery equipment for $800, and paid expenses of $1,000, in all
$1,800. There is therefore a balance of $6,200 to be accounted for.
$1,000 cash is still on hand, so that he must have paid creditors
$5,200. Since he still owes creditors $1,000 for goods bought, his
purchases must have been in all $6,200.
The ability to make accounting statements and to analyze accounting
data for various purposes constitutes a very important part of the
equipment of the accountant.
CHAPTER II
ASSETS, LIABILITIES, AND CAPITAL
Before discussing the form and content of the balance sheet and some
of its major uses, the chief classes of assets, liabilities, and
proprietorship or capital will be explained so that the student will
have an intelligent notion of what is meant by each asset, liability,
and capital item.
=Kinds of Assets.=—Accounting terms are not wholly standard. An account
title is often used in one business to include items not mentioned
under that title in another business. One finds also terms and titles
peculiar to particular businesses. However, there is a tendency
towards a standardization of the terms used in balance sheets. It is
the purpose here to present and explain those which are common to
practically all businesses. These include the asset titles Cash, Notes
Receivable, Accounts Receivable, Merchandise, Investments, Deferred
Charges or Expense Assets, Furniture and Fixtures, Delivery Equipment,
Buildings, and Land.
CASH. Cash includes all kinds of money and usually whatever serves
as a medium of exchange, which is in the possession or control of
the business—deposits in banks, moneys in the safe and cash drawers,
and sometimes funds in the possession of agents. Checks received in
the regular course of business and not yet deposited in the bank are
usually classified as cash.
NOTES RECEIVABLE. The formal promises to pay, made by others for
debts owed the business, are classified under the general title Notes
Receivable. Time drafts drawn on the debtors of the business and
accepted by them may be included under this title, although they are
sometimes shown under a separate title, such as Acceptances Receivable.
This is particularly true when the acceptances are trade acceptances.
It will be seen later that the promissory note has a somewhat different
legal status from the open account claim against a debtor, and should
therefore be classified under such title as will indicate the exact
nature of the item.
ACCOUNTS RECEIVABLE. These usually represent the claims of the business
against its trade customers for goods sold on open account and not
paid for. The term is, however, broader than this, being sometimes
used—although the practice is to be deplored—to include all claims
against debtors except those which are in the form of notes.
MERCHANDISE. This asset represents the stock-in-trade in which the
business deals. It is of course a sort of revolving asset, that
is, merchandise is purchased and sold continuously, so that the
stock-in-trade is constantly being turned over. The rate of turnover is
very important, as will later be seen.
INVESTMENTS. This asset represents the stocks and bonds of other
companies, municipalities, school districts, and so forth, owned by
the business. As a usual thing there are seasons of the year when the
cash funds of a business are built up and lie idle in the bank unless
they are invested in securities of some sort. These securities can be
reconverted into cash when the business requires a larger fund of cash.
DEFERRED CHARGES. Certain types of expenditure are necessary in
every business to secure operating supplies. Fuel must be purchased
for heating and power purposes; brooms, oil, waste, and other similar
supplies are needed for cleaning and maintaining the business plant;
stationery, stamps, wrapping paper, twine, cartons, packing materials,
and so forth must always be on hand; insurance policies giving
protection against fire are usually purchased for from one to three
years and so are seldom completely used up at any given date. All items
of this sort, necessary for the operation of the business but not dealt
in as stock-in-trade, are called “expense assets.” The portions of
these assets on hand at a given time, the use of which will be deferred
to a later period, are classified as “deferred charges.”
FURNITURE AND FIXTURES. A business plant must be equipped with
furniture and fixtures suitable for the display of the stock-in-trade,
for the accommodation of customers, for the care and protection of
the necessary records of the business, for the efficient performance
of duties by the employees, and for other similar purposes. Assets of
this type which are not a permanent part of the business plant but are
removable should the business desire to change location, are listed
under the title of Furniture and Fixtures. This may be subdivided to
suit conditions. Sometimes several titles—Store Furniture and Fixtures,
Office Furniture and Fixtures, Factory Furniture and Fixtures,
Machinery and Tools—are used.
DELIVERY EQUIPMENT. If a business delivers its commodities it will
usually have its own delivery equipment. This may comprise horses,
wagons, harness, automobile trucks, and so forth. The delivery
equipment may be used for both inbound and outbound deliveries.
BUILDINGS. All buildings owned by the business, whether used for
business purposes or not, will usually be classified under the asset
title Buildings. Store, office, factory, warehouses, residences owned
and rented to employees—all assets of this type are to be listed here.
LAND. This item represents land—city lots, plant sites, and so
forth—owned in fee simple or subject to mortgage. Sometimes when a plot
of land is leased for a term of years and a lump sum payment made at
the beginning of the lease, the asset may be included either under the
title Land, or under the broader title Land and Leaseholds.
=Kinds of Liabilities.=—Just as with assets, there is not entire
uniformity in terminology for the various classes of liabilities.
The more common types of items met with are: Notes Payable, Accounts
Payable, Accrued Expenses, Mortgages Payable, Bonds Payable, and so
forth.
NOTES PAYABLE. These represent the formal promises to pay, signed
by the business or its owners. They represent the formal claims
of others, that is, creditors, against the business. Just as with
notes receivable, it is sometimes desirable to make a more distinct
classification of notes payable. In such cases the titles Acceptances
Payable, Trade Acceptances Payable, Long-Term Notes Payable, etc., are
used.
ACCOUNTS PAYABLE. Under this title are listed the liabilities to
creditors on open account, as distinguished from those formally
acknowledged by a written promise to pay. These include obligations to
trade creditors for merchandise, supplies, equipment, and property of
almost any kind purchased for use by the business. In a broad sense an
account payable includes any item for which the business is liable.
ACCRUED EXPENSES. Accrued Expenses represent usually the accumulating
but unpaid claims against the business for service rendered it, as
distinguished from the Accounts Payable, which usually represent
purchases of an asset of one kind or another. Thus the amounts due at a
given time to employees for work done since the last date of payment of
their wages, salaries, or commissions, to the landowner for the rent of
leased premises, to lenders for interest on moneys borrowed, are items
properly to be listed under this title.
MORTGAGES PAYABLE. These represent the claims of creditors against
particular properties owned by the business but against which the
creditors have been given a lien or preferred claim as security for the
borrowed or unpaid amount. Mortgages are evidenced by a formal legal
document and are usually recorded in the county clerk’s office.
BONDS PAYABLE. These are a type of long-term mortgage which is split
into lots of more or less standard amount and so made available to a
larger number of holders than is usually the case with the ordinary
mortgage payable. This type of liability is limited almost exclusively
to corporations.
The student should realize that usually the owner or owners of a
business enterprise have both assets and liabilities other than those
employed in the business. These personal properties and obligations
of the owners are not to be taken into account when showing the
proprietorship of a business unit or enterprise. They are to be
considered only in showing the total proprietorship of any individual
owner, when of course all of his properties, both inside and outside of
the business, must be listed.
=Kinds of Proprietorship.=—Proprietorship, called also Net Worth,
is shown under such titles as Capital, Investment, Capital Stock,
Surplus, Undivided Profits, Reserves, and so forth. The title used
depends largely on the type of organization under which the business is
operated.
CAPITAL. Under this title is shown the amount of the investment of each
owner in a single proprietorship or partnership business. To show each
owner’s share in the ownership the title Capital is preceded by his
name. Illustration of this is given on pages 19 and 20.
INVESTMENT. This title usually is synonymous with capital. Sometimes it
is used to indicate the amount of original investment in the business
as distinguished from the present investment.
CAPITAL STOCK. Under this title is indicated the sum total of the
portions of net worth owned by the shareholders as evidenced by stock
certificates and subject to their individual control. On page 20 is
given an explanation of the way in which the proprietorship or net
worth of a corporation may be composed of two (or more) parts: (1)
the capital paid in by the owners; and (2) the capital, representing
profits made but not distributed to the owners. While capital
stock usually represents the capital contributed by the owners, it
sometimes arises from other sources, such as the distribution of a
stock dividend; but the portion of the net worth owned and controlled
individually by the owners is the capital stock.
SURPLUS. In a corporation this represents the second portion of the
net worth, as indicated in the preceding section. Surplus is sometimes
defined as the excess of the net worth over the capital stock. In other
words, it is the difference between the assets and the sum of the
liabilities and the capital stock.
UNDIVIDED PROFITS. This is a term used chiefly in financial
institutions to indicate the portion of the net profits concerning the
disposal of which no action has been taken.
RESERVES. Under this title are included whatever portions of the
surplus are set aside or reserved for specific purposes.
Where Surplus, Undivided Profits, and Reserves appear as parts of Net
Worth, they together represent the difference between Net Worth and
Capital Stock. The reason for the careful segregation of these items
from the Capital Stock is given in the explanation of the corporate
form of organization, on page 20.
=Types of Business Organization.=—Before proceeding with a discussion
of proprietorship as it appears on the balance sheet, the three general
types of business organization will be treated briefly, because the
manner of indicating proprietorship is dependent to a certain extent
on the type of organization. These types are: (1) the single or sole
proprietorship, (2) the partnership, and (3) the corporation.
=The Single Proprietorship.=—The simplest form of business enterprise
is that conducted by a single proprietor. This form is well adapted
to businesses where the capital necessary for efficient production is
small, where the processes are simple and capable of being handled by
the average individual, and where the risks are slight. Very few legal
obstacles are placed in the way of the individual desiring to go into
business for himself, nor is a great deal required of him. In some
cases registration and a license are necessary. The observance of the
general laws, concerning the payment of taxes and of local regulations
concerning disease and fire is all that is usually expected. Subject to
the general restrictions which ordinary business acumen and foresight
impose, one can enter practically any field of enterprise, as a single
proprietor, have entire freedom and privacy in the conduct of his
business, and share with none the results of his endeavor.
On the other hand, these conditions oftentimes prove to be decided
disadvantages. As industry is at present organized, many fields of
activity demanding large capital and many kinds of technical knowledge,
are closed to the single proprietor. Freedom of action carries with it
sole responsibility, and oftentimes the counsel and advice of others
would prevent the disasters which sometimes overtake the single owner
of a business.
=The Partnership.=—A partnership is “a contract of two or more legally
competent persons to combine their money, property, skill, and labor,
or some or all of them, for the prosecution of some lawful business
and to divide the profits and bear the losses in certain proportions.”
There are different kinds of partnerships, as will later be shown, but
the essence of each from the point of view of a working organization is
mutual agency, each partner being the agent of the others, and, within
the limitations of the partnership agreement, capable of acting as a
principal for the firm. The partnership is subject to practically as
few restrictions as the individual. In some localities, to secure the
right to sue and be sued in the firm name, it is necessary to file in a
public office a brief statement of the firm name and the names of its
members.
The chief advantages of the partnership are larger capital and
therefore access to fields closed to the individual; the combining of
the business wisdom, skill, and knowledge of several individuals; the
subdivision of duties and therefore the opportunity for specialization.
While in the view of the business community the partnership is an
entity or a business unit, it is not so in the sight of the law, each
member of the firm being held liable to creditors for the entire debts
of the partnership as if it were his sole business. If any one member
has to pay the firm debts, he has a claim against his copartners for
contribution.
Some of the disadvantages of this type of organization are the
possibility of friction among the partners and consequent delay of
action; the extension to the firm of credit based not on the firm
property but rather on the total property of the members, and the
consequent liability of each partner and his entire private fortune for
the debts of the firm.
It is important to note that the partnership agreement should be very
carefully drawn to cover in detail the relations of the partners, their
duties and their rights, particularly as to their shares in the profits
or losses of the firm.
=The Corporation.=—The corporate type of business organization is
distinguished from the other types discussed:
1. By the freedom of each owner from the personal
liability for the debts of the business to
any greater extent than his stock interest in
the business, though frequently in financial
corporations, and in a few states for all
corporations, his liability is double that stated.
2. By each share of ownership being evidenced by a
formal document called a certificate of stock.
3. By each owner being allowed a voice in the affairs
of the business only to the extent of his stock
ownership therein.
4. By the necessity of securing from the proper
authorities permission to do business.
5. By the necessity of complying strictly with the
terms of this permit and submitting to certain
requirements such as the filing of annual reports,
payment of special taxes, and the like.
The owners of a corporation, or its stockholders as they are called,
conduct the business through a board of directors which they elect
for that purpose and they review its management periodically, usually
annually. In this way they exercise indirect supervision over the
business. This remoteness of personal interest and supervision has
been somewhat overcome by electing to the board only those largely
interested in the business, and by retaining on the board those whose
ability as managers has been tried and proved. The board usually hires
and delegates to others the active management of affairs.
The advantages of the corporate form of organization are: (1) it
limits the liability of its owners; (2) it lends itself well to
accumulation of the large funds of capital necessary for the promotion
of large-scale enterprises; and (3) it secures through its board of
directors a convenient and effective means of centralized control and
management.
=Showing the Proprietorship of These Types=.—The methods of showing
in the balance sheet the proprietorship for these three types of
organization differ somewhat. The title under which proprietorship is
listed is Capital. In a single proprietorship such title is preceded by
the proprietor’s name, as shown in the following illustration:
_Assets_
Cash $2,000.00
Accounts Receivable 5,000.00
Merchandise 3,000.00
Furniture and Fixtures 500.00
---------
Total Assets $10,500.00
_Liabilities_
Accounts Payable $4,450.00
Due Clerk 50.00
---------
Total Liabilities 4,500.00
----------
_Proprietorship_
James Runyon, Capital $ 6,000.00
==========
In a partnership the capital is not shown in one item, each partner’s
interest being stated separately, thus:
_Assets_
Cash $ 2,500.00
Accounts Receivable 10,250.00
Merchandise 8,750.00
Furniture and Fixtures 625.00
----------
Total Assets $22,125.00
_Liabilities_
Notes Payable $ 1,660.00
Accounts Payable 5,465.00
----------
Total Liabilities 7,125.00
_Proprietorship_
Represented by:
James Runyon, Capital $ 8,000.00
Philip Adams, Capital 7,000.00 $15,000.00
---------- ==========
In a corporation, proprietorship is shown by the aggregate of the
outstanding shares of stock, which are valued at a fixed par, or cost,
under the single title Capital Stock, and if the proprietorship is
greater than that indicated under this title, the excess is listed
separately under the title Surplus or some of the other proprietorship
titles already explained. This method of showing proprietorship is
prescribed by law and is an effort to inform creditors, or those who
may become creditors, that the corporation has observed the legal
requirement not to distribute to stockholders any of its original
capital. Hence, the capital stock of the corporation must be listed
separately from the other items of proprietorship. Any changes in
proprietorship during the life of the corporation are taken care of
under these other titles, somewhat as illustrated below.
_Assets_
Cash $ 1,850.48
Notes Receivable 1,645.65
Accounts Receivable 15,285.35
Merchandise 10,045.94
Supplies 1,145.37
Furniture and Fixtures 1,636.97
Delivery Equipment 1,427.50
Buildings 8,000.00
Land 2,000.00
---------
Total Assets $43,037.26
_Liabilities_
Accounts Payable $ 5,762.26
Notes Payable 4,250.00
Salaries Due but Unpaid 25.00
Mortgage on Land and Buildings 3,000.00
----------
Total Liabilities 13,037.26
_Proprietorship_
Represented by:
Capital Stock $25,000.00
Surplus 5,000.00 $30,000.00
---------- ==========
CHAPTER III
THE BALANCE SHEET
=Purpose and Use.=—The balance sheet of a business is designed to show
its financial condition at a given time. As previously illustrated, it
marshals the assets in one list or schedule, and the liabilities in
another. The difference between the totals of the two schedules gives
the present or net worth of the business. In compiling a balance sheet
it is not sufficient to give simply the figures of proprietorship or
net worth; schedules of assets and liabilities must be drawn up to show
the items making up that net worth. From the viewpoint of a prospective
investor or purchaser, a banker to whom the business has applied for a
loan, or a concern considering the advisability of extending it credit
on a bill of goods, it makes all the difference in the world to know
that with a net value of $10,000 the business has assets of $15,000 and
liabilities of $5,000; or to know that its assets are $260,000 and its
liabilities $250,000.
The ratio of total assets to total liabilities is almost as important
information to an investor, purchaser, banker, or creditor as is
the character of the assets and liabilities. If the assets are in
properties for which there is not a ready market and the liabilities
are claims which mature soon and will have to be met, the situation
is unfavorable. If there are large values invested in easily salable
assets; if there is a large balance of cash on hand after meeting
current claims and providing for those which will soon mature; if
other liabilities are of a more permanent nature, such as mortgages or
long-time notes not requiring immediate attention—the situation may
show evidence of too large a capital, or of inefficient management
as indicated by the failure to invest a part of the surplus cash in
properties from which some return might be secured.
=Form and Content.=—Questions of the kind raised above are not
usually capable of definite answer from the information contained on
the balance sheet alone. Oftentimes information as to the volume of
business done, future plans for expansion or contraction of business
operations, and so forth, is needed in addition to that supplied by the
balance sheet. Of immediate interest to us, however, is the information
contained in the balance sheet. Here two main problems are met: that
relating to the form of the balance sheet, and that concerned with the
content of the balance sheet.
By form of the balance sheet is meant its physical appearance—the
arrangement and classification of its items. The form is not standard.
In this country there are few legal regulations governing the way in
which the records of a business are to be kept or its reports are to
be made. Some efforts have been made, however, to establish a more or
less standard form of balance sheet and to secure the use of standard
titles in the balance sheet so that wherever found those titles can be
relied upon to mean one and only one thing. Because balance sheets are
not always drawn up for similar purposes, such regulations should not
be too inflexible. The form of any business statement or report should
always have regard to the purposes it is to serve. Standardization of
form is desirable within this limitation.
By content of the balance sheet is meant the items that are admitted to
it and the basis of their valuation.
These two problems of the balance sheet—form and content—are
fundamental and will be briefly considered here.
=Titles—Main and Group.=—Instead of “Balance Sheet,” other terms are
used as names for the statement itself, such as “Financial Statement,”
“Statement of Resources and Liabilities,” “Statement of Assets and
Liabilities.” Within the statement, Resources is an alternative
title for Assets; and Net Worth, Present Worth, and Net Assets, for
Proprietorship. For the present, use of the terminology previously
employed will be continued, with the substitution, however, of the term
Net Worth for Proprietorship.
The title of a statement should be full; it should include the name of
the business enterprise and date, and should appear somewhat as follows:
SHONGOOD & GOODWELL
BALANCE SHEET
December 31, 19—
As stated, this should be followed by the schedules of Assets,
Liabilities, and Net Worth. Since the statement is a formal one, due
regard should be had for its general appearance, which should be neat
and attractive. Further consideration will be given to some of these
features in Chapters XXVI and XXVII.
=Classification and Arrangement.=—As indicated above, the balance sheet
is used to picture the financial condition of a business at a given
time. Some of the questions which arise in determining the financial
condition of a business have already been mentioned. The chief use to
which a balance sheet is put is the determination of the solvency of
the business for purposes of getting credit extensions. By solvency is
meant the ability of the business to pay its debts when due. Regardless
of how great the excess of assets over liabilities is, if it is tied up
in assets which cannot be used for the payment of debts, the creditors
of the business will become impatient and may ask a court to take the
control of the business away from its owners and place it in the hands
of a representative of the court and the creditors, who will conduct
the business for the purpose of converting assets into cash to a
sufficient extent to pay all debts.
A balance sheet should therefore be so arranged that the condition
of the business, viewed from the standpoint of its ability to pay its
debts, will be clearly and easily determinable. Cash is usually the
only medium used for the payment of debts. In the regular course of
business, debts are incurred which come due at different dates. Hence
it is not necessary to have on hand at a given time cash sufficient
to pay all of the debts of the business. Certain classes of debts
will not wait. The sums owed employees for services must usually be
paid when due. The debt to the government for taxes, to the public
service company for heat, light, and power, to the landlord for rent,
to the bank for money borrowed—all these debts must usually be paid
immediately as they come due.
The cycle of business operation includes the purchase of merchandise,
the payment of operating expenses, and the conversion of merchandise
into cash through sale, either directly, as when the sale is for cash,
or indirectly as when credit is extended a customer and cash is later
collected from him. This cycle or turnover of merchandise recurs
constantly in the management of the financial affairs of a business.
It is necessary so to order the buying and selling of goods and the
collection of accounts from customers that there will be on hand at all
times sufficient cash to pay the expenses of operating the business and
the debts contracted in the purchase of merchandise. This is the vital
and fundamental problem of the business executive. In the solution
of that problem it may sometimes be necessary to borrow funds from
the bank. Before lending money, the banker assures himself that the
business will be in a position to repay the borrowed money when due.
The balance sheet, accordingly, should be so arranged that the
condition of the business as related to its ability to pay its debts
will be apparent. This requires a classification or marshaling of the
assets which are concerned in the trading cycle on the one side, and
the liabilities which must be assumed in conducting the business during
the trading cycle, on the other.
At the head of the list of assets is the item Cash, the most liquid
of all, as it can be used directly for the payment of debts. Following
Cash come in order Notes Receivable, which, with proper indorsement,
can be sold to the banker and converted into cash almost immediately;
Accounts Receivable, which represent the claims against customers for
merchandise sold and which are collectible within the term of credit
extended to the customer; and finally, the Merchandise on Hand, which
must be sold either for cash or on credit and then converted into
cash by the collection of the outstanding accounts. Sometimes, also,
there is included in this group the asset Investments, representing
stocks and bonds of other companies which can be converted into cash
by sale on a stock exchange. On such securities, and also on the
notes receivable, there is usually at the date of the balance sheet
some interest which has accrued and may not yet be collectible. It is
customary to include the amount of this interest receivable in the same
group with the assets from which it arises.
This group of assets, comprising Cash, Notes and Accounts Receivable,
Merchandise, and so forth, is called the group of Current Assets. Asset
items are classified as current if conversion into cash is expected
within three to six months. These are the assets to which the current
creditors of the business will have to look for the payment of their
claims.
The claims of current creditors are usually included under the titles
Notes Payable, Accounts Payable, and Accrued or Unpaid Expenses. The
classification of a creditor in the current liability group is usually
determined on a time basis. Thus, all debts that will have to be met
within six months’ or one year’s time from the date of the balance
sheet are usually classed as Current Liabilities.
The excess of current assets over current liabilities is called the
working capital of the business; that is, an amount of the current
assets equal to the current liabilities will have to be used for the
payment of these debts, leaving the excess or difference free for use
within the business. While it is not possible to determine, without
considering all the circumstances in a given case, how large this
working capital should be, the standard rule-of-thumb is that it should
equal the amount of the current liabilities. It will thus be seen that
the standard ratio of current assets to current liabilities is two to
one. The solvency of a given business is always judged by a comparison
of the current asset group with the current liability group.
The next main group of assets is given the title Deferred Charges. The
content of this item was explained on page 12. Thus, if a management
has paid some of its expense bills in advance—rent for January paid
during December, for example—when showing its financial condition as
at the end of December it is proper and necessary, in order to make an
accurate showing, that all such prepaid expenses be listed as assets;
for, had the payment not been made until the service which it purchased
had been used up, the asset cash would have been larger by the amount
of the prepaid expenses.
Similarly, with regard to the Accrued Expenses mentioned on page 14,
whatever expenses have been incurred that properly belong to the past
period, such as wages due but unpaid, are liabilities; for the cash
would be smaller by the amount of such postponed or accrued items had
the claims been met during the period. The close relationship of both
deferred charges and accrued expenses to cash is thus apparent—the one
as an indirect addition to the cash, the other as an indirect deduction
from or claim against cash. Accordingly, deferred charges are shown on
the balance sheet immediately following the group of current assets,
whereas accrued expenses are listed with the current liabilities as
noted above.
The next group of assets is called Fixed Assets. Under this title are
listed those assets which are used for carrying on the business but
are not bought for the purpose of being resold. A certain amount of
capital must be invested in the physical business plant. Furniture and
fixtures, delivery equipment, buildings, land, machinery and tools, and
so forth, must be purchased before the business can commence operating.
It is assets of this type that comprise the class of fixed assets.
There is a corresponding group among the liabilities which are known
as Fixed or Long-Term Liabilities. All debts maturing a year or more
after the date of the balance sheet are classed as fixed liabilities.
As examples of this class, we have long-term notes payable, mortgages
payable, bonds payable, and so forth.
The difference between the fixed assets and the fixed liabilities
indicates the amount of owner’s capital which has been invested in the
business plant.
The final group of assets is called simply Other Assets, and includes
all assets which cannot be classified in any other groups, such as
good-will, patents, trade-marks, accounts and notes receivable having a
credit term longer than six months, and other similar items. If there
are any liabilities not capable of classification in the two groups
of liabilities given above, they may be put in a group called Other
Liabilities.
For the purpose of an easy showing of these various groups and their
titles, it is customary to list the amounts of the several detailed
items of each group in an inner money column, and to extend the total
into the adjoining money column on the line of the last item in the
group. A similar arrangement is made of the groups of liabilities so
that not only the items in the various groups but the group totals as
well are available. The totals of the various groups give the grand
totals for the assets and the liabilities respectively.
The balance sheet as now classified and arranged provides first a
formal title, giving the name of the business and the date of the
balance sheet; then the assets, under which appear the groups Current
Assets, Deferred Charges, Fixed Assets, and Other Assets; under the
liabilities appear the groups Current Liabilities, Fixed Liabilities,
and Other Liabilities. The showing of Proprietorship or Net Worth under
the three different kinds of ownership has already been set forth. The
illustration on page 31 shows a typical form of classified balance
sheet. This should be studied carefully, as it is the type which will
be used hereafter.
=The Problem of Content.=—The form of the balance sheet serves the
purpose of making easily available the information contained in the
balance sheet. Form is of little value unless the content is accurate.
What a balance sheet contains is, after all, far more important
than its form. The problem of content comprises a consideration of
two points: (1) the proper inclusion of all items, both assets and
liabilities, belonging in the balance sheet; and (2) the correct
valuation of the items so included.
With regard to the first, it may be said briefly that care must be
exercised to see that all assets belonging to the business and having
value, and that all claims against the business of whatever nature, are
included.
Assuming that a given balance sheet contains a list of _all_ the
assets and _all_ the liabilities, the further problem of the proper
valuation of these items must be considered. A balance sheet in
which the title Cash includes counterfeit bills, N. G. (that is,
uncollectible) checks and other similar items, would not be considered
a reliable balance sheet. Similarly, the basis for the valuation of
each of the asset items must be investigated and determined correct
before the balance sheet may be considered to represent the true
financial condition of the business. It is the experience of every
business that it cannot collect all of the credits extended to
customers. Regardless of how carefully credit is granted, it will be
found that some customers do not pay their debts. Accounts and notes
receivable must, accordingly, be valued with a proper consideration
for the estimated amount of the uncollectible portion. The stock of
merchandise on hand must be valued according to the standard formula,
at cost or market, whichever is the lower. The deferred charges group
of assets will show the value of the unconsumed portions of the assets
purchased, with due regard to the time element. Thus, a three-year
insurance policy purchased at the beginning of the year will at the
close of the year be valued at two-thirds of its original cost. The
fixed asset group will be valued at cost less depreciation, which
represents the amount of the loss in value of the assets due to wear
and tear, lapse of time, and obsolescence.
In determining liabilities, providing they have all been included,
there is not the danger of an understatement, because their amount is
subject to verification on the basis of the creditors’ claims. For
obvious reasons the liabilities are seldom overstated.
=General Principles Governing Form and Content.=—In drawing up a
balance sheet, the form must be flexible enough to meet whatever
requirements for information may be placed upon it. Thus, a balance
sheet to be presented to the banker as the basis of a loan should be
carefully classified so as to show clearly the financial condition,
and sufficient detail should be given to indicate the basis used in
valuing the various items. A balance sheet drawn up for publication
may, on the other hand, contain less detailed information and less
attention need be given to its form. A balance sheet drawn up for use
within the business itself may well contain very full information
and its form should be such as will accurately portray the status of
affairs. A balance sheet which shows on its face that cognizance is
taken of uncollectible accounts and of the loss in fixed assets due
to depreciation, is much more valuable as a financial statement than
one lacking that information, provided of course it is to be used to
indicate that consideration has been taken of those elements. Excepting
for the general remark that regard must always be had to the purpose
for which the balance sheet is drawn up, no hard-and-fast rule can be
laid down in the matter of the relative fullness of detail with which
it should be made.
=Illustration.= To illustrate the features of the balance sheet
discussed in this chapter, the following statement showing the
financial condition of the partnership of Jackson & Edwards is given:
JACKSON & EDWARDS
BALANCE SHEET
June 30, 19—
_Assets_
Current Assets:
Cash $ 2,365.00
Accounts Receivable $8,500.00
_Less_—Reserve for
Doubtful Accounts 170.00 8,330.00
---------
Merchandise 10,425.00 $21,120.00
---------
Deferred Charges:
License Fees Paid in Advance $ 175.00
Unexpired Insurance 75.00
Supplies 80.00 330.00
----------
Fixed Assets:
Furniture and Fixtures $ 750.00
_Less_—Reserve for Depreciation 75.00 $ 675.00
---------
Buildings $9,680.00
_Less_—Reserve for Depreciation 242.00 9,438.00
Land 2,500.00 12,613.00
--------- ---------
Total Assets $34,063.00
_Liabilities_
Current Liabilities:
Notes Payable $2,500.00
Accounts Payable 6,750.00
Wages Accrued 250.00
Interest Accrued 75.00 $ 9,575.00
---------
Fixed Liabilities:
Mortgage on Land and Buildings 2,500.00
----------
Total Liabilities 12,075.00
---------
_Net Worth_
Represented by:
S. J. Jackson, Capital $10,267.00
P. R. Edwards, Capital 11,721.00 $21,988.00
---------- ==========
CHAPTER IV
THE COMPARATIVE BALANCE SHEET
=Comparison of Net Worths.=—The aim of every business enterprise is to
increase its net worth. If James Runyon at the beginning of the year
is worth $5,000 and at its close $7,500, it is evident that he has
increased his wealth by $2,500. Very little information is given him or
anyone else as to the manner in which the increase took place, except
that it came about in the ordinary course of business. No criterion is
given by which to compare effort with result. An increase of $2,500 may
or may not be commensurate with the labor expended in effecting it.
However, since a business is not likely to remain stationary, there is
a degree of satisfaction in knowing merely the extent of the change in
its net worth. The taking of an inventory, the appraising of the value
of the assets from time to time, and the setting of the liabilities
for the same dates over against them, is the method of determining
the corresponding net worths. A comparison of these net worths shows
their increase or decrease during the period. A further analysis of
the individual items may be made. A comparison of each asset at the
beginning of the period with its value at the end of the period, shows
the increase or decrease in that item. A similar comparison of each
liability item brings out the increase or decrease during the period.
=How a Gain or Loss May Be Evidenced.=—During a period a gain or
increase in net worth may come about in one of four ways:
1. The assets may remain the same and the liabilities
may decrease.
2. The liabilities may remain the same and the assets
may increase.
3. The assets may decrease but the liabilities suffer
a greater decrease.
4. The assets may increase but the liabilities undergo
a smaller increase.
Provided no more money has been invested in the business, and none has
been withdrawn, there has been in all the above instances an increase
in net worth, that is, a profit has resulted. If the reverse of the
above relationships obtains, there has been a decrease in net worth, or
a loss.
The following statements illustrate the points discussed above.
AARON CONNERS
BALANCE SHEET,
June 30, 1921
_Assets_
Cash $ 1,000.00
Notes Receivable 250.00
Accounts Receivable 5,250.00
Merchandise 8,500.00
Store Fixtures 525.00
----------
Total Assets $15,525.00
_Liabilities_
Accounts Payable $ 5,365.00
Notes Payable 1,250.00
----------
Total Liabilities 6,615.00
----------
_Net Worth_
Aaron Conners, Capital $ 8,910.00
==========
One year later Conners’ financial condition is shown to be:
AARON CONNERS
BALANCE SHEET,
June 30, 1922
_Assets_
Cash $ 850.00
Notes Receivable 100.00
Accounts Receivable 6,425.00
Merchandise 10,260.00
Store Fixtures 472.50
Delivery Equipment 350.00
----------
Total Assets $18,457.50
_Liabilities_
Accounts Payable $ 6,192.75
Notes Payable 950.00
Accrued Salaries 50.50
----------
Total Liabilities 7,193.25
----------
_Net Worth_
Aaron Conners, Capital $11,264.25
==========
The various types of information essential to judging the financial
condition as disclosed by the above balance sheets will now be
discussed.
=Comparison of Balance Sheets.=—A comparison of balance sheets gives
more information than merely the amount of profit for the year. It
indicates trends in the business. Thus a comparison of the notes and
accounts receivable for the two years may give some indication of the
vigor with which collections are pressed. If the volume of business
done, that is, the amount of sales made, was about the same during the
two years, and if there are more uncollected accounts at the close
of the second year than at the close of the first, it would tend to
show that collections were less satisfactory during the second year.
Investigation may show that this is due to general conditions of
business in the country rather than to failure to push collections
vigorously. If there is any marked change in the amount of the stock
of merchandise on hand it would invite inquiry. If the stock is much
larger at the end of the second year than at the end of the first, it
might indicate that the business man is speculating in merchandise,
that he considers the buyer’s market during the year particularly
favorable and has laid in an abnormally large stock. A banker with
large experience in similar businesses can formulate a fairly accurate
judgment of how much working capital a concern should have invested in
merchandise. With that as a criterion he can tell the normal amount of
merchandise the business should carry.
A comparison of current liabilities for the two periods will indicate
the extent to which borrowed working capital is being used. Thus,
an unusual increase in stock-in-trade may be offset by an equally
large increase in current liabilities, and so would indicate that the
merchant has done his buying on credit or has used borrowed working
capital to increase his stock. The danger of this is apparent in a
fluctuating merchandise market, particularly if the swing is generally
downward. A comparison of the working capital for the two periods gives
useful information. A decrease in the amount of working capital may
indicate an investment of it in fixed plant which, if continued, will
lead to trouble with current creditors. An increase in working capital
may point to the advisability of greater sales effort.
A comparison of fixed assets for the two periods will show the
increase or decrease in the plant investment. If this has been offset
by a corresponding increase or decrease in fixed liabilities, no
additional capital of the owners has become tied up in fixed plant,
while the reverse is true if there is not that correspondence between
fixed assets and fixed liabilities. Where the ratio between current
liabilities and fixed liabilities has increased, it may point to
the desirability of funding some of the current debt. Short-term
liabilities have apparently been incurred for the purpose of extending
the fixed plant. It is usually desirable to convert, that is, fund
these current liabilities into long-term liabilities in order to
conserve working capital to pay current debts.
Thus it is seen that a proper understanding of the items in the two
balance sheets and of their various interrelationships will oftentimes
give very valuable information. Banks and business houses which
are called upon to extend credit, maintain regular files of credit
information, including periodic balance sheets, concerning their
present and prospective customers, so that they can judge fairly
accurately the condition of the businesses.
=The Comparative Balance Sheet—Its Content and Form.=—A comparison of
the above balance sheets shows an increase of net worth of $2,354.25
during the year. It shows also that this profit is accounted for by an
increase of $2,932.50 in the assets, which is offset by an increase of
$578.25 in the liabilities, leaving a net increase of $2,354.25.
The two statements thus separated do not lend themselves easily to a
comparison of individual items. Accordingly, a method of showing the
comparison known as the “Comparative Balance Sheet” form is used. This
brings all the data into juxtaposition and so makes comparison easy.
The balance sheet for the current year is shown first, followed by
that for the preceding year. The increase and decrease column uses the
current year as a basis for comparison with the preceding year.
AARON CONNERS
COMPARATIVE BALANCE SHEET
June 30, 1922 and June 30, 1921
Increase
and
_Assets_ 1922 1921 Decrease
Current Assets:
Cash $ 850.00 $ 1,000.00 - $ 150.00
Notes Receivable 100.00 250.00 - 150.00
Accounts Receivable 6,425.00 5,250.00 + 1,175.00
Merchandise 10,260.00 8,500.00 + 1,760.00
---------- ---------- ---------
$17,635.00 $15,000.00 + $2,635.00
---------- ---------- ---------
Fixed Assets:
Store Fixtures $ 472.50 $ 525.00 - $ 52.50
Delivery Equipment 350.00 + 350.00
---------- ---------- ---------
$ 822.50 $ 525.00 + $ 297.50
---------- ---------- ---------
Total Assets $18,457.50 $15,525.00 + $2,932.50
---------- ---------- ---------
_Liabilities_
Current Liabilities:
Accounts Payable $ 6,192.75 $ 5,365.00 + $ 827.75
Notes Payable 950.00 1,250.00 - 300.00
Accrued Salaries 50.50 + 50.50
---------- ---------- ---------
Total Liabilities $ 7,193.25 $ 6,615.00 + $ 578.25
---------- ---------- ---------
_Net Worth_
Aaron Conners, Capital $11,264.25 $ 8,910.00 + $2,354.25
========== ========== =========
While it is true that a great deal of valuable information can be
secured from a comparative balance sheet, and that this form of balance
sheet locates definitely the changes in the asset and liability items,
summarizes those changes, and shows the net profit, it nevertheless
fails to disclose the forces within the business organization which
have brought about the changes—it sets forth effect or result but not
cause. A supplementary or rather a complementary statement is needed to
show the reasons for the changes. This is discussed in the following
two chapters.
CHAPTER V
THE ECONOMIC OR PROFIT AND LOSS ELEMENTS OF A BUSINESS
=Fuller Information Needed.=—As indicated in Chapter IV, in the
summarization of the business transacted during a given period, it
is not usually sufficient to know how much net worth has changed;
nor is the whole story told when it is known exactly what items are
responsible for the change, that is, which of the properties are worth
more and which are worth less at the end than at the beginning of the
period. Additional information is necessary to account for the changes
shown by the comparative balance sheet.
The proprietor who knows simply that his cash is $1,000 less now than
it was at the corresponding time in the last fiscal period, has not
the kind of control over his business that his competitor has who
knows that the $1,000 was expended for an increased stock of goods, or
that an outstanding liability of that amount has been settled, or that
his expenses for the period have been larger by $1,000 than for the
former period. His competitor may be worse off but he at least has the
advantage of knowing the reason for his being so. He has made a correct
diagnosis of the pulse beat of his business. If he cannot heal its ills
or secure aid for it, he can at least have the satisfaction of giving
it a respectable burial, and the autopsy will then disclose that he
failed to take advantage of his information until it was too late.
However, the point should be clearly held in mind that the proprietor
who knows exactly what is happening in his business is in a position
to exercise a definite and sure control over it. Hence, the accounting
department, to justify its existence, should aim to give full
information as to what is taking place within the business and what
eventually will be the result in its financial life. Only in this way
can the department serve as a means of control.
=Kinds of Records.=—A business must have assets and usually must incur
liabilities; a plant must be used, stock-in-trade must be bought,
and sold, and usually sufficient capital must be provided for the
extension of credit to customers. Capital for the payment of the
operating expenses of the business, the maintenance of the plant, the
payment of salaries and wages of employees, and so forth must at all
times be provided. While it is true that the balance sheet shows the
financial condition of the business, it gives little information as to
the volume of business operations. It indicates the net worth and may
even indicate the increase or decrease in net worth if the comparative
balance sheet is used. Yet as to how that increase or decrease in net
worth came about, little or no information is given. The balance sheet,
in other words, is static; it indicates a quiescent state. It is a
snapshot, showing the wheels of business momentarily stopped.
To give a full survey of the operations during a given period, a
motion picture of the events between the dates of the balance sheets
must be shown. Such a picture is dynamic. It gives a realization of
the whirl and bustle of business being carried on. It pictures volume,
content, and extent, whereas the balance sheet indicates the state
arrived at as of a given moment. For purposes of management, which
must control all the phases of business activity, a balance sheet
is insufficient. A review of the factors producing results up to a
given time must be had. Accordingly, the accounting department must
supply not only information as to the present state of the assets and
liabilities, but also information which indicates how the changes
in assets and liabilities since the last fiscal period were brought
about—what volume of transactions occurred, what expenditures of assets
and energy were necessary to accomplish the results attained. This
information, for purposes of internal management, is more vital than
that concerning simply the present status of assets and liabilities. It
is complementary to that obtained by a comparison of net worths and it
is therefore explanatory of the changes in net worth.
=The Net Worth Section Expanded.=—In its operation of buying
and selling goods, a business executes many different types of
transactions. As was indicated in Chapter I, in the development of the
proprietorship equation, some types of transactions have no effect on
proprietorship, that is, they involve neither a profit nor a loss;
while other types of transaction—the really vital types, because it
is for these that the business is carried on—involve a change in
proprietorship, either increasing or decreasing it. Goods are bought
for one price and sold at a price sufficiently higher to pay for
all the expenses of operating the business and leave a reasonable
margin of profit. For example, goods may be bought for $1,000 and
sold for $1,800, bringing about an increase of $800 in the sum total
of the assets. This $800 may represent temporarily an increase in
proprietorship but the increase must be used first to meet the expenses
of operating the business during the period in which the sale is made,
after which the net result represents the real or permanent increase in
proprietorship. The temporary increase of $800 is offset by a temporary
decrease of, say, $600 for operating expenses. It is vital to business
management to have information not only concerning the net increase
in proprietorship but also concerning these temporary increases and
decreases. To give this information the net worth section of the
balance sheet might be expanded as in the illustration given below.
EDWIN MARKHAM
BALANCE SHEET,
December 31, 19—
_Assets_
Cash $ 5,000.00
Accounts Receivable 75,000.00
Merchandise 20,000.00
Plant 50,000.00
----------
Total Assets $150,000.00
_Liabilities_
Accounts Payable $30,000.00
Accrued Expenses 5,000.00
Mortgage on Plant 30,000.00
----------
Total Liabilities 65,000.00
---------
_Net Worth_
Edwin Markham:
Capital at the beginning
of the year $70,000.00
Profits during the year:
Sales $200,000.00
Cost of Goods Sold 140,000.00
-----------
Temporary Increase in
Proprietorship $ 60,000.00
Operating Expenses 45,000.00
-----------
Net Increase in Proprietorship 15,000.00
----------
Capital at the end of the year $ 85,000.00
-----------
In the net worth section of this balance sheet, the capital with which
the owner started operations for the year is given first. To this is
appended a summary of the operations for the year resulting in a net
increase in proprietorship which, added to the beginning capital, gives
the capital in the business at the end of the year. This method of
setting up the information concerning the operations of the business
is not used to any extent because the information is of such vital
importance that it deserves more display. Accordingly, a separate
statement, known as the “Statement of Profit and Loss,” or “Statement
of Business Operations,” is drawn up to explain the balance sheet net
worth item, Net Increase in Proprietorship for the year, which shows
just the amount of the net profit. The detail of this item is given in
this complementary statement. The above illustration is given merely
for the purpose of pointing out the relationship between the statement
of operations and the balance sheet. From this it will be seen that the
statement of profit and loss is really a part of the net worth section
of the balance sheet.
TEMPORARY PROPRIETORSHIP RECORDS.—The proprietorship records,
indicating as they do the sources of changes in net worth, are kept day
by day as transactions take place, are summarized at the close of the
period, and the net result is determined. They are called temporary
because, as is seen, they do not at the time of record have regard for
the final change in proprietorship. At the end of the regular periods,
to determine the total or final change, the temporary proprietorship
records are closed or transferred to the summarized record called the
“Profit and Loss Summary.”
Referring to the case of Aaron Conners discussed in Chapter IV, assume
that the accounting department furnishes the following additional
information from its records:
During the year from July 1, 1921 to June 30, 1922, Conners
bought $22,362.50 worth of goods; his sales amounted to
$28,465.20; he paid for help $3,050.50; his other expenses
were $2,405.45; and he estimated the wear and tear on
furniture at 10%, or $52.50. As shown in his statement for
1922, he had $10,260 worth of merchandise on hand on June
30, 1922.
The analysis of this information explains the changes in
his net worth during the year. The goods he started with
plus those purchased during the year are the total goods to
be accounted for, which amounted to $30,862.50 ($8,500 +
$22,362.50 = $30,862.50). These goods were accounted for by
his sales during the year and the amount on hand. Knowing
how much was on hand June 30, 1922, viz., $10,260, he
determined that the goods sold must have been the difference
or $20,602.50 ($30,862.50 - $10,260 = $20,602.50). The price
which he received for these goods sold was $28,465.20;
hence, his profits from sales were $7,862.70, the difference
between selling price and cost.
We find, also, that the expenses he incurred in selling his
goods and conducting his business generally were $3,050.50
for clerk hire, office help, delivery boys, etc.; and other
expenses, such as rent, taxes, repairs, delivery upkeep,
supplies, heat, light, and the like, amounted to $2,405.45.
He estimated that his store fixtures depreciated in value
$52.50. All these items, representing costs of doing
business, amounted to $5,508.45 ($3,050.50 + $2,405.45 +
$52.50 = $5,508.45), which subtracted from his profits from
sales, $7,862.70, gives him a net gain of $2,354.25
($7,862.70 - $5,508.45 = $2,354.25). This gain tallies with
the increased proprietorship of that amount shown by the
balance sheet of June 30, 1922.
Without regard to a form which would be technically correct, the data
of the preceding paragraphs may be shown as follows:
Goods on hand at the beginning, July 1, 1921 $ 8,500.00
Goods bought during the year 22,362.50
----------
Total goods to be accounted for $30,862.50
Goods accounted for, now on hand 10,260.00
----------
Goods accounted for, by being sold $20,602.50
==========
Selling price of goods sold $28,465.20
Cost price of goods sold, as above 20,602.50
----------
Profit from sales $ 7,862.70
Expenses of doing business:
Clerk hire $3,050.50
Other expenses 2,405.45
Depreciation 52.50
---------
Total expenses 5,508.45
----------
Net profit, or increase in net worth $ 2,354.25
==========
The technical form of the summary of the temporary proprietorship
elements will be presented in the next chapter.
CHAPTER VI
THE PROFIT AND LOSS SUMMARY
=Type of Information Needed.=—The need and purpose of the information
to be furnished by the temporary proprietorship records was pointed
out in Chapter V. Without information of this sort, proper control
of business operations cannot be exercised. These records supply a
summarized picture of the activities of the business during a definite
period, which have as their goal the increase in proprietorship—the
making of a profit. In attaining this goal, two main types of
activities or operations are entered into, usually classified under
the heads of: (1) income or earnings, by which is meant those
activities which immediately and directly increase proprietorship;
and (2) expenses or outgo, comprising those activities which decrease
proprietorship. Expenses are the costs incurred in securing income, and
are therefore deductions from it. A fuller explanation of these terms
will now be given.
=Income.=—Income is usually of two types: operating and non-operating.
These terms are always relative; that is, what is an operating income
in one business may be a non-operating income in another business.
The term “operating income” is used to indicate the main sources of
income in a given business. It is always the duty of the accounting
department to indicate the sources of income. Thus in a trading or
mercantile business, the selling of goods to customers is the main
source of income. In a professional business, the selling of services,
often titled “professional fees,” is the main source; in a brokerage or
commission business, commissions earned; in institutions, tuition and
other fees; in a financial business, interest earnings; in a society,
membership fees. These are typical titles for indicating the main
source of income in the several kinds of undertakings mentioned.
While sales are the major source of income in a trading concern,
there may be supplementary sources. It may own stocks and bonds from
which income may be derived. In a manufacturing or mining enterprise
the company may own dwelling houses and rent them to its employees.
Conditions of travel and communication may also force it to provide
stores, places of amusement, and so forth for its workers. From all
these supplementary activities it will derive income. As it was not
organized primarily for these purposes, but chiefly to manufacture,
or mine a commodity, the income from these collateral activities is
classed as non-operating income.
The distinction, then, between operating and non-operating income is,
as mentioned above, always a relative one and will be determined in
any given instance on the basis of major activities and supplementary
or minor activities. Some of the titles under which income is recorded
will now be explained:
SALES. Under this title is recorded the amount of sales of the
stock-in-trade in a merchandising or manufacturing concern. The two
elements included here, namely, the decrease of the asset merchandise
and the increase of proprietorship—the true income element—will be
discussed later.
SALES RETURNS. This title does not represent income but, as its name
indicates, shows the amount of the goods sold which have been returned
because of dissatisfaction with the quality or condition of the goods
or some error in sending the wrong kind.
SALES ALLOWANCES. These are similar to sales returns in that they
indicate a deduction from the sales income for the allowances made
to the purchasers who for one reason or another have just cause to
be dissatisfied with the goods but agree to retain them providing an
allowance from the original selling price is made.
INTEREST INCOME. Under this title is recorded the income from money
loaned or credit extended. Notes receivable and bonds are the usual
sources. Sometimes open accounts receivable also bring interest.
RENTAL INCOME. Under this title is recorded income received from the
lease of premises, lands, or buildings.
PROFESSIONAL FEES. Under this title is recorded the income from charges
made for professional services.
COMMISSIONS EARNED. Included under this title is the income received
from services rendered in the selling of commodities for a principal.
PURCHASE DISCOUNT. This represents the deduction allowed from the
original charge for paying a debt in advance of the date named in the
purchase contract.
=Expenses.=—Expenses are also of two types: operating and
non-operating. The same distinction is made here as with income. Those
expenses incurred in securing operating income are operating expenses,
while those incurred in securing non-operating income or for other
purposes are called non-operating expenses.
To secure control over the operating and non-operating types of
activities, it is necessary to compare operating income with operating
expenses, and non-operating income with non-operating expenses, in
order to measure the return by the effort expended in securing that
return. Some of the more common titles under which the record of
expenses is made are as follows:
SALARIES (WAGES). Under this title is included the cost of the services
rendered by employees. This may be classified in accordance with the
department in which the service is rendered; for example, factory
wages, salesmen’s salaries, office salaries, and so forth.
TRAVELING EXPENSES. The costs of railroad fare, entertainment, and so
forth, when traveling in the interests of the business.
ADVERTISING. The cost of publicity in making known the commodities
offered for sale by the business.
BUYING EXPENSE. The costs incurred in making purchases for the
business. These may comprise the salaries of buyers and all expenses in
connection with maintaining a purchasing department.
RENT. The cost for the use of premises not owned.
PLANT MAINTENANCE. The cost of upkeep, repairs, and so forth, on the
plant used by the business. The cost, by purchase or manufacture, of
light, heat, and power is included here.
DEPRECIATION. The decrease in value of a fixed asset due to wear and
tear, lapse of time, obsolescence, etc.
BAD DEBTS. The amount of outstanding accounts receivable which have
proven or are judged to be uncollectible.
SALES DISCOUNTS. The cost incurred because of the financial policy
of charging a customer a smaller amount than the amount of the bill,
provided he pays by a given date.
TELEPHONE, TELEGRAPH, STATIONERY, POSTAGE, INTEREST COST, COMMISSIONS
PAID, AND SO FORTH. These all indicate by their titles the nature of
the expense or cost items.
The student should understand that expenses may be set up in very
much greater detail than that indicated by the above titles. Usually
the title under which record of an expense is made will indicate with
sufficient clearness its character.
=The Profit and Loss Summary.=—As indicated in Chapter V, the profit
and loss summary shows the manner in which the net worth of the
business has been changed as the result of operations of the business,
as distinguished from changes brought about through withdrawal or
investment of capital. Although it is really a part of the balance
sheet, which shows financial condition, because of its importance it
is, however, set up as a separate statement. It amplifies and fills out
the record shown by the balance sheet. It is a supplementary record
because it gives additional information, and is complementary to the
balance sheet because it rounds out and completes the story of business
life there recorded.
Just as with the balance sheet, the main problems of the profit and
loss summary relate to: (1) its form; and (2) its content. After an
explanation of some of the terms used in connection with the summary,
these two problems will be discussed.
=The Fiscal Period.=—Because of the work involved and the frequent
incompleteness of the records at the close of each day, a daily
statement of condition is very seldom made up. The business experience
of a particular enterprise determines the frequency of preparation of
these statements. Whatever the period may be between statements, be
it a month, three months, a half-year, or a year, it is called the
fiscal period, i.e., it is the period at the end of which records are
summarized for the purpose of ascertaining the profit or loss for the
period. For purposes of comparison with preceding and following fiscal
periods, under similar conditions, the fiscal period should be, and
usually is a period of regular length—a half-year or year being perhaps
the most common, though in many enterprises it is customary to draw up
supplementary monthly statements.
=Need for the Physical Inventory.=—Again, because of the work
involved, especially where the product dealt in is small in value and
sales are numerous—as in stores dealing in clothing, food, and the
like—no record of the cost of each article is kept as it is sold,
only the sale price being recorded. It is not possible, therefore, to
determine from the records as usually kept, the cost of the goods on
hand at a given time. The records are kept in this way, not because
systems of accounting cannot be devised to make both records, but
because the results obtained by such systems are not justified by their
cost when other and less expensive means can be used with almost as
satisfactory results.
The customary method of finding the cost of goods sold was indicated in
Chapter V. Summarized, it requires that from the sum of goods on hand
at the beginning and those purchased since, there be subtracted the
goods on hand and unsold at the close of the period. This last item,
the goods on hand and unsold, is secured by making an actual count
and valuation of such goods at the close of the fiscal period. The
expedient of physical inventory-taking is therefore brought in as an
aid to the accounting records, but only in the interests of economy.
Form of Profit and Loss Summary
GENERAL PRINCIPLES GOVERNING MAKE-UP. The profit and loss statement, as
the complement of the balance sheet, is just as formal in character and
the same general considerations govern as the make-up of the balance
sheet, viz.: (1) the general purpose it is to serve; (2) the likelihood
of obscuring essential facts through too great detail; and (3) the
general appearance is to legibility, clearness of form and expression,
and arrangement on the page.
TITLE. The heading of the summary must show the name of the business,
followed by the title of the summary and the statement of the exact
period covered by it. It was noted in Chapter V that whereas the
balance sheet is a statement of financial condition as at a given date,
the profit and loss summary is a statement of operations which have
taken place during a given period. Hence, it is not sufficient merely
to state the date of the close of the period. If, as is usually the
case, the fiscal periods are of uniform length in a given business,
the phraseology “For the Period Ending ...” will be sufficient for
use within that business. It is better, however, for all statements
of operation to indicate the length of the period covered. A typical
heading for the profit and loss summary is indicated below:
JAMES R. ROBINSON & COMPANY
STATEMENT OF PROFIT AND LOSS
For the Six Months’ Period Ending December 31, 19—
ARRANGEMENT. The arrangement of the summary has already been indicated.
The income from operations, that is, the operating income, is shown
firsthand, and is followed by the operating expense, and then by the
amount of the difference or the net result of operation. Next is shown
the non-operating income, followed by the non-operating expense. The
net result of this combined with the net result from operations gives
the net result for the period, which is the figure shown on the balance
sheet, the detail of which is explained by the profit and loss summary.
=Content of Profit and Loss Summary.=—The content of the profit and
loss summary is determined by the need of information for purposes
of management. A profit and loss summary which is sufficient for a
small business, where the proprietor is in intimate contact with all
phases of the business, would not give sufficient information for the
proper control of a large business, where the managing executives are
dependent for their information as to the various phases of business
activity on reports made to them. There is, however, a fairly standard
outline or skeleton in accordance with which this summary is usually
drawn up. It is the purpose here to explain that outline.
The first section of the statement has for its purpose the separation
of the sales item into its two elements, referred to above: (1) the
Cost of Goods Sold, which indicates the amount by which the asset
merchandise has been decreased through sale of goods; and (2) the Gross
Profit or the excess of selling price ever cost, out of which must
be met the costs of operating the business before the net change in
proprietorship can be determined. This section is usually spoken of
as the “trading” section of the statement. The set-up of this section
shows, accordingly: (1) the Sales item, from which is shown deducted
the amounts of sales returns and sales rebates and allowances in order
to arrive at the figure of net sales; and (2) the Cost of Goods Sold,
under which is listed the cost of goods sold as explained in Chapter V.
This cost requires the showing of the initial inventory, the purchases
for the period, the inward costs of laying down the merchandise at the
place of business, such as insurance on goods in transit, freight and
cartage costs, and so forth. From the sum of these items will be shown
deducted the returned purchases and the amount of the final inventory,
the difference indicating the cost price of goods disposed of by sale.
With the “inward” cost of goods is sometimes included the sum total
of all buying expenses. In other cases, particularly where a complete
purchasing department is maintained, a separate buying expense section
is set up to summarize these costs.
Following this trading section comes the formal statement of operating
expenses which are usually classified for purposes of information into
the groups: Selling Expenses, General Administrative Expenses, and
Financial Management Expenses. Under each one of these groups should be
listed the detailed items. Thus, under the selling expense group should
be shown such items as salaries to salesmen; the traveling expenses
incurred by them; the cost of publicity, advertising, and so forth; the
sales management expense; and the delivery expenses, although these
expenses are sometimes set up in a group by themselves.
The student will note that under the head of selling expenses are
grouped all of the direct costs incurred in making sales.
Under the general administrative expenses should be shown such items
as office salaries, stationery and supplies, postage, telephone and
telegraph, light, heat, insurance, depreciation, and all other items
which cannot be charged to definite departments of the business but
must be borne by the business as a whole.
Under financial management expense should be listed the various items
of expense which represent the financial activity of the business as
related to its major purposes and which are operating financial expense
items. Here will be shown such items as interest on money borrowed for
operating the business; sales discounts granted customers in order to
secure cash payments from them at an earlier date than the limit of the
normal credit period allowed them; collection costs, and so forth.
A final section of the _operating_ portion of the profit and loss
statement lists the items of income arising out of the management
of the working capital finances of the business. Interest received
on customers’ notes and on cash balances in the bank, and purchase
discounts, are usually the only items of income under this head.
The difference between gross profit on sales and the sum of these
operating expenses minus the financial income, is the operating profit
of the business, sometimes called Net Operating Profit.
The section following this is devoted to the marshaling of the items
of Non-operating Income and Expense. Whichever of these two groups is
the larger is set up first, and from its total is deducted the total of
the other group. The net amount is then shown extended under the item
of net operating profit, to which it is added if it is a net income
item and from which it is subtracted if it is a net expense item. The
resulting figure is the Net Profit for the period.
Occasionally there are extraordinary items of profit or loss not to
be classified under any of the above heads, which have to be shown in
additional sections of the profit and loss statement. These are matters
which will be taken up later.
It should be noted that the above paragraphs outline a simple
statement of profit and loss for a commercial or trading business as
distinguished from an industrial or manufacturing enterprise, the
statement for which is somewhat more complex even in its general
outlines.
=Algebraic Content of the Profit and Loss Statement.=—An algebraic
presentation of the profit and loss statement is oftentimes valuable.
The cost-of-goods-sold portion becomes:
(1) Initial Inventory + Purchases - Final Inventory
= Cost of Goods Sold
(2) Sales - Cost of Goods Sold = Gross Trading Profit
The rest of the statement is covered by the following equation:
(3) Gross Trading Profit
- (Selling Expenses
+ General Administrative Expenses
+ Financial Management Expense
- Financial Management Income)
± (Non-operating Income - Non-operating Expense)
= Net Profit
=The Disposition of the Net Profit.=—The net profit for the period
belongs to the proprietor and constitutes an increase in his
proprietorship or investment, unless he has already drawn out some
of these profits as they accrued. In this case, his drawings must be
subtracted from the net profit indicated before showing the increment
to his net worth. Accordingly, a final section of the profit and
loss statement may give the disposition of the net profit and its
appropriation or addition to the previous net worth or proprietorship
item. This section, when used, is known as the appropriation section.
If the business is a partnership, this section should show in detail
the distribution of net profit among the several partners according to
the agreement among them as to the proportions in which they are to
share gains or losses. If a corporation, it should give the disposition
made of the net profit in the way of dividends to the stockholders, and
any other appropriation made of these profits, including transfer to
surplus.
Two illustrations—one very simple, the other more complex—typical of
profit and loss summaries are given for the guidance of the student.
_Illustration 1_
AARON CONNERS
STATEMENT OF PROFIT AND LOSS
For the year ending June 30, 1922
Sales for the year $28,465.20
Goods on Hand July 1, 1921 $ 8,500.00
Purchases during the year 22,362.50 $30,862.50
---------
Goods on Hand June 30, 1922 10,260.00
---------
Cost of Goods Sold 20,602.50
---------
Gross Trading Profit $ 7,862.70
Clerk Hire $3,050.50
General Expenses $2,405.45
Depreciation 52.50 2,457.95 5,508.45
--------- --------- ---------
Net Profit for the year $2,354.25
=========
_Illustration 2_
KIMBALL AND MOREY
STATEMENT OF PROFIT AND LOSS
For the Year Ending June 30, 19—
Sales $525,600.00
_Less_:
Sales Returns $ 5,000.00
Sales Rebates and Allowances 600.00 5,600.00
----------- -----------
Net Sales $520,000.00
Cost of Goods Sold:
Inventory, July 1, 19— $ 96,670.00
Purchases during the year 350,000.00
Freight-In 1,000.00
Insurance (Goods in Transit) 750.00 $448,420.00
-----------
_Less_:
Purchase Returns $ 1,750.00
Final Inventory,
June 30, 19— 105,000.00 106,750.00
----------- -----------
Cost of Goods Sold 341,670.00
----------
Gross Profit $178,330.00
Selling Expenses:
Salesmen’s Salaries $ 20,000.00
Advertising 25,000.00
Delivery Expense 5,000.00 $ 50,000.00
-----------
General Administrative Expenses:
Office Salaries $ 10,000.00
Stationery and Supplies 1,500.00
Postage 250.00
Telephone and Telegraph 750.00
Light and Heat 1,750.00
Insurance (Stock and Fixtures) 1,500.00
Depreciation:
Furniture and
Fixtures $2,000.00
Buildings 1,500.00 3,500.00
---------
Miscellaneous Expenses 750.00 20,000.00
-----------
Financial Management Expenses:
Interest Paid $ 250.00
Sales Discounts 5,000.00
Bad Debts 1,000.00
Collection Costs 250.00 6,500.00
----------- -----------
Total Operating Expenses $ 76,500.00
Financial Management Income:
Interest Received $ 1,350.00
Purchase Discounts 3,500.00 4,850.00
----------- -----------
Net Operating Expense 71,650.00
-----------
Net Operating Profit $106,680.00
Non-Operating Expense and Income:
Income--Interest on Liberty Bonds $ 2,000.00
Expense--Loss on Stocks Sold 900.00 1,100.00
----------- -----------
Net Profit for the year $107,780.00
===========
Appropriation of Net Profit:
J. H. S. Kimball, ⅖ share $ 43,112.00
H. F. C. Morey, ⅗ share 64,668.00 $107,780.00
----------- ===========
=The Two Methods of Determining Net Profit.=—It is particularly
important to note that the profit shown by the profit and loss
statement must be the same as that developed by the comparative balance
sheet, since both cover the same period and constitute merely two
ways of developing the same result. For this reason they are valuable
in proving the correctness of results, acting as checks against each
other. The student must bear in mind, however, that the increase or
decrease in net worth as shown by the comparative balance sheet must
always be adjusted by taking account of additional investments or
withdrawals of capital before the net profit for the period can be
determined, and therefore before this figure can be used as a check
against the amount of net profit shown by the statement of profit and
loss.
The accounting department keeps both classes of records, viz., the
asset and liability records and the temporary proprietorship or income
and expense records, not because both are needed to develop the amount
of net profit—either class would do this—but because both are needed
for the additional information which they give and which is valuable
and necessary for the intelligent management of the business.
CHAPTER VII
INTERRELATION BETWEEN THE ECONOMIC AND THE FINANCIAL ELEMENTS OF A
BUSINESS, AND SOME INTER-RATIOS
=Various Aspects of the Temporary Proprietorship Records.=—The profit
and loss statement has been explained as a summary of the temporary
proprietorship records kept for the purpose of registering the changes
in net worth as they occur from day-to-day, and also for the purpose
of noting the source or cause of many of the changes in assets and
liabilities. The temporary proprietorship records may be regarded as
the chronicle or history of the economic life of the business. The
efforts of the business to produce income with the least possible outgo
in the form of costs or expenses, may be viewed as the work of forces
or agencies striving towards that end. Every effort is offset by the
cost of that endeavor, and unless the result of the effort be more than
its cost, its aim, viz., the increase of net worth, is not accomplished.
=Relation between Profit and Loss and Financial Elements.=—These
income-producing efforts are the agencies that bring about the changes
in the values of assets and liabilities. Expenses and costs are
incurred for the purpose of securing income. Every expense or cost that
is settled causes a diminution of business assets, usually of the asset
cash. If not settled, it causes an increase in the liabilities, usually
the accounts payable, for the business becomes bound by or liable for
it. Both of these conditions result in a decrease in the net worth.
On the other hand, every item of income, as when a sale of goods
is made, is reflected in an increase of assets or a decrease of
liabilities. The result of every sale is usually an increase in the
cash or in the claims against persons, the accounts receivable. The
sale may sometimes result in a lessening of liabilities through a
cancellation of the claims of creditors by means of the claims against
customers arising out of the sale. This would be true when goods are
bought from, and sold to, the same person. Thus there is constantly
a direct interrelation between the financial and the profit and loss
elements of every business.
=Exchanges within the Asset and Liability Groups.=—All changes in
individual assets and liabilities, however, are not always the result
of business or economic forces. There may be an even exchange of one
asset for another asset, as when delivery equipment is purchased for
cash. The asset Delivery Equipment is increased by the same amount
as the asset Cash is diminished. Or if a bill of goods is purchased
on credit, an increase of assets is exactly offset by an increase in
liabilities. These changes are illustrated in the second example in
Chapter I, showing Runyon’s proprietorship.
It is seen, therefore, that the changes in individual assets and
liabilities are not so certain an index of changes in proprietorship
as those registered by the temporary proprietorship records. The vital
history of a business is its profit and loss record, the story of
its economic life. As a means of control this is of first importance
because it chronicles the causes of most changes in financial
condition. The statement of financial condition may be looked upon as
a picture of the framework, the skeleton of the business personality,
upon which is superimposed its economic structure. When both the
financial framework and the profit and loss summary are given, it is
possible with reasonable accuracy to tell the whole history of the
business activities for the period covered.
=Confusion between Profit and Loss and Balance Sheet Items.=—The
beginner frequently has trouble in making a proper classification of
income items and sometimes of expense items. Take Interest Income as an
example. The asset Cash Received is confused with the title Interest
Income, which denotes the source of the cash received. The accounting
department maintains both types of records. The receipt of cash arising
out of interest income would be classified and recorded under two
heads: (1) the asset Cash, to indicate the increase in that asset; and
(2) the temporary proprietorship record Interest Income, to give the
profit and loss information necessary for purposes of management.
Similarly, the beginner oftentimes confuses the sales income record
with the cash record of a cash sale transaction. Also, when cash
is disbursed for expense purposes, the decrease in the asset is
often confused with the expense record. When an expense is incurred
it brings about either a decrease in assets, usually cash if the
transaction is settled at once; or an increase in liabilities, usually
an accrued expense item if the transaction is not immediately settled.
Accordingly, in making the record the accounting department must
show the decrease in the asset or the increase in the liability in
the balance sheet group of records and the source of that decrease
or increase under some expense title in the profit and loss group of
records. Familiarity with the titles appearing in the profit and loss
statement should prevent this confusion.
=Illustration.=—To show the interactions between the balance sheet
and the profit and loss groups of records, the following illustration
is given. There is shown first a comparative balance sheet, indicating
the condition of a business at the beginning and the end of a period.
This comparative balance sheet, it will be noted, shows a net profit of
$33,250. There is also given a statement of profit and loss, showing
the sources of the income and the expenses of the business. The
statement indicates a net profit of $33,250 for the period. By starting
with the financial condition as indicated by the balance sheet at the
beginning of the period and working into it the operations for the year
as shown by the statement of profit and loss, and by using the balance
sheet at the end of the period as a goal, we can trace the probable
interaction of the two types of records for the period.
JACKSON L. GORDON
COMPARATIVE BALANCE SHEET
December 31, 1922 and December 31, 1921
Increase
and
Assets 1922 1921 Decrease
Cash $ 10,000.00 $ 15,000.00 - $ 5,000.00
Accounts Receivable 100,000.00 119,000.00 - 19,000.00
Merchandise 70,000.00 65,000.00 + 5,000.00
Unexpired Insurance 1,000.00 250.00 + 750.00
Plant and Equipment 350,000.00 325,000.00 + 25,000.00
----------- ----------- ----------
Total Assets $531,000.00 $524,250.00 + $ 6,750.00
----------- ----------- ----------
_Liabilities_
Notes Payable $ 30,000.00 $ 35,000.00 - $ 5,000.00
Accounts Payable 50,000.00 40,000.00 + 10,000.00
Accrued Sales Salaries 2,500.00 1,500.00 + 1,000.00
Mortgage Payable 150,000.00 200,000.00 - 50,000.00
Depreciation Reserve Plant
and Equipment[1] 50,000.00 32,500.00 + 17,500.00
----------- ----------- ----------
Total Liabilities $282,500.00 $309,000.00 - $26,500.00
----------- ----------- ----------
_Net Worth_
Jackson L. Gordon, Capital $248,500.00 $215,250.00 + $33,250.00
=========== =========== ==========
[1] The student should note the manner of showing depreciation reserves
in the comparative balance sheet. This is done solely for the purpose
of eliminating the detail column in the assets needed to handle the
subtraction item. This method of showing is countenanced only in
comparative statements where saving of space is a chief consideration.
JACKSON L. GORDON
STATEMENT OF PROFIT AND LOSS
For the Year Ending December 31, 1922
Sales $470,000.00
Sales Returns 20,000.00
----------
Net Sales $450,000.00
Cost of Goods Sold:
Merchandise on Hand December
31, 1921 $ 65,000.00
Purchases 305,000.00
Inward Freight and Cartage 15,000.00 $385,000.00
-----------
_Deduct_—Merchandise on Hand
December 31, 1922 70,000.00
----------
Cost of Goods Sold 315,000.00
-----------
Gross Profit $135,000.00
Selling Expenses:
Sales Salaries $ 20,000.00
Advertising 30,000.00
Sundry Sales Expense 10,000.00 $ 60,000.00
-----------
General Administrative Expenses:
Office Salaries $ 10,500.00
Insurance 3,000.00
Sundry Office Expense 2,000.00
Depreciation 17,500.00 33,000.00
-----------
Financial Management Expenses:
Interest Cost $ 10,000.00
Sales Discounts 7,000.00 17,000.00
----------- -----------
Total Operating Expenses $110,000.00
Financial Management Income:
Interest Income $ 250.00
Purchase Discounts 8,000.00 8,250.00
----------- -----------
Net Operating Expenses 101,750.00
-----------
Net Profit for the year $ 33,250.00
===========
INTERRELATION BETWEEN SALES INCOME, ACCOUNTS RECEIVABLE, AND CASH. In
these two statements, if to the outstanding accounts at the beginning
of the period we add the net sales for the period as shown in the
profit and loss summary, and if from their sum we deduct the sales
discounts allowed customers and the accounts outstanding at the close
of the period, as shown by the comparative balance sheet, we arrive at
the amount of cash received from customers during the year. This is
shown by the following statement:
Accounts Receivable, December 31, 1921 $119,000.00
Net Sales for the year 450,000.00 $569,000.00
-----------
_Deduct_:
Sales Discounts $ 7,000.00
Accounts Receivable, December 31, 1922 100,000.00 107,000.00
----------- -----------
Cash Received from Customers during year $462,000.00
===========
INTERRELATION BETWEEN PURCHASES, ACCOUNTS PAYABLE, AND CASH. The
amount of cash paid for merchandise during the year may be arrived at
similarly, as indicated by the following statement:
Accounts Payable, December 31, 1921 $ 40,000.00
Purchases during the year 305,000.00 $345,000.00
-----------
_Deduct_:
Purchase Discounts $ 8,000.00
Accounts Payable, December 31, 1922 50,000.00 58,000.00
----------- -----------
Cash Paid for Merchandise during year $287,000.00
===========
INTERRELATION BETWEEN CASH AND OTHER BALANCE SHEET AND PROFIT AND LOSS
ITEMS. If to the amount of cash on hand at the beginning of the period
we add the cash received from customers, as determined above, and that
received from interest income, as indicated by the profit and loss
statement, we arrive at the total cash available for use during the
period.
Cash expenditures have been made for the following purposes:
1. Payments to creditors for merchandise of $287,000
as above.
2. Inward freight and cartage $15,000, as shown by the
profit and loss statement.
3. Sales salaries $19,000. (This amount is determined
by considering the expense of $20,000, as shown
by the profit and loss statement, in conjunction
with the unpaid sales salaries, as shown by the
comparative balance sheet. Thus, if to the unpaid
sales salaries amounting to $1,500 at the beginning
of the period, we add the sales salary expense of
$20,000 incurred during the period and from their
sum we subtract the amount of unpaid salaries,
$2,500, at the end of the period, we arrive at the
amount of $19,000 spent for salaries during the
period.)
4. Advertising $30,000.
5. Sundry selling expense $10,000.
6. Office salaries $10,500.
7. Insurance $3,750. (This amount is also determined
by considering the amount of unexpired insurance
as shown by the comparative balance sheet in
conjunction with the cost of insurance used during
the current period, as shown by the profit and
loss statement. It will be noted that $250 worth
of insurance was in force at the beginning of the
period, that $3,000 worth of insurance was used
during the period—hence it must have been
necessary to buy additional insurance amounting to
$2,750 during the period. When we find, however,
that there is unexpired insurance at the end of the
period amounting to $1,000, it will be seen that
there must have been purchased during the period
$3,750 worth of insurance.)
8. Sundry office expense $2,000.
9. Interest cost $10,000.
10. Plant and equipment $25,000. (It will be noted from
the comparative balance sheet that there has been a
net increase of only $7,500 in plant and equipment.
While $25,000 was added to the plant and equipment
asset during the year, there was a decrease in
value due to depreciation, amounting to $17,500,
as shown by the profit and loss statement. This
depreciation expense is reflected as a decrease in
the value of the asset Plant and Equipment and does
not therefore decrease the asset Cash.)
11. Notes payable $5,000—the decrease being shown by
the comparative balance sheet.
12. Mortgage payable $50,000—also shown on the
comparative balance sheet.
If from the total cash available for use there is deducted the cash
expended, as indicated above, the difference should indicate the amount
of cash on hand at the close of the period. This balance of $10,000, as
indicated by the tabulated statement below, is the amount shown by the
comparative balance sheet as being on hand.
Cash Receipts:
Balance on Hand December 31, 1921 $ 15,000.00
From Customers, as above 462,000.00
Interest Income 250.00
-----------
Total Cash available for use $477,250.00
Cash Expenditures:
For Purchases as above $287,000.00
Inward Freight and Cartage 15,000.00
Sales Salaries 19,000.00
Advertising 30,000.00
Sundry Selling Expense 10,000.00
Office Salaries 10,500.00
Insurance 3,750.00
Sundry Office Expense 2,000.00
Interest Cost 10,000.00
Plant and Equipment 25,000.00
Notes Payable 5,000.00
Mortgage Payable 50,000.00 467,250.00
----------- -----------
Balance of Cash on Hand
December 31, 1922, per Balance Sheet. $ 10,000.00
===========
By a careful study of the interrelations between various items as
explained above, the student will see that the interactions between
all of the transactions for the year as set forth in the comparative
balance sheet and the profit and loss statement, have been indicated
and proved. The proof is secured in the tie-up between the figure of
cash as shown by the cash statement, and that shown in the comparative
balance sheet statement as cash on hand at the end of the period.
=Inter-Ratios and Their Uses.=—Before leaving the study of the balance
sheet and profit and loss statement and their interrelations, it
is desirable to explain certain ratios between items found on both
statements. These are ratios which are watched very carefully in
judging the financial condition of a business. Their significance is
apparent.
1. MERCHANDISE TURNOVER. By merchandise turnover is meant the rate
at which the merchandise stock is moved or turned over by sale during
the fiscal period. The ratio expressing the rate of turnover is found
by dividing the cost of goods sold, as shown in the profit and loss
statement, by the average inventory carried for the year. Where there
are available only the figures of opening and closing inventory,
the amount of the average inventory is taken as one-half of the sum
of these two inventories. The rate of turnover varies in different
businesses, ranging as high as 15 or 20 in some and as low as 1 or 2 in
others. The value of a rapid turnover is apparent. One dollar invested
in merchandise where the rate of turnover is 10 is equivalent to $10
invested where the rate is only 1. The more work a dollar does, the
greater the profit possibilities.
2. WORKING CAPITAL TURNOVER. The amount of sales as indicated by the
profit and loss statement, divided by the working capital—the excess of
current assets over current liabilities—as determined from the balance
sheet, is called the “working capital turnover.” This indicates the
rate at which the working capital is used in securing sales. Where the
amount of working capital on hand varies markedly at different periods
of the year, the average should be used as the basis for estimating the
rate of turnover.
3. ACCOUNTS RECEIVABLE TO SALES. The fraction represented by dividing
the amount of outstanding accounts at the end of the year by the
volume of sales during the year, indicates the portion of sales which
has not yet been collected in cash. If this fraction is multiplied
by the length of the fiscal period, expressed in months, and the
result compared with the normal credit term allowed customers, it will
indicate the trend of collections. For example, if the outstanding
accounts at the close of the period are $150,000, the sales for the
year are $1,200,000, and the normal credit period is 30 days, it will
be seen that by the above ratios the $150,000 of outstanding accounts
represents on the average the sales for approximately 1½ months
( 150,000 )
(--------- × 12 months = 1½ months).
(1,200,000 )
Since the credit term is only 30 days, the indication is that
collections are slow and should be pushed more vigorously. It must be
understood that this ratio indicates merely a trend and must be judged
in the light of other significant facts in the business.
4. PROFITS TO NET WORTH. The net profit for the period divided by the
net worth at the beginning of the period is used to indicate the per
cent of earnings on the capital invested.
=Other Ratios.=—For the purpose of watching the progress of business
operations, it is customary to develop the following ratios:
1. Cost of goods sold to net sales.
2. Gross profit to net sales.
3. Selling expenses to net sales.
4. General administrative expenses to net sales.
5. Net financial management expenses to net sales.
6. Net profit to net sales.
These ratios, set up each fiscal period and compared with similar
ratios for previous periods, indicate very definitely the trend of
income and expenses and are useful in the determination of business
policies.